In the past few months, oil prices have sold off heavily on four major factors: a higher dollar, a weaker global demand picture, a supply glut, and the apparent easing of Middle Eastern tensions. While the first three are undeniably true, one can easily question the last point, especially on recent developments in the Middle East region.
The biggest focus in the oil market is on Iran, less for its production capabilities (4.9% of global production), but more for its geographic position. Iran, through the strait of Hormuz control the major (20% of global production) supply line of oil tankers from the Middle East. Recently, however, hopes had been that talks in Baghdad between the P5 + 1 countries and Iran would create common ground and a democratic resolution.
I questioned and still do how any major talks will resolve any of the underlying issues, especially in the context of past talks - none of which were successful. In my eyes, Iran will try everything to obtain a nuclear weapon, because without one, the regime in charge will fall. Iran has huge internal divisions, except for bi-partisan support for a nuclear Iran, which unites the people. If the current regime caves into international pressures from the west, it would be game over for the regime.
Recently, a UN investigation has found 27% enrichment levels above previous stated levels (20%), and far above the levels (4%) needed for purely "energy" purposes. This is not an isolated news story. The continued development of the defenses at Fordow Enrichment plant, which when completed will be strong enough to survive any air-strike. This plant, like one at Natanz was not disclosed by Iran, but discovered by British-American-French intelligence units. The trend is clear, Iran is trying to understate its capabilities in talks and Uranium statements, while in the meantime developing stronger and more secret reactors.
While from the US's perspective, it may still have time on the bargaining table before military intervention, for Israel the situation is vastly different. I will re-highlight comments from Israeli Prime minister Netanyu that I have written about previously;
"Israel has waited for diplomacy to work; we've waited for sanctions to work. None of us can afford to wait much longer..... As prime minister of Israel I will never let my people live in the shadow of annihilation" - Netanyahu
When Fordow is complete, only the US will have the military capabilities to attempt to destroy it. While there is a clear alliance between Israel and the US, Netanyahu does not want to be in a position where the US dictates all. Israel wants action and it needs it fast.
The threat of tensions in the Middle East, has driven oil higher many times. The Arab spring last year, and previous break down of Iranian talks have pushed oil as high as $120, as also have many previous Iranian conflicts. I feel it certain that the question of war comes back on to the table, time and time again. This will continue to boost oil prices dramatically. But, in the longer run over perhaps a 2-5 year picture, I find a war with Iran inevitable for Israel. The exact consequences of which are unknown, but the direction of oil will only be one way - up and dramatically so.
I will briefly comment on the other dynamics affecting oil and why I believe it will ultimately be positioned in a bullish manner. Weaker economic growth will not be allowed to continue for too much longer thus it is only a matter of time until another round of Quantitative easing - a risk on for all risk assets, oil higher and dollar lower. If economic growth returns to more normal levels then demand for oil will increase through more conventional means anyway. As for supply, the biggest driver has been Saudi Arabia, which has ramped up production. While there is no change in rhetoric yet, it can not sustain a budget below $80, and similarly for other nations (Russia $97 Brent). This marks the downside scenario, as these oil producing countries will do all they can to support their budgets.
I feel going long oil directly is probably the best path through an ETF such as CRUD or perhaps indirect plays as going long Russia ERUS as the best way to play Iran. The oil equity names are extremely cheap and thus offer fantastic value, but if a war breaks out it may end up hurting supply, and equities do not always follow their underlying commodity.
That been said, I am long BP, RDS.A and GZPFY.PK on fantastic valuation and a more bullish tone to the global economy than what the market prices in. Besides going long an oil major is an attractive way of covering all eventualities, while taking the upside and being paid a hefty dividend in the meantime.