Missing Risk Premium Could Lead To Oil Price Shock

| About: SPDR S&P (XES)


Due to high oil inventories, there is essentially no risk premium being factored into the price of oil.

Confrontation is brewing as Saudi Arabia, Gulf Cooperative Council nations, Israel, and the U.S. all firm opposition to Iran.

The recent actions against Qatar by GCC nations and U.S. missile deployment in Syria are not good signs for peace.

The real risk to oil production in the Middle East is in Iraq, which looks like a sacrificial lamb, and Iran, which can't win an all-out conflict.

Oil services stocks serving U.S. shale oil are highly levered to rising oil prices and have two ways to win.

Over the past two years, there has been essentially no "risk premium" in oil prices due to a supply glut and large inventories. That could change if tensions in the Middle East turn into wider conflict. With oil supply and demand in balance, even small disruptions to supply or transportation could disrupt inventory enough to drive oil prices higher.

Risk Premium in Oil Prices

According to a paper by the Reserve Bank of Australia:

‘commodity risk premiums’ can be defined as returns that speculators expect to receive as compensation for taking another party's natural exposure to fluctuations in commodity prices through buying or selling a commodity futures contract. For example, suppose the spot price of oil is $50 per barrel today, and the market expects the spot price to be $60 in one year's time. If the futures price is equal to $57, then the risk premium speculators expect to receive for balancing the market and assuming the future spot price risk is $3.

Currently, the future's price of oil exceeds the expected future spot price of oil, a condition called "contango." This implies the risk is that oil prices will fall further and that there is essentially no risk premium for future oil delivery. The market is saying that the current oil glut will last at least another year and that the cost of storage is a bigger risk than the potential costs of finding oil to deliver.

Oil in contango and falling In addition, as you can see, the spot price and the futures price (June 2018) have been falling precipitously for months now. This demonstrates an extremely bearish sentiment towards oil prices.

With the market believing that oil will remain in a glut at least another year, I think it is important to ask these questions: What if the market is not taking into account all factors? What if today's supply and demand, as well as inventory, are being considered within a vacuum of pure price speculation independent of consideration for potential supply disruptions?

In a paper by Steven D. Baker of the McIntire School of Commerce, University of Virginia, and Bryan R. Routledge of the Tepper School of Business, Carnegie Mellon University, they discuss The Price of Oil Risk. The paper harkens back to the ideas surrounding contango and normal backwardation of Keynes:

'normal backwardation' (or 'natural') refers to the situation where the current one-year futures price is below the expected spot price in one year. This you will recognize as a risk premium for bearing the commodity price risk. This relation is 'normal' if there are more hedgers than there are speculators. Speculators earn the risk premium, and hedgers benefit from off-loading the commodity price risk.

They go on to quantify how risk premium rises or falls in relation to demand growth. If I interpreted their work correctly, they make that point that as demand growth slows for oil and supply remains essentially constant, then the risk premium will also shrink in general. That makes sense and seems to be what has gone on recently. Slow demand growth, coupled with inventory now at a five-year high, appears to have led to a practically non-existent risk premium which is currently independent of circumstances on the ground in the Middle East.

The Roots of Confrontation

Rivalry between Saudi Arabia and Iran is no secret. Dueling religious ideologies underlies their quests for power and influence in the region. Since the United States removed Saddam Hussein as the barrier between the two perpetually feuding nations, the region's stability has further diminished as the two fight proxy wars and due to the rise of ISIS. Here, I would suggest that analysts consider that the destabilization of the region was not a result of unintended consequences but rather has been part of a long game to coax either assimilation to western standards within the region, particularly by nuclear motivated Iran or to force a confrontation.

Saudi Arabia has recently made it a point to not only stand up to Iran but also to become far more aggressive. Defense Minister of Saudi Arabia, Prince Mohammed bin Salman, recently made things very clear: "We are a primary target for the Iranian regime. We won't wait for the battle to be in Saudi Arabia. Instead, we'll work so that the battle is for them in Iran." He went on to say that a dialogue with Iran was impossible. "Their stance is that the awaited Mahdi will come (the hidden Mahdi), and they need to create a fertile environment for the arrival of the awaited Mahdi, and they need to take over the Islamic world. Where are the common points that we might be able to reach an understanding on with this regime?"

And now, Prince Mohammed bin Salman is the new heir to become King of Saudi Arabia. His power is second only to the King, and he is clearly a hawk with regards to relations with Iran. It is not hard to empathize with the Prince's viewpoint even if you don't empathize with the Prince. Iran has delayed, manipulated, bent or broken every agreement with the West it has had since the Ayatollah Khomeini, is relentless in its official propaganda against the U.S., still swears that Israel must be destroyed, and is clearly one of the leading state sponsors of terrorism globally. President Trump has made it clear that standing up to Iran is a priority for his administration. It might be the priority.

For those creating the narrative that oil prices will stay lower for even longer, I ask: Where is the consideration for the clear conflicts in a region of the world that produces a third of global oil supplies?

Rising Tensions

In recent months, the turmoil in the Middle East has only gotten worse. The rising tension has had no discernible impact on oil prices, though. Here is a synopsis that oil traders and oil stock investors have essentially ignored so far:

  • Syrian civil war enters sixth year.
  • In January, Saudi Arabia cuts diplomatic ties to Iran, after the Saudi embassy is stormed and fire-bombed after Saudi Arabia executes Shiite Muslim cleric supported by Iran.
  • On April 4th, Syria, likely by command of President Bashar Assad, used chemical weapons against Syrian citizens.
  • On April 6th, President Trump authorizes a missile strike on a Syrian air base after the confirmed chemical attack.
  • In early April, Iraqi cleric Moqtada Sadr called on Syrian President Bashar al-Assad to step down.
  • In May, multiple battles rage in Syria as U.S. offensive operations intensify.
  • On or about May 18th, an Iranian supported militia advanced on the American al-Tanf military base and was destroyed by air.
  • On or about May 29th, a large Iranian-backed fighting force approached the Syrian border from Iraq.
  • On June 5th, Saudi Arabia, Egypt, and GCC allies cut ties with Qatar over its perceived support or ambivalence towards the Iran-backed Muslim Brotherhood.
  • June 7th, ISIS claims responsibility for assault on Iran's parliament and nearby shrine to Ayatollah Khomeini.
  • On June 8th, the U.S. shot down a drone that had attempted to bomb U.S. coalition forces near al-Tanf with a bomb that failed to detonate.
  • On June 14th, the United States deployed mobile long range mobile artillery to Syria in early June.
  • On June 18th, a U.S. Navy F/A-18 Super Hornet shot down a Syrian SU-22 fighter-bomber after that jet bombed Syrian Democratic Forces.
  • Also, on the 18th, Iran fired six ballistic missiles over Iraq and into Syria at suspected ISIS positions in an area it seeks to control in direct confrontation to U.S. goals.
  • On or about June 19th, the U.S. shot down another (3rd) Iranian built pro-Syrian regime drone near al-Tanf, Syria.
  • Shortly after the U.S. had downed the third reported Syrian drone of the year, a Russian fighter flew within 5 feet of a U.S. RC-135 reconnaissance plane over the Baltic Sea.
  • Also, on or about June 19th, Saudi Arabia stopped and detained three members of Iran's Islamic Revolutionary Guard Corps (IRGC) who were on a boat carrying explosives towards a major offshore oil facility.
  • About June 20th, Iran states that its oil facilities have also been targeted for attack recently.
  • June 20th, Australia stops air missions over Syria due to Russian threats to treat planes west of the Euphrates as targets.
  • Democratic Sen. Chris Murphy of Connecticut warned Tuesday that the United States could be edging toward a military conflict with Iran and Russia in Syria.

Note: The timeline above was constructed from reports in Reuters, BBC, CNN, The Guardian, The Philadelphia Trumpet, Stratfor.com, and Wikipedia.

The timeline above is a very abbreviated version that only touches on some of what has gone on and that has made its way into the media.

I understand that the lower for even longer narrative on oil prices has been right so far. However, in the context of geopolitics, I think the market is missing the potential of significant disruptions to oil supply.

I particularly think that the market is completely missing that in the context of the long game that the U.S. and Russia might have some aligned goals in the Middle East that could lead to outcomes that many have not considered. For example, what if Russia stands down as a coalition of Saudi Arabia, Egypt, GCC nations, Jordan, Israel, and the U.S. supports an uprising in Iran by the educated, pro-democratic, pro-western urban populations that rose up in 2008 only to be put down without any outside support?

If that support manifested in attacking, suppressing, and largely destroying the Iran's IRGC, that would leave the Ayatollah and mullahs largely defenseless against people whom they violently punished eight years ago. If in the attacks on the IRGC there was significant temporary damage to Iranian oil infrastructure, that would lead to higher oil prices which Russia desires. It could also lead to Russia finding a way to be a white knight in a peacekeeping process after the fact.

While that is a speculative (but educated) scenario, it is in fact at least as possible as Russia, Iran, the U.S., and coalition forces coming into aligned direct conflict that could spill over into Iraq or Iran from Syria. Any of the scenarios in the Middle East currently, the feared conflict between the U.S. and Russia, a spillover conflict, escalation between Iran and Saudi Arabia or civil war in Iran could all endanger oil infrastructure and global oil supplies.

We would be remiss to also not consider that low oil prices are in fact putting pressure on Middle Eastern governments fiscally. It is not out of the realm of possibility that some of them are willing to try to disrupt other nation's oil production and transportation for financial and political gain.

Risks to Oil Production and Transportation

The Middle East supplies one-third of global oil about 30 million barrels per day (mbd). Currently, Iran exports about 2.1mbd of oil, as well as, about 600,000 barrels of condensate with plans to increase those levels beginning sometime next year through about 2021. Iraq exports about 1mbd and is seeking to increase its exports by next year as well.

At the moment, oil supply and demand in the world are roughly in balance, according to the IEA and the EIA.

Global Oil Demand Global Oil Supply Oil Supply and Demand

The biggest force on keeping prices of oil down right now is the large inventory.

Oil Inventory

According to the IEA, oil inventory is about 292 million barrels above the five-year average inventory. That begs the question: What would it take for that excess to be reduced dramatically?

Consider this: What if Iranian and Iraqi oil exports were both cut in half for just six months due to disruptions from destruction of war? That would amount to about 1.5mbd and about 240 million barrels or just about enough to bring inventory near average. What if the disruptions lasted longer? What if Saudi Arabia's oil exporting or other GCC nations' ability to export were also harmed?

It is not hard to see that if the rising tensions in the Middle East lead to more conflict that there could be significant enough disruptions to cause a shortage of oil rather quickly. While U.S. frackers could add one or two million barrels per day for a few years, it would not happen instantly.

With regard to Qatar, it is the world's largest exporter of liquefied natural gas. Unless it relents to pressure from Saudi Arabia and the other nations pressuring it, it will have to adapt its marketing to exclude ports and facilities it normally uses. This could prove to be not only a major hindrance to that market but at least a ding in the oil market as well. According to OPEC, Qatar exports about 490 mbd of oil. While I am not calling for oil to surge to $200 per barrel as some have hyped to sell investment letters, I do believe it is naive to have little to no risk premium in the current price of oil.

Going back to studies above, both demonstrated that an oil price risk premium of at least 9% was common. While no qualitative assessment was made, I would generally attribute that to the historical potential for disruption in the Middle East. Given the breakeven prices for much of the marginal oil in the market, the prices realized early in 2017, in the middle $50s, seem to make a lot of sense. I expect a reversion of the losses of the first half of the year in the second half of the year unless we suddenly witness a significant move toward a more tranquil Middle East.

How to Position for a Rise in Oil Prices

First, I would start out with what not to do. Many amateurs try to use the United States Oil ETF (NYSEARCA:USO) to speculate in oil prices. That is a loser's game unless you are a fantastic systematic day trader. USO is a terrible vehicle that suffers immensely from rollover costs when the market is in contango as it is now. A recent article on SA outlined some of the problems with it.

To get levered to rising oil prices, there are really two effective ways to do it. The more traditional is to buy oil E&Ps. There are several ETFs for doing that, including the SPDR Energy ETF (XLE) and the SPDR Oil & Gas Exploration & Production ETF (XOP), which are two of the most popular. The SPDR XLE is market cap weighted and top heavy, with Exxon (XOM) and Chevron (CVX) comprising 38% of the fund. The SPDR XOP is equal weighted and gives investors more leverage to shale producers.

I prefer the SPDR XOP as shale is a bigger winner than the majors if oil prices rise. It doesn't have the legacy costs of the majors, nor will it have to write down nearly as many assets as Exxon and Chevron will have to continue doing in coming years. By now, everybody knows that the shale players have the ability to ramp up production relatively quickly relative to their size, making it easier to move the needle on their revenues and earnings. XOP also gives good exposure to some of the better refining assets.

My favorite ETF investment for a potential rise in oil prices at some point in the second half of 2017 is the SPDR S&P Oil & Gas Equipment & Services ETF (XES). I recently did an extensive "ETF File" breakdown of this fund from how the underlying index has changed to comparing it to other oil services ETFs.

In short, the XES is an equal weighted oil services ETF that gives great exposure to about three dozen survivors in the oil services industry after the rout of recent years. The correlation of the group to oil prices is actually slightly in excess to the E&Ps, so if oil prices do rise, then these companies should do slightly better as a group.

I rate XOP and XES both as buys right now on the extreme oil pessimism and lack of a risk premium in the oil price.

Disclaimer: I own a Registered Investment Advisor, however, published separately from that entity for self-directed investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk as all investments carry the potential for loss and should consult an investment advisor before proceeding on any trade or investment.

Disclosure: I am/we are long XES.

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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