Oil: A Slippery Risk Premium

Oil is a commodity, but it's also something more. Therein lies the complication - and risk and opportunity.

The dual status of oil as raw material and proxy for global macroeconomic risk dates to at least the 1973-74 oil crisis, when OPEC waged an economic war against the West with crude as its primary weapon in support of the Arab attack on Israel. Although oil was used previously as a strategic weapon, the events of 1973-74 elevated the commodity's profile on the global stage on that front to unprecedented heights. Since then, oil's price has reflected the forces of both supply and demand, and global risk perceptions.

Supply and demand are almost always the dominant pricing factor. Global risk's influence on price, by comparison, waxes and wanes. In the late-1990s, the risk premium in oil was relatively low; today, it's quite high.

No one can say for sure how much risk impacts price for oil on any given day. But it's clear that crude is not just another commodity. Yes, gold too is influenced by global risk, but gold has no strategic economic use. Jewelry and industrial demand are pricing factors for the precious metal, but those applications are hardly critical in the global economy. In any case, most of the gold mined in history sits in vaults and safe-deposit boxes and so no one worries about a shortage. The only question is price, which is largely driven by sentiment and the vague memories that the metal was once used as legal tender. We don't discount gold's value as indicator of danger in the world economy, but in terms of practical applications it's virtually irrelevant next to oil.

Oil's dual role is no secret, of course, and much ink has been spilled over the years on the subject. Yet it seems that some analysts don't fully grasp the implications. There's no shortage of research focused on oil's economic status in isolation of the political risk, a narrow view that leads some to wonder why the commodity's price remains so high. Cries of "the fundamentals don't support the price" are common. A number of observers of the energy scene have gone so far as to charge that speculators are to blame for the bull market in oil, insinuating that buying the commodity's futures contracts, either directly or through publicly traded funds such as commodity ETFs, is somehow illegitimate if it's not tied directly to refinery activity.

In fact, such claims overlook the fact that going long oil offers a hedge on global risk. At the moment, there's no shortage of risk fears. Perhaps at the top of the list are reports of Iran's recent threats to block the Strait of Hormuz--through which 40% of the world's oil moves--if and when it's attacked.

More generally, there's an ongoing apprehension about oil and its potential to destabilize political and economic plans. "We do have to do something about the energy problem," Secretary of State Condoleezza Rice told the Senate Foreign Relations Committee in 2006, via Spero News. "I can tell you that nothing has really taken me aback more, as Secretary of State, than the way that the politics of energy is… ‘warping' diplomacy around the world. It has given extraordinary power to some states that are using that power in not very good ways for the international system—states that would otherwise have very little power."

Some of oil's status as more than just another commodity resonates on the global stage in ways that aren't always obvious. Take China's growing appetite for energy to support its economic growth. The Middle Kingdom's search for reliable sources of oil have pushed Beijing to invest far and wide, sometimes bringing economic resources and money to nations that the U.S. considers something less than a strategic ally. Oil, in short, creates a broad array of tensions in the world.

The challenge for strategic-minded investors is separating the risk-premium in oil's price from the pure economic factors. This is inherently a speculative task and so no one can be confident that they understand how much of oil's price is affected by risk considerations vs. supply and demand analytics. Nonetheless, the biggest risk is underestimating, or ignoring the potential for an oil risk premium--which can and does fluctuate widely over time.

In fact, the risk premium itself is the source of a significant amount of risk. Because its driver is sentiment, it can rise or fall dramatically, sometimes overnight. Or, it may adjust slowly over time, almost imperceptibly, catching economic-focused oil analysts by surprise.

In a perfect world, someone would model the oil risk premium and create an ETF to track its synthetic value. Alas, risk isn't always so open to quantitative analysis and hedging. No wonder, then, that speculation and guesswork are rife when it comes to pricing oil, a necessity that leads to mistaken estimates at times, if not routinely. But as hazardous as this terrain is, the landscape is even more so if you ignore the oil risk premium and its capacity for laying waste to the best laid plans of mice and men.

Comments

[Bruce Pile:]

The 70's had a significant geopolitical element in it's oil pricing. The oil import dependency of the world outside the Mid-East was a rude awakening back then, and a speculation component in oil price was induced. But the situation then and now is comparing apples and oranges.

Oil must be stored in vast amounts to be speculated on for any significant length of time. Back in the 70s, it was bought and stored as an import days-of-coverage safety measure - a lot of it. Besides the birth of the SPR back then, commercial storage climbed to historical highs - a speculation "element". This had its downside in 1986, when the Mid-East chaos of the 70s had cooled down for awhile and oil prices had eased thanks to the death of the 15 mpg land barge in the U.S. and a bad recession. Much of the inventory oil was put on the market aggravating a $30 to $15 slide in oil.

But today, the speculation element is nothing like it was back then, Import days-of-coverage are at historical lows, in fact. In the 70s, it was a combination of embargos, speculation, and a huge demand surge (cause in large part by the birth of carefree land barging) that drove a 900+% climb in the price of oil. The main cause was the demand surge; there was no embargo that lasted the whole decade. As Matt Simmons points out in his book Twilight, the brief embargo of '73 was merely the lit match that ignited the climb that would have happened anyway. Today, we have a vastly larger demand surge from India, China, and their like. Back in the 70's, we had much spare production capacity to deal with a surge, and prices went up 900% anyway. Now we have essentially no spare capacity in light sweet and dialing demand back down will be far more difficult than switching size of car or having a U.S. recession. Every barrel of destroyed U.S. demand will be gladly bid on by those BRICs who can afford it with much more robust economies. Oil demand destruction could be a blessing in disguise for BRIC - a sort of Fed type brake pedal to moderate their growth to stable, sustainable levels. This would be at the cost of the U.S. economy, of course, which needs a gas pedal so bad, it's president mails out tax money to spenders. BRIC can gladly take the oil we can't use, trade amongst themselves, and leave America to drown in its energy policy (and other policy) stupidity. They have been the global village idiot of energy policy for too long now. The first letter of BRIC, Brazil, embarked on the energy moves that political idiocy killed in the U.S.A. soon after the 70s.

2008 Jul 07 08:48 PM

[Ames Tiedeman:]

When does oil crack and go back to 100?

2008 Jul 08 07:36 AM

[Jack Yetiv:]

Oil does NOT go back to $100. OPEC will not let it. They will cut production.

Libya threatened to cut poroduction recently when oil was about $135; do you think they won't do it if oil threatens to approach $100?

Jack

2008 Jul 08 01:19 PM