So You Think Oil’s Expensive Now?

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Includes: DBO, OIL, UGA
by: Robert Carpenter

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 (NYSE: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.