Keeping a Close Eye on Impending Risk of Oil Price Spike

The biggest risk of higher oil prices looks to be the latest storm brewing in the Middle East. Our contention has been that oil prices are destined to slip back to their pre-stock-bounce range once economic reality sets in and demand remains persistently low. To that end, we own a hedge against falling oil prices.

However, the likelihood of military action against Iran by either the US, Israel, or both is growing, and such action would cause oil prices to spike. Let's look at the situation and chance of an attack, and why it would put upward pressure on oil prices.

In April, the Obama administration granted Iran until Sept. 24 to open talks with the five members of the UN Security Council plus Germany, a group referred to as P-5+1. The consequence of not doing so was going to be harsh sanctions. Since then, Obama extended a fig leaf to the Islamic world with his friendly speech in Cairo, the appointments of special envoys George Mitchell for Israel/Palestine and Richard Holbrooke for Afghanistan/Pakistan, and soft-edged diplomacy intended to reverse harsh feelings left over from the Bush years.

The result of the fig leaf has been impressive when judged by the content of warm speeches all around, but not so great when judged by the list of concrete steps to improve upon America's interests in the region. Terrorist activity has not declined, Mitchell was unable to change the situation between Israel and the Palestinians on the settlement issue, Holbrooke hasn't improved the Afghanistan War situation at all, and, most vital to our discussion, Iran hasn't budged in its nuclear ambitions or even attitude toward the US and the P-5+1. It's now past the Sept. 24 deadline, and the situation technically calls for sanctions to be applied. Will they be?

Apparently not right away, because the talks have been rescheduled to start this Thursday, October 1. Few are holding their breath for the talks to mean anything, anyway, so attention is already turning to what will happen when Iran changes nothing.

If the sanctions are applied, they need the cooperation of China and Russia in order to work. Either country could supply Iran with all the fuel it needs, and both countries have expressed their disapproval of the sanctions. So, the sanctions are looking like a joke.

That leaves an attack as the most probable way of thwarting Iran's nuclear plans. It would likely involve both the US and Israel, because either country's initial entry into a fight with Iran would draw the other in. Israel can't go it alone against Iran and the US won't let Israel come out of a conflict worse off.

Besides, the first thing Iran would do in case of being attacked is close the Strait of Hormuz, which would bring the US immediately into the fight. In July, Iran's oil minister issued the threat and received the US response, as reported by Fox:

The US Navy and its Gulf allies will not allow Iran to seal off the strategic Strait of Hormuz if the country is attacked, the commander of US naval forces in the Gulf said Wednesday.

The warning comes as Iran's oil minister vows that any attack on his country by the United States or Israel would provoke an unimaginably fierce response.

The announcement by Vice Adm. Kevin Cosgriff, commander of the 5th Fleet, came as he was holding talks with naval commanders of Gulf countries at a conference in the United Arab Emirates capital of Abu Dhabi. The one-day meeting was to focus on the region's maritime and trade-route security and the threat of terrorism.

The 5th Fleet is based in Bahrain, across the Gulf from Iran. Cosgriff said that if Iran choked off the Strait of Hormuz, it would be "saying to the world that 40% of oil is now held hostage by a single country."..

Here, we run up against the risk of an oil price spike. Whenever 40% of the world's oil supply is perceived to be held hostage, prices will spike.

That's where we may be heading. Monday, Iran test-fired missiles that it claims can hit any regional target. That came on the heels of the US and its allies expressing concern that not only has Iran not slowed down its nuclear ambitions, but has in fact grown them by building a second uranium enrichment facility.

There is always the option of doing nothing, but that would make the US look unbelievably weak to sit by idly while Iran makes nuclear weapons. It would also force Israel to go it alone, which would cause Iran to close the Strait of Hormuz, which would draw the US into the fight anyway. Doing nothing would be about the worst option because the US would look weak and still end up in another military action.

Thus, as Iran moves ahead, the options before the US are sanctions that won't work, a military strike that will result in the Strait of Hormuz closing for a brief period, or doing nothing until forced into joining an Israeli military strike that causes the closing of the Strait of Hormuz for a while.

As you can see, the odds are pretty good that we'll see the Strait of Hormuz close in the near future, which will send oil prices higher. That's why we're watching this issue carefully, and may need to sell our oil hedge soon.

Disclosure: Long PowerShares DB Crude Oil Double Short (DTO)

Comments

[Ferdinand E...:]

This is a brilliant article that needs widespread circulation. At the same time however, remembering all the very intelligent Iranians I have met or taught, and believing that there must be similar persons in the Iranian government, it must be possible to substitute some constructive conversations (of one sort or another) for war.

The author is correct in using the word spike, although this spike might turn into a sustainable rise. For those people who attribute the oil price rise in 2008 to speculation and the purchase of millions of barrels of 'paper' oil, they will find out what happens to an oil price if a couple of million barrels per day of physical oil leaves the market.

Sep 29 09:33 AM

[BullnBear:]

Great summary/timeline and great capture on the Strait of Hormuz which of course seems to be lost in all of this and is probably one of the biggest issues involved with Iran other than the nuclear weapons concern.

Sep 29 09:55 AM

[chap08:]

Interesting. I'm no expert here, but a few thoughts:

1. I understood that Russia were not going to obstruct or bust sanctions. This was part of the "understanding" over missile shields.
2. Either way, I think that they will pursue the sanctions route until there is absolutely no hope.
3. If Russia has been persuaded not to be unhelpful, then China could be too. They don't want a conflict in the middle east either and they have more to lose than Russia (who in some respects stand to gain). However, there would be a price to pay to the Chinese. This might be an understanding on trade. Alternatively, could it possibly even be an understanding on future US monetary policy?

Sep 29 09:57 AM

[whisperonth...:]

We slap a tariff on China, we punch Iran with sanctions, and this results in friendship? What is this administration thinking of? We are already at war with two different countries. If we add two more (and that's assuming North Korea just sits on the sidelines and keeps score), then what? Is this how we put the country's autoworkers back to work?

At what point do we stop and take a breather - settle down and work on getting jobs for our own people?

I'm not anti-war, but there is a limit. Are we, or are we not, a kinder, gentler nation? Exactly how is this CHANGE? War is war. Or are we to sit back and say, "Hooray, Obama brought our boys home from Iraq. Now they can go to Afghanistan/China/Iran instead!"

People, what are we doing???? The price of oil won't matter, because we will be fighting off everyone in our own backyard. Or is this how we finally decide to drill here at home?

Sep 30 08:58 AM

[realold:]

I think that your arguments are interesting but your conclusion is incorrect. Israel will not strike alone and will be encouraged not to do so by the U.S. The U.S. will do nothing because Obama is a public relations B.S. president and will do nothing even close to attacking Iran. Jeez! He cannot even get enough backbone to DECIDE what to do in Afghanistan. Besides, he needs the money for his wealth transfer schemes at home. Nothing will be done and Iran will continue on. Obama will shrug his shoulders and lobby for the Olympics in his home town.

Sep 30 11:29 PM

[realold:]

ps. Nothing can really be done about nuclear proliferation. You cannot stop all scientists everywhere when the technology is old hat. You will end up attacking the whole globe. It is what it is.

Sep 30 11:33 PM

[realold:]

pps. A few nuclear explosions in the right place would put a sudden halt to global warming worries - nuclear winter. So, look on the bright side.

Sep 30 11:34 PM

[meridian575:]

We NEED to stop relying on oil. We don't have enough, and the reserves in Alaska are tied up in the beurocracy and are more difficult to acquire than other locations. Canada has shale oil but the aquisition and production costs are, at the moment, too high to justify its widespread usage. I have been reading up on the Natural gas reserves, and get mixed opinions myself of how effective it may be in reducing oil dependence. Some figures I have seen quote that the natural gas reserves in this country alone are enough to sustain our population for the next 80 years at current production estimates.
Yahoo Finance has a link on the DOE Clean Cities Program which was earmarked $300 million with the goal to advance the number of alternative vehicles on the road. And that includes all technologies, electric, hybrid, biodiesel, ethanol, but also propane and natural gas.
Take a look at YAHOO FINANCE:
finance.yahoo.com/news...

Oct 01 11:50 AM

[a. palmer jr.:]

I understand that around 20% of our imported oil comes from the middle east. So, with all the other countries relying totally on the middle east for their oil, why is it exclusively the problem of the United States? I might say, also, that the United States doesn't seem to want to drill (or redrill) for oil, at least the liberal politicians don't so they'd better come up with a sustainable alternative quickly or just cut back our usage more than 20%.

Oct 05 09:19 AM