The crisis in Egypt has raised alarm bells for global oil markets. Political risk is ‘back’, but is it priced in? Fundamentals might say one thing, but speculative pressures loom large in the horizon.
By Matthew Hulbert for ISN Insights
If any further evidence was required for the fact that we are back in a bull oil market, recent events in Egypt have done the trick. Benchmark prices breached $100/b directly on the back of political turmoil in Cairo. This is not because Egypt sits on much oil, but because it is a crucial transit route for Middle Eastern oil to global markets via the Suez Canal, and home to the Sumed pipeline linking the Red Sea to the Mediterranean. If either of these routes were to be closed, oil tankers would have to be diverted 6,000 miles around the southern tip of Africa – taken in conjunction, that amounts to over 2mb/d of oil, equal to around 2.5 percent of global supplies slipping offline.
Is this a classic case of price movements linked to fundamentals? Well perhaps; but when we consider that excess supplies still top 5mb/d from OPEC ranks alone, the record becomes a little more circumspect. It is a well known fact that speculation plays a hand in oil, and commodities have undoubtedly been driven up by recent rabid asset rotations, but the critical point is that geopolitics is ‘back’ – and it will be back with a vengeance in a $100/b world. Buckle up; the ride is about to get bumpy.
We have of course been here before. Looking back to 2008 – a consummate tale of two markets. In the run up to the $147/b July peak every scrap of geopolitical friction was used to push up prices. This ranged from the death of Benazir Bhutto in Pakistan (late 2007) to failed presidential candidate, Hillary Clinton, firing a ‘virtual warning shot’ across Iranian bows. A supposed ‘Andean cataclysm’ in Latin America between Venezuela and Colombia was the icing on the geopolitical cake for investors building up net long positions in crude oil futures. Taking note of falls in US employment figures or weakened growth in Asia was not part of the narrative: Talking the market up towards $200/b was, however, at least if you worked for Goldman Sachs.
That was until the financial crisis hit; post-Lehman’s nobody wanted to be the next ‘nightmare on Wall Street’, positions were rapidly unwound to realise capital gains and release liquidity. And although genuine demand destruction was firmly setting in as prices slumped to as low as $33/b (early 2009), the market still had more than enough geopolitical ammunition to firm prices should they have wished. The Russo-Georgian war was brushed aside and storms in the Gulf of Mexico actually depressed prices further. Evo Morales had to fight for his political life in Bolivia, while fresh Iranian threats to block the Strait of Hormuz failed to touch the sides. Political risk only mattered in as far how credibly OPEC, and more specifically Saudi Arabia, was willing to set a price floor via massive production cuts, not how high producers could blow the roof off the ceiling.
The fact that we are getting back towards a pre-July 2008 ‘geopolitical’ status, despite conflicting market fundamentals, should therefore be as interesting as it is concerning for those in the oil game. On the most basic level it is abundantly clear that markets are inherently fickle when it comes to pricing geopolitical risk in, or indeed out the market; never more so than when fundamentals start tightening. If so, the key question then becomes just how fickle are we talking? Surely if geopolitical risk is ‘back’, the market has priced it in. That’s what markets do, right? Actually, no. They are extraordinarily bad at getting political risk right, and the Egypt crisis is no exception.
Call it ‘$147/b redux’ if you will: If money can be made going long on oil you might as well capitalize on geopolitical freebies as you go along. No sooner had the barricades been broken in Cairo than talk of ‘political contagion’ in the Middle East broke out across the trading floors of London and New York. Events in Tunisia obviously provide a handy ‘straight line’ narrative; Ben Ali has fallen, Mubarak is on borrowed time, Iran is still simmering from the ‘Green Revolution’, any one of the decrepit monarchical regimes in the Gulf could be next. Saudi Arabia, Kuwait, UAE and even Qatar are all on the list, as are Algeria, Libya and Morocco in the Maghreb. Or so the story goes.
While it is no doubt true that such states share similar structural flaws and deep political fault lines – all factors that politicos go to great pains to point out – it is even truer that they have prolific track records of containing the sources of social unrest through political repression rather than addressing the underlying sources. That is the fundamental ‘call option’ here: Stability will be maintained as far as the key oil producing states are concerned. Anything else is mere political bluster.
But if the markets are already jittery about small players such as Tunisia and Egypt, it begs the bigger question of where the market will head if Iraq takes another turn for the worse, or if Venezuela, Bolivia or Ecuador enact snap expropriations? Further unrest in Central Asia could also be a problem, as could further upstream slippage in Russia. West African production has been a little stronger of late, but if MEND goes back to full scale war in the Niger Delta, or if chronic corruption in Luanda wards off fresh international investment, then the picture could rapidly change. More dramatically, Yemen could go beyond the point of no political return, with potentially detrimental effects on Bab el-Mandab that carries over 3mb/d.
Iran is an even bigger challenge. We know that Tehran will keep nudging towards nuclear capabilities for political gains; it is far less certain that it will actually go nuclear. Yet the dangers of conflating this with apocalyptic scenarios for the Middle East are all too real, either for regional players involved or trigger happy Republicans over in Washington. Close the Strait of Hormuz, and you have just wiped out around 20 percent of global supplies. And that is before we even get to discussion about the inherent risks associated with China’s ‘string of pearls’ policy vis-à-vis its Asian counterparts.
This is the crux of the problem of course: The (mis)perception of political risk can be just as potent, if not more so, than the actual risks themselves for the market. If the Egypt crisis is anything to go by, then geopolitical factors have not been properly priced in. The $8 price spike from the chaos in Cairo will look like small beer compared to the more explosive geopolitical problems down the track. This prospect should come as harrowing news for consumers. OECD states already paid a $790 billion import bill in 2010, up $200 billion from the previous year, which is equal to a loss of income of about 0.5 percent of OECD GDP. In EU terms that’s an increase of $70 billion in 2010, and in the US a $72 billionn jump. Japan has paid an additional $27 billion, while less developed nations are being hit to the tune of a $20 billion rise – a figure equal to a loss of income of 1 percent of GDP. More importantly, as a ratio of oil import bills to GDP, this equates to 2.1 percent in Europe; on par with the 2.2 percent level reached at the height of the market in 2008. One can only imagine what that must be costing emerging markets in subsidies.
Readers can probably see where the argument is going. High prices might sound like good news for producers, most of whom remain structurally dependent on oil receipts to replenish depleted state coffers. But it carries two major risks. The first is prompting potential demand destruction. The assumption in 2008 that demand had become relatively inelastic proved to be a grave miscalculation. Most producer regimes were lucky to survive the shock. Whether $100/b will break the bank again remains to be seen, but with anaemic growth in the West and inflationary pressures gathering steam in the East, it would be foolhardy to assume that anything north of $100/b would be a positive development for the global economy. Which directly links to the second risk for producers: They will rapidly lose control of the market if geopolitics starts dictating benchmark prices beyond the fundamentals in play.
Price hawks such as Iran, Algerian, Nigeria, Venezuela (and indeed Russia outside OPEC) probably have no problem with that – it’s not like they have any excess supply to put on the market anyway – but for the swing producer, Saudi Arabia, it creates the age old problem of either going along with the hawks to maximise receipts, or regain control of the market by providing greater supply. Price signals have been deafeningly silent so far to do so – not least because Riyadh has been busy blaming speculation for upward price movements rather than fundamentals. No doubt that’s partially true, but that’s the whole point: Speculators like nothing more than the risk of geopolitical calamity to make a killing. Egypt has sent a clear signal to OPEC; quell the market now, or it will politically emasculate you later.
Matthew Hulbert is a senior researcher at the Center for Security Studies (CSS). He previously worked in the City of London advising on energy markets and political risk and headed up the Global Issues Desk at Control Risks Group, specializing in political risk and security analysis for multinational companies and institutional investors. Prior to this, he held political consulting positions at Weber Shandwick Worldwide and worked in a number of parliamentary and think tank positions writing policy papers for the UK government (DfID), World Bank and Commonwealth of Nations. He holds a BA in History & Politics from Durham University and an MPhil International Relations from Cambridge. This article was published by International Relations and Security Network (ISN)