Why Is The Oil Price Risk Premium Gone?

Includes: USO
by: ModernMonetaryTheorist


Current oil prices provide the global oil industry with insufficient cash flow to maintain current production over the longer term.

The recent 'Big Short' on Wall Street is oil. The focus on massive short term profits is leaving the global economy vulnerable to an oil price shock.

The Shia vs Sunni Islamic rivalry may burst into a wider regional war in the Middle East with the Saudi's decision to execute the Shia cleric Nimr Baqir al-Nimr.

Brent crude oil is trading for $35 per barrel. The price is well below what is needed to provide capital to reinvest in global oil infrastructure to maintain current supply, no less grow supply over the longer term. The fall in the rig count is testament to the lack of adequate returns on capital for most global drilling locations.

Most of the drilling locations that are profitable at current prices are in the Middle East. Almost all of them are in nations that are members of OPEC. However, the cash flow being provided from these national oil companies represent the primary source of revenue for their respective governments. All of the OPEC nations are currently running large budget deficits that are unsustainable over the longer term.

The Saudi's have led OPEC on a new strategy to go for marketshare. This is in contrast to the decades old strategy to optimize prices. Combined with an oil inventory glut, the new OPEC strategy has set up the recent 'Big Short' on Wall Street. Most private sector oil companies borrowed huge sums of money to grow production faster than their cash flow alone would allow. The fall in oil prices by 2/3 has left many companies in a difficult position to pay their debts.

Just like with the subprime real estate bubble, Wall Street shorts have pounced. They have shorted the bonds and the stocks of oil companies. Then, they have shorted oil on the commodities markets to drive down the value of those stocks and bonds. On paper it seems like an easy trade. But that is on paper.

The real estate bubble was based on bad mortgages, which were paper assets. The Federal Reserve was able to flood the financial system with "printed money" to keep the banks afloat and bring the economy back from the brink. But while oil is being traded like a paper asset, it is also a physical asset. The geopolitical risks of the Middle East have given the price of oil a steep risk premium over the last decade. Oil is trading a price that will not allow for growth in supplies. It will not even allow for current supplies to be maintained over the longer term. Clearly there is zero geopolitical risk premium in oil prices. The big question is why? There are five main possibilities.

First, oil is being technologically replaced and there is no need to maintain current supplies. Perhaps someday, but not now.

Second, the global economy is going into a tailspin and will consume less oil. No doubt the global economic picture is not pretty. But oil has been demonstrated to be very price inelastic through upturns and downturns in the global economy. The lack of confirmation in the stock and real estate markets makes the idea that oil prices are forecasting economic collapse seem remote. While oil is signaling a deflationary environment and slower economic growth, it is doubtful it is signaling an economic collapse.

Third, advancements in drilling and discovery techniques makes oil profitable at current prices. This can be dismissed based on the prices of junk bonds tied to oil companies. If oil was still profitable why are so many smaller oil companies on a path toward bankruptcy?

Fourth, the geopolitical situation is much more stable in the Middle East than it appears on the surface. Since the Arab Spring the only major oil exporting country to experience significant interruptions in supply has been Libya. Nothing to see here and no reason to panic. Hence, no reason for a price risk premium. I am not buying this idea and will soon elaborate.

The fifth reason, and the one I am buying, is that the recent 'BIG SHORT' is based on a strong desire for very high returns in very little time. So what if it isn't true, like hot potato you just have to get rid of it before the music stops. The oil market is being driven by outsized returns on the short side of the trade. As long as prices stay down more companies will go bankrupt leading to more profits for the shorts. There is currently no focus on maintaining the balance between supply and demand over the longer term in the oil markets. This is why there is no geopolitical risk premium.

But there should be a large geopolitical risk premium in current oil prices. This means a price above the price necessary to grow the future supply of oil to meet future oil demand. While that price may be debatable, it is at least something above $60 to $70 per barrel. Certainly not the current price of $36 per barrel. A large geopolitical risk premium would price oil above what is needed to maintain supply and demand in a geopolitically stable world. The Middle East has not been geopolitically stable. It may be about to come apart at the seams.

The decision by Suadi Arabia to execute the Shia cleric Nimr Baqir al- Nimr may turn out to be the spark that ignites a wider regional war in the Middle East. Hopefully cooler heads will prevail and the situation can be kept under control. But no one knows what might happen next. Saudi Arabia has cut diplomatic ties with Iran and multiple Sunni Arab Gulf States have downgraded relations with Iran in the last 48 hours. Things are moving fast.

The big difference between the Sunnis and Shia goes back to the death of the Prophet Muhammad in 632. The Sunnis believed the successor to the Caliphate should be decided by consensus and the Shia believed the new leader should be a descendant of the Prophet Muhammad. Christian wars have broken out over differences in doctrine as recently as the Thirty Years' War primarily pitting Catholic nations against Protestant nations in Europe in the seventeenth century.

Nimr Baqir al-Nimr was a Shia cleric born in Saudi Arabia. In 2007 he handed the Saudi government a petition for religious freedom for all Shia living in Saudi Arabia. The Saudi's considered him an insurrectionist and the Shia consider him a martyr. The decision to execute him has enraged the Shia in the region and further divided the Middle East along religious lines. This is very significant for the need for a geopolitical risk premium in the price of oil.

The New York Times has printed an excellent map delineating where the Shia and Sunni populations are concentrated in the Middle East:

In the map the Sunni populations are depicted in red and the Shia population concentrations are depicted in blue. Notice the concentration of Shia in the central-eastern part of Saudi Arabia.

Now take a look at where the main oil infrastructure is in Saudi Arabia:

Most of the Saudi oil infrastructure is located in the central-eastern part of the country dominated by Shia populations. There is already a hot civil war in Yemen between the Sunni and Shia that Saudi Arabia is participating in. One can just look at Syria and see how things can quickly spin out of control. The two maps highlight the need for a geopolitical oil risk premium since the death of Nimr Baqir al-Nimr.

Unlike paper assets the Federal Reserve cannot print 10 million barrels of oil per day. It is estimated there are only one to two million more barrels of oil supply than there is in oil demand on any given day. A sudden loss of several million barrels of oil would eat away the oil storage glut in a couple of weeks.

There are many ways to invest in a rapid rise in oil. The purpose of this article is to highlight the need for an oil risk premium. One can keep an eye on any quick spike in the price of oil simply by keeping track of the United State Oil Fund (NYSEARCA:USO). One can also do due diligence on large well funded oil companies like Exxon (NYSE:XOM) or Chevron (CHV) as potential investments.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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