The fall of dictators in North Africa and the refusal of others to leave has created a political mess throughout the oil producing regions. Tunisia, Egypt, Libya, Iran and others are all facing internal military conflicts. Some may turn into civil wars while others may squelch civil unrest through political concessions or direct government aid to their people. However, when it comes to the world’s supply of oil, the method of reconciliation isn’t nearly as noteworthy on the open markets as the fact that there are issues to reconcile in the first place. The era of instant press and relatively equal opportunity to generate information has created millions of on site reporters in the form of the common man producing cell phone videos, Tweets and Facebook networks.
The news has created an oil spike. The manic pursuit to grab the headlines has brought speculation in oil futures trading to new heights. Libya is responsible for 2% of global oil output. Egypt and Tunisia are irrelevant and Iran produces a sour crude of such low quality that they don’t have the domestic capabilities to refine it themselves and have to import 40% of their gasoline. Saudi Arabia has already broken ranks with OPEC and volunteered to increase output to appease the market and I wouldn’t be surprised if Obama tapped the strategic reserves.
There is a fundamental disconnect between the price of oil on the open markets and the fundamentals that move prices over the long term. The crude oil traded in the U.S. is typically referred to as West Texas Intermediate (WTI) while the oil that is produced and traded in the North Sea, Iran and Russia is Brent Crude. Brent crude is a lower quality crude that is both produced and consumed throughout Europe and Asia. WTI is easily refined and produced in the Gulf of Mexico, Alaska and the Black Tar Fields of Canada.
WTI crude oil is stored in Cushing, Oklahoma and the storage tanks are nearly full. Commercial traders of WTI strongly believe the market will not support these prices. In fact, they have accumulated a record short position. They have never sold so much of their future production at market prices as they are doing now. This is exactly opposite the of the Commodity Index Traders (CIT’s) and small speculators who have jumped on board the news events. History has shown that no one knows their market like the people who make their living in it. Therefore, it is not wise to bet against commercial traders for very long.
It is comforting to believe that the commercial traders may be right and that oil won’t stay at these levels for very long. However, Middle Eastern politics is a wild card game at best. The Schork Report states that we could have $4 gasoline with WTI crude trading at $115 per barrel. This is due to the refining and crack spread issues we discussed two weeks ago. Gas didn’t hit $4 in 2008 until oil traded over $145. This would have a serious effect on our economy. Ball State released a paper on January 21st, stating that GDP will decline by 2% if oil climbs to $110. Furthermore, 10 of the last 11 recessions accompanied rapidly rising oil prices.
It’s already been speculated that Obama may tap the strategic reserves to prevent higher energy prices from dragging down our struggling economy. Saudi Arabia isn’t the only oil exporter aware of the bearish fundamentals of the oil market and I suspect that other oil producing countries will sell all the forward production they can at these prices. I don’t expect energy inflation to dictate monetary policy. Ben Bernanke co-authored a paper in 1997 stating that the correlation between high energy prices and recessions had more to do with the over tightening of fiscal policy to clamp down on inflation than did the actual price of energy. Therefore, I don’t expect to see knee jerk rate hikes in response to the howls of inflation hawks.
Currently, the primary beneficiary overseas is Russia. They have the reserves, refining capacity and infrastructure to supply old world Europe and Asia. These are the areas most greatly affected. They are fully industrialized and their economies are heavily reliant on oil imports. The question we should be asking ourselves is why we spend between $50 and $100 billion a year to protect roughly $35 billion dollars worth of the oil we import. This amounts to the 15% of our total U.S. imports that come from the Golden Crescent. Two separate pools of academic research, nearly 10 years apart, 1997 and 2006, have addressed this issue and gone nearly unnoticed. Why is it that we pay the bill to keep the oil flowing overseas to other countries?
This blog is published by Andy Waldock. Andy Waldock is a trader, analyst, broker and asset manager. Therefore, Andy Waldock may have positions for himself, his family, or, his clients in any market discussed. The blog is meant for educational purposes and to develop a dialogue among those with an interest in the commodity markets. The commodity markets employ a high degree of leverage and may not be suitable for all investors. There is substantial risk of loss in investing in futures.
