So You Think Oil’s Expensive Now?

Oil’s move above $140 a barrel and the pronouncement by OPEC that oil prices could rise between $150 and $170 a barrel this summer is another hit for US consumers whose budgets are already at the breaking point. In addition, rumors on Tuesday that Israel had bombed Iran’s nuclear facilities resulted in a sharp spike in oil prices, reminding investors how painfully delicate the market is.

While many speculators have lauded the news that Saudi Arabia will increase oil production, oil prices have more than doubled over the past year over rising demand by China and India and supply disruptions in the Middle East. Moreover, there are a number of plausible scenarios—taken from today’s headlines—that could greatly impact world oil prices and take an even greater toll on US consumers. We doubt that these risks are fully priced into the market.

A Major Act of Piracy: Far from being eradicated, maritime piracy is making a comeback. Pirates are operating more brazenly in the lawless areas off the coast of Somalia and the Gulf of Aden, a lifeline for European energy and goods transporting through the Suez Canal. Just Tuesday, a European yacht was seized by pirates; more ominously, last October a Japanese tanker carrying highly flammable benzene was briefly hijacked before a US Navy destroyer came to the rescue. The chances are good the pirates will eventually succeed in landing a “big fish.”

(Another) Hizballah-Israel War: The threat of Hizballah, which, with the help of Iran, is re-arming at an alarming rate on Israel’s northern border, is a truly grave concern to Israelis. Hizballah considers its 2006 war with Israel a strategic victory, and both sides are on a hair trigger. Add to the mix the recent political turmoil in Beirut, in which Hizballah expanded its political grip, and the threat of escalating hostilities that could crossover into neighboring states like Syria and Jordan looks possible.

Escalation of Nigeria Conflict: Last Thursday’s attack on a Shell (RDS.A) oil field off the coast of Nigeria which caused Shell to shut production at the Bonga oilfield caused shivers all over the oil industry, showing definitively that deep-water fields were vulnerable to attacks by Nigerian militants, a notion that had previously been discounted. The Nigerian government has talked a lot in recent months but effective security measures have so far not materialized. The Movement for the Emancipation of the Niger Delta announced a cease-fire Tuesday, which probably means they believe they have the upper hand -- they may be right.

Attack in a Gulf State: Saudi Arabia's Interior Ministry reported Wednesday that authorities have disrupted terrorist attack plans against the kingdom’s oil industry and arrested more than 700 militants. This coupled with the recent fourth anniversary of the Saudi militant attack on a Saudi Aramco oil refinery in Yanbu demonstrates the vulnerability to disruptions of a key source of Western oil. Mirroring threats in the kingdom, in mid-June, the British Foreign Office issued a warning there was a “high threat” of a terror attack in the United Arab Emirates, a report largely overlooked in the American press. Considering the UAE’s relatively newfound role as a regional finance as well as energy production hub, it’s hard to overstate the psychological effect such an attack would have on investors throughout the developed world that have been flocking to put money into the country.

Any Significant Terrorist Action: Targets abound -- a who’s who list of international militants with ties to rogue states are ready to seize the world’s attention and spike oil prices to a all time high. Take your pick: the United States in the run-up to the presidential election, China before or during the Olympics, or Europe during the UEFA (soccer) finals are all juicy targets and any type of spectacular attack, particularly coming in the wake of economy-influencing natural disasters in Asia and the US, would cause tremors in the energy markets. Even if ultimately unsuccessful in terms of overall body count, such an attack would have a powerful psychological effect on the populace, and global financial markets.

Hopefully none of the dire scenarios will come to pass and with luck, worldwide summer energy demand will abate and autumn will herald a new era of more manageable fuel prices. That said, has the market fully priced risk into the cost of energy? It seems unlikely.

Comments

[fxtrader07:]

that market hasn't priced in anything. it is just in a crazy mood. if none of these events occured, the price is way too high. if any of it happened, it is too low.
as for now, the mere possibilities are taken to justify the current run-up and they will probably still serve as an excuse when oil hits 160$

2008 Jun 27 09:07 AM

[johnhaskell:]

what if we have extracted half of the total extractable oil in the world? I know it's forbidden to suggest that we have reached "peak oil," or to even put the words "peak" and "oil" in the same sentence, but if that is the case you won't have to think up various James Bond scenarios to justify a higher oil price.

2008 Jun 27 12:49 PM

[carbonates:]

These are only the events that would cause a short-term spike in price. Contrary to the rhetoric from Washington, there are major structural problems in the market that weigh much more heavily than these short-term events. Bigger and more important questions abound. Can the Saudis actually increase production or are they at peak? (With over 100 rigs operating, they are obviously working very hard to maintain production). Can the Iranians sustain production? They may be in decline. Will the Russians begin investing in infrastructure that is badly needed to reverse Russia's production decline? Will the US change its tax structure and cause oil production in the US (currently 25% of US consumption) to further decline? (a significant amount of US production comes from stripper wells that are marginally profitable under the current tax regime) Will Mexican and Venezuelan production continue to decline? Will the portions of the world that subsidize consumption (Venezuela, Middle East, China, Indonesia, India, Malaysia, Columbia, Mexico, Taiwan, Thailand, etc) of oil continue to do so, offsetting and preventing demand destruction? These types of questions are much more important and fundamental than these short-term and local risks. For example, until the Saudis can prove they can meet the projected new levels of production, it is apparent that the market does not really believe them. Since the majority of buyers in the market are currently commercial positions (industry participants) it seems likely they truly understand the short term risks but are much more uncertain about the long term factors, and that risk is probably being priced in incrementally as oil prices fluctuate. BTW, you forgot hurricanes. Another major Katrina/Rita hit on the Gulf would cause a major price spike. It is hurricane season.

2008 Jun 27 01:00 PM

[dtblount:]

ridiculous article...of course those risks are not "fully priced into the market." with such general geopolitical "risks," as these, anyone can run down a list of worst case scenarios that will affect the price of oil...such as "war between two large economies," "rogue regime acquires nuclear weapon," "bad thing happens," and the list could go on and on. if the article is intended to illustrate the fact that oil is a volatile commodity, coming from some very volatile parts of the world, and heavily dependent on geopolitical issues, then i'm quite certain any halfway-intelligent investor is aware of this.

2008 Jun 27 02:25 PM

[Black Corsair:]

What a rediculous paranoic, american stlyle article !

2008 Jun 27 02:35 PM

[The Watcher:]

Sadly enough, until that day is upon most will not believe.

2008 Jun 27 03:02 PM

[Loup-Garou:]

"All" the risks are unknown, and cannot be fully priced in. Many oil related stocks still trade at low multiples of earnings, as though the "correct" price is $70 bbl. Some of the potential supply disruptions are very real and have high probability. The demand destruction factors seem to be over the horizon.

Now we see through a glass darkly. After Labor Day we shall see more clearly.

2008 Jun 27 03:02 PM

[King of Sanity:]

Let's see how many excuses we can make in an attempt to justify the mauling that is happening to millions of people with the ever increasing price of Oil. I would love to know what has gone so wrong this spring and summer as compared to last summer when oil prices were well below $3.00 a gallon. I would say that very little has happened these past 3-4 months to justify this raping of the pocket books of people trying to survive this onslaught. My wife and I have bought a nice little Prius. This is the best way we can to the oil robber barons to kiss off and stay out of our pocket book!

2008 Jun 28 12:14 PM

[Ronmac:]

King of Sanity...you have taken the exact correct approach. High prices are their own solution. Unless, of course, the idiots in Congress try to get involved.

2008 Jun 28 12:36 PM

[Still Laughing:]

KoS - you know while you're right and maybe the best thing would be to just let the speculators drive it up and eat the loss, I'm still trying to grasp the half-assed economic logic of the "low supply" argument.

So many people are trying to say that it's high because supply is dwindling, but these are futures that are being traded and not gas which means they expect the price to continue to increase. However, how can the price continue to increase when it is heading past the point of being more expensive than a substitute energy and the research cost to develop it. It's like half of Wall Street was only paying attention in economics class to a basic supply and demand curve and missed the opportunity cost and substitute good lectures. The tragedy is that unlike other "bubbles", energy behaves like a tax and and the true cost of speculation isn't the gas high price but the slowing overall slowing of global GDP.

2008 Jun 29 02:05 AM

[Max Petrisek:]

The oil pricing system is out of control or just crazy! Soon there will be a real crisis caused t by speculation driving up oil prices!!

2008 Jun 29 11:34 PM