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Oil Prices: Irrational Complacency - A Perfect Storm Gathering Photo:
 
 
Tim O'Brien | Sep, 04 2014 | 6 Comments

There is pain at the pump heading our way. And it’s all to do with one word: “uncertainty”.

That one word can change markets in the blink of an eye. And in a market so heavily traded on futures, as is the global oil market, “uncertainty” can send a market into an upward gallop as readily as it can send traders rushing to the lifeboats.

Despite a complacent market - it is only in the past few days that Brent, the international oil benchmark, has edged upwards to around US$103 a barrel - the seriousness of the geopolitical tensions in Europe and the Middle East, should they suddenly worsen, will quickly shake this complacency out of the market .

When it does, because imbalances in the supply side - like Saudi Arabia turning on the taps - have been obscured by subdued demand, oil prices, which can turn on a nail, will take off at a gallop.

Here’s why.

First, Russian armaments, and now soldiers, in the Ukraine.

Each day, Moscow and Kiev inch closer to all-out conflict. And, such is the bellicose intransigence of Putin and the irrational hubris he rides at home as ‘the defender’ of all Russians, it is unthinkable that he might back down - whatever the pressure from Germany and the European Union.

He knows, or thinks he knows (and is banking on it), that with Europe heading into winter, it needs him. More to the point, Europe needs Russian oil - all 3.0 million barrels per day (bpd) it currently supplies the EU.

Oh yes, and Ukraine, and Europe, also needs Russian gas.

In fact, the current confrontation between Russia and the Ukraine sits against the backdrop of a festering energy-supply dispute: the Ukrainian national energy company Naftogaz owes Russia’s Gazprom no less than US$11billion under a “take or pay” clause of a 2009 gas-supply contract.

Ukraine refuses to pay, disputing two successive price hikes earlier this year taking the price of gas supplied by Gazprom from an "acceptable market price" of US$268 per 1000 cubic metres to $485.50.

Ok, gas isn’t oil. Unfortunately, the collapse in Europe/Russia relations also has ramifications for oil.

Currently, 84 percent of Russia’s oil production goes to Europe, as does more than 30 percent of its gas production. Collectively, Russian gas and petroleum exports to the EU topped €166.3billion in 2013.

If relations deteriorate further, worse, if the conflict escalates and Russia ceases its charade and shows its hand with troops and heavy armour under a Russian flag, the hardening stance of Europe to Russia’s ambitions on its Eastern borders will compel the EU to ‘cut the pipeline’.

Of course, Europe’s loss will be China’s gain (but also Russia’s loss).

While Russia has increased oil exports to Asia to 1.3 million bpd, and exports to Europe have decreased from 3.72 million to 3.0 million bpd, it has a tougher time of it doing business with its old foe China.

There are no emerging signs of any détente between the Ukraine and Russia; the reverse in fact, each day it looks bleaker and the stupidity of conflict more inevitable.

That will force Europe’s hand in sanctions, and force Europe to look to secure its fuel and energy supplies elsewhere.

“Elsewhere”, in large part, means back to the arms of the OPEC cartel: Iran, Iraq, Kuwait, Saudi Arabia, Nigeria, Angola, Libya and Venezuela et al.

Collectively, OPEC produces just over 30 million barrels of oil per day (bpd)

But with murderous lunatics with very big guns running rampant in the Middle East, with clear signs that Iraq will likely lose forever the notion of a ‘central government’, and with things looking bleaker there by the day with the amassing on Iraq’s borders of 30,000 Saudi troops and its Shiite foe, Iran, with its Revolutionary Guard troops active within Iraq - not to mention the escalation by degrees of America’s involvement - there is potential for vast disruption.

Let’s put the other pieces together.

Libya has Africa’s largest oil reserves, but remains in turmoil.

In 2011 it was supplying 1.59 million bpd to the global market. With a government there that had lost key ports to militias (more thugs wirh guns), then regained control, supply dropped to just 220,000 bpd, recovering in August to 500,000 bpd - still a long way short of its 2011 output.

Production in Nigeria has been down by more than 10 percent for most of 2014, climbing in August by 380,000 barrels to 2.3 million bpd.

But output there is regularly disrupted by unrest in the Niger River delta, and it has its own bunch of religious loonies running around with guns and bombs and a growing threat to production in the north of the country.

And then there’s Iraq itself. It produces around 3.25 million bpd, amounting to around four percent of global production of 92.7 million barrels.

While the nutters are running rampant in the north, production from its oil wells in the south have not yet been affected. But with a fragmenting government, and fragmenting country, for how long?

Some analysts warn that if “even just a third of Iraqi oil production went offline”, global crude oil prices could rise by as much as US$40 per barrel. (Dr Kent Moors: Oil and Energy Investor.)

Take just one or two of these significant suppliers out of the market, add a European market turning off the tap with Russia, and, history shows, the price of a barrel of oil can quickly skyrocket.

They rose nearly 50 percent from 1988 to ’90 (from US$14.92 to a high of US$23.73 a barrel) amid the sabre-rattling in the lead-up to the first Gulf War and then jumped from US$28.83 in 2003 to US$138.73 in June 2008 in the mess that followed the second Gulf War.

Given the confluence of negative events we’ve witnessed this year, all rapidly worsening by day, and that history of precedence, the current complacency in the market would seem to be resting on very shaky foundations.

Of course, the market may prove right, that demand will remain subdued, that increased production globally and a self-sufficient North America will keep the pressure off prices.

And that things are not going to turn totally pear-shaped in the Ukraine and the Middle East.

Even the US Energy Information Administration (EIA) predicts Brent crude to average around US$107 a barrel over the second half of 2014 and to decline slightly to US$105 a barrel in 2015.

It predicts a similar softening in West Texas Intermediate (WTI) crude.

But for how long will price stability withstand Putin’s brinkmanship? And, right now, who in their right mind would place a bet on the Middle East?

I wouldn’t put my house on it.

It will, in fact, take very little for the seeds of uncertainty to sweep through oil markets. Go back to the start of this piece: oil markets rise and fall on ‘futures’ trading - on second-guessing where the market is likely to head.

Traders trade on what they think the market will look like next month, six months or even 12 months ahead. It’s the traders who really set the price of oil, who drive it up and - equally - drive it down.

And uncertainty, any volatility, any prospect of interruption to stable supply, will most certainly drive it up.

With geo-political tensions as they are, the comfortable sentiment behind the current complacency will easily be upset. The IS crisis in Iraq spreading south, or escalation in the Ukraine - each will do it, exactly as it’s done before.

When the shift comes, it will come quickly. As soon as traders sense there is money to be made from tightening supply and a disrupted market, the barrel-price will gallop.

And how will that effect pump prices in Australia? In the absence of other factors like currency fluctuations (and there is no absence of other factors), any rise in the barrel price on global markets hits Australian pump prices almost immediately.

That’s a little legacy of ‘world parity pricing’ and our pump prices taking their lead from Singapore’s MOGAS 95.

But if the barrel price returns again to the US$138.73 price per barrel it hit in June 2008, we’ll most certainly see a return to pump prices of $1.60 per litre, and worse.

And if it rises more, the pain will really begin.

Tim O’Brien
TMR Managing Editor

Price data sources:
www.oilandenergyinvestor.com
US Energy Information Administration (www.eia.gov)
www.oilprice.com
Bloomberg

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