Will the Arab Revolution Result in Higher Oil Prices?

Includes: OIL, USO
by: Sean Bellamy McNulty

The recent oil price activity is relevant to every investor regardless of the particular market sector the individual is invested in. This is due to the prevalence of oil as an input into our current way of life. For an exhaustive look at how this pertains to a diverse range of industrial industries, see "On the dynamic effects of oil price shocks: a study using industry level data" by Kiseok Lee and Shawn Ni. A brief example can be seen below in a graph of food and oil prices:

This intuitively makes sense when you consider the farm equipment and transportation infrastructure used in the production and distribution of food. Multiply that out to everything from your new iPad to the gorgeous black dress your date wore to the David Gray concert this weekend and the interwoven nature of the world's modern economy begins to take shape.

After the past few weeks and months of turmoil in the Middle East, the question now becomes is the situation beginning to stabilize or are we in the proverbial "eye of the storm"?

To forecast the potential for revolt and subsequent disruption of the Oil supply, I'll use The Economist's newly created Shoe Throwers Index, a weighted index that measures the share of the population under 25, number of years the government has been in power, corruption, lack of democracy, GDP and censorship, then creates a bar chart indicating the index of unrest in each country.

Interestingly, this index was published on February 9th, 6 days prior to protests erupting in Benghazi, Libya, indicating that there's truth to the metrics rather than it being a case of curve fitting.

Based off of this index, I then compiled an excel chart with each respective countries oil production per day:

The source of the fabulous lifestyles of Saudi Sheiks becomes quiet obvious.

I then research the worst case scenario in terms of which countries could be home to a revolt, firstly eliminating countries that rank below 50 on the Shoe Throwers Index (Tunisia, Morocco, Bahrain, Lebanon, UAE, Kuwait and Qatar), and secondly eliminating countries that for better or for worse, the USA would back with its military might (Saudi Arabia, which is also low on the Shoe Throwers Index, and Iraq). The math works out as follows:

Therefore, the absolute worst case scenario, and a highly unlikely one, is a 7% disruption in oil production. Saudi Arabia has said that it will step in to fill the supply gap, but there will be a significant lag in them doing this, as well as questions about their actual reserve capacity with Wikileaks revealing last month that their oil reserves are potentially 40% overstated. Thus I'll assume that the Saudi's ability to step in is marginal at best.

How the market has priced this risk in:

Oil has been trending upwards the past 6 months, with the average price in the $87 range. The highlighted section of the graph is the time period of February 1st to the 15th, the days leading up to the Libyan revolt, with the subsequent spike from $84 to $104 afterwards.

This represents a 20% increase in prices, and with the aforementioned worst case scenario being a 7% disruption in daily oil production, this spike can not be accounted for by the Arab revolution. The market could be pricing in a robust recovery in the states, but given the latest job numbers, continuing decline in home values and the stage we're at in the de-leveraging process, a 20% jump is not warranted.

So short oil? It's not quiet that simple. To paraphrase Keynes, the market can stay irrational longer than you can stay solvent, and I don't believe the "hype" is over yet. But I do expect in a 6 month to 1 year time frame oil prices will retract to the range they were trending in.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.