Egypt and the Global Oil Market: Geopolitics Is Back
Markets are extraordinarily bad at getting political risk right — and the Egypt crisis is no exception.
- The dangers of conflating apocalyptic scenarios for the Middle East are all too real.
- OECD states already paid a $790 billion oil import bill in 2010, up $200 billion from the previous year, which is equal to a loss of income of about 0.5% of total OECD GDP.
- Producers will rapidly lose control of the market if geopolitics starts dictating benchmark prices beyond the fundamentals in play.
- Markets are extraordinarily bad at getting political risk right, and the Egypt crisis is no exception.
- Markets are inherently fickle when it comes to pricing geopolitical risk in, or indeed out.
If any further evidence were required that we are back in a bull oil market, then Egypt has done the trick. Benchmark prices surpassed $100 per barrel directly on the back of political turmoil in Cairo.
This is not because Egypt sits on much oil, but because its Suez Canal is a crucial transit route for getting Middle Eastern oil to global markets, and because it is home to the Sumed pipeline linking the Red Sea to the Mediterranean.
If either of these routes were to be closed, oil tankers would be diverted 6,000 miles around the southern tip of Africa — taken in conjunction, that amounts to over two million barrels per day of oil, equal to around 2.5% of global supplies, slipping offline.
A classic case of price movements linked to fundamentals, then? Perhaps. But when we consider that excess supplies still top five million barrels per day from OPEC alone, the scenario becomes a little more circumspect.
We all know that speculation plays a hand in oil prices, and commodities have undoubtedly been driven up by rabid asset rotation of late. However, the critical point is that geopolitics is “back” for the market — and it will be back with a vengeance in a $100 per barrel world. Buckle up — the ride is about to get bumpy.
We have, of course, been here before. Go back to 2008 — a consummate tale of two markets. In the run-up to the $147 per barrel peak in July 2008, every scrap of geopolitical friction was used to push up prices.
This ranged from the death of Benazir Bhutto in Pakistan in late 2007 to failed presidential candidate Hillary Clinton firing a “virtual warning shot” across Iranian bows. A supposed “Andean cataclysm” in Latin America between Venezuela and Colombia was the icing on the geopolitical cake for investors looking to prop up high oil prices.
Taking note of contrasting developments, such as declines in U.S. employment figures or weakened growth in Asia, wasn’t part of the narrative. Talking the market up towards $200 per barrel was — at least if you worked for Goldman Sachs.
This persisted until the financial crisis hit. After the collapse of Lehman Brothers, nobody wanted to be the next “nightmare on Wall Street.” Positions were rapidly unwound to realize gains and release liquidity.
And although genuine demand destruction was firmly setting in as prices slumped to as low as $33 per barrel in early 2009, the market still had more than enough geopolitical ammunition to firm up prices should it have wished to do so.
The Russo-Georgian war was brushed aside, and storms in the Gulf of Mexico actually depressed prices further. Evo Morales had to fight for his political life in Bolivia, while fresh Iranian threats to block the Strait of Hormuz failed to have an impact.
Political risk only mattered insofar as how credibly OPEC, and more specifically Saudi Arabia, was willing to set a price floor via massive production cuts, not how high producers could blow the roof off the ceiling.
The fact that we are getting back towards a pre-July 2008 “geopolitical” status, despite conflicting market fundamentals, should therefore be as interesting as it is troubling for those in the oil game.
On the most basic level, it is abundantly clear that markets are inherently fickle when it comes to pricing geopolitical risk in, or indeed out — never more so than when fundamentals start tightening.
If so, the key question then becomes: Just how fickle is the market? Surely, if geopolitical risk is “back,” the market has priced it in. That’s what markets do, right? Wrong. They are extraordinarily bad at getting political risk right, and the Egypt crisis is no exception.
If money can be made going long on oil, you might as well capitalize on geopolitical freebies as you go along. No sooner had the barricades been broken in Cairo than talk of “political contagion” in the Middle East broke out across the trading floors of London and New York.
Events in Tunisia obviously provide a handy “straight line” narrative. Ben Ali has fallen, Mubarak is on borrowed time, Iran is still simmering from the “Green Revolution” and any one of the decrepit monarchical regimes in the Gulf could be next. Saudi Arabia, Kuwait, UAE and even Qatar are all on the list, as are Algeria, Libya and Morocco.
While it’s undoubtedly true that such states share similar structural flaws and deep political fault lines — all factors that politicos go to great pains to point out — it is even truer that they have prolific track records of containing the sources of social unrest through political repression rather than addressing the underlying sources. That is the fundamental “call option” here: Stability will be maintained as far as the key oil-producing states are concerned. Anything else is mere political bluster.
But if the markets are already jittery about small players such as Tunisia and Egypt, it begs the bigger question of where the market will head if Iraq takes another turn for the worse, or if Venezuela, Bolivia or Ecuador enact snap expropriations.
Further unrest in Central Asia could be a problem, as could further upstream slippage in Russia. West African production has been a little stronger as of late, but if MEND goes back to full-scale war in the Niger Delta, or if chronic corruption in Luanda wards off fresh international investment, then the picture could rapidly change.
More dramatically, Yemen could go beyond the point of no political return, with potentially detrimental effects on the Bab el-Mandab strait that links the Red Sea to the Gulf of Aden and carries over three million barrels per day.
Iran is an even bigger challenge. While we know that Tehran will keep nudging towards nuclear capabilities, it’s far less certain that it will actually go nuclear. Yet the dangers of conflating this with apocalyptic scenarios for the Middle East are all too real, either for regional players involved or trigger-happy Republicans in Washington.
Close the Strait of Hormuz between the Gulf of Oman and the Persian Gulf, and you’ve just choked off around 20% of global supplies. And that’s before we even get into discussion about the inherent risks associated with China’s “string of pearls” policy vis-à-vis its Asian counterparts.
This is the crux of the problem, of course: The (mis)perception of political risk can be just as potent, if not more so, than the actual risks themselves for the market. If the Egypt crisis is anything to go by, then geopolitical factors have not been properly priced in.
The several-dollar price spike from the chaos in Cairo will look like small potatoes compared to the more explosive geopolitical problems down the road. This prospect should come as harrowing news for consumers.
OECD states already paid a $790 billion oil import bill in 2010, up $200 billion from the previous year, which is equal to a loss of income of about 0.5% of total OECD GDP. In EU terms, that’s an increase of $70 billion in 2010, and in the United States, a $72 billion jump. Japan has paid an additional $27 billion, while less developed nations are being hit to the tune of $20 billion — a figure equal to a loss of income of 1% of GDP.
More importantly, as a ratio of oil import bills to GDP, this equates to 2.1% in Europe, which is on par with the 2.2% level reached at the height of the market in 2008. One can only imagine what that must be costing emerging markets in subsidies.
High prices might sound like good news for producers, most of whom remain structurally dependent on oil receipts to replenish depleted state coffers.
But they carry two major risks. The first is prompting potential demand destruction. The assumption in 2008 that demand had become relatively inelastic proved to be a grave miscalculation. Most producer regimes were lucky to survive the shock.
Whether $100 per barrel will break the bank again remains to be seen, but with anemic growth in the West and inflationary pressures gathering steam in the East, it would be foolhardy to assume that anything north of $100 per barrel would be a positive development for the global economy.
Which directly links to the second risk for producers: They will rapidly lose control of the market if geopolitics starts dictating benchmark prices beyond the fundamentals in play. Price hawks such as Iran, Algeria, Nigeria and Venezuela — as well as Russia outside OPEC — probably have no problem with that, as they have no excess supply to put on the market anyway.
However, for the swing producer, Saudi Arabia, it creates the age-old problem of either going along with the hawks to maximize receipts, or regaining control of the market by providing greater supply.
Price signals have been deafeningly silent so far — not least because Riyadh has been busy blaming speculation for upward price movements rather than fundamentals. No doubt that’s partially true, but that’s the whole point: Speculators like nothing more than the risk of geopolitical calamity to make a killing. Egypt has sent a clear signal to OPEC: Quell the market now, or it will politically emasculate you later.