Inconvenient Geopolitical Truths
What does politics have to do with oil markets?
- The days of price moderates within OPEC could be over.
- Financial investors remain the last thing the world needs to worry about in the coming years.
- Traders failed to let news of sharp falls in U.S. employment figures or weakened growth in Asia cool the market.
- Every scrap of geopolitical friction was seized upon to push prices up.
- Speculation has added a sizeable chunk to the oil price.
Strange things have been happening in oil markets of late. Classic price signals such as falling oil reserves, economic quagmire in the OECD and slackened growth in emerging markets all failed to quell the market on the way up to July, while geopolitical flashpoints, storms over the Gulf of Mexico and even production cuts by OPEC are now failing to stop its decline.
This raises a number of “inconvenient truths” as to the self-selecting nature of “fundamentals” in play at any given time in oil markets.
During a soaring market up to July 2008, traders failed to let news of sharp falls in U.S. employment figures or weakened growth in Asia cool the market.
The reason was simple enough — speculators knew that they were onto a good thing to make money on the back of tight conditions in the oil market from 2004 onwards.
Every scrap of geopolitical friction was seized upon to push prices up. Hijacked oil cargoes passing through the Gulf of Aden prompted the market to hit $117 per barrel, while intractable conflicts in Iraq and Nigeria, alongside fears of production cuts in Libya, all supposedly served to bring supply-demand fundamentals closer together.
Rumblings in Latin America were billed as a potential “Andean cataclysm” rather than a well-rehearsed contratante between Venezuela and Colombia.
Even former presidential candidate Hillary Clinton managed to move the market by firing a “virtual warning shot” across Iranian bows.
Contractual instability for international oil companies (IOCs) operating in Russia and Central Asia also came as a supposed surprise to the market in restricting non-OPEC supply — which admittedly still has more mileage than the death of Benazir Bhutto in drawing supply-demand fundamentals closer together as the markets closed in on $100 per barrel into 2008.
Little wonder then, that despite a lack of any major change in market fundamentals, investment banks started to hint towards forecasts of $200 per barrel.
Gazprom nudged estimates a little higher hitting $250 per barrel, a figure that many analysts started to present as a self-fulfilling prophecy as the markets approached the $150 mark in July 2008.
But just as the rising market wouldn't let dampened growth forecasts stop the oil market’s meteoric rise, it is now highly unlikely that a declining market will let “minor” inconveniences such as heightened contractual instability in oil-producing states or major geopolitical flashpoints stem its decline.
Long-standing OPEC stubbornness to increase output no longer appears to be a major problem, nor do entrenched difficulties in the Niger Delta.
The fact that Evo Morales has been fighting for his political life in Bolivia as Pervez Musharraf desperately clung onto his last vestiges of power in Pakistan barely touched the sides as the oil price slipped to $112 per barrel.
Iran's threat in early August to block the Strait of Hormuz should Tehran be attacked, also failed to register — a point which stands in stark contrast to the $6 spike following Iranian missile tests merely a month earlier.
This all points us towards our first inconvenient truth — namely, that speculation has added a sizeable chunk to the oil price by capitalizing on tight market fundamentals.
The latest “price signals” in the Caucasus over the fraught existence of the BTC pipeline and broader access to Central Asian oil reserves that feed it, along with storms in the Gulf of Mexico, have actually prompted the oil market to drop even further. This provides strong evidence that the market is currently being dictated by financial investors moving out of the oil markets to boost their balance sheets to avoid becoming the next “nightmare on Wall Street.”
Crude prices dropped to a seven-month low in mid-September (to $93 per barrel) following the collapse of Lehman Brothers, despite Hurricane Ike causing widespread disruption to U.S. refining operations, and MEND declaring an “oil war” in the Niger Delta and upping its offensive on Shell installations.
Merely two months ago, such events would have made prices above $180 per barrel entirely conceivable. Instead, the market is now steering itself towards a fundamental correction to the $90-95 per barrel mark, which remains a truer reflection of the oil supply-demand fundamentals.
Even the latest production cut from OPEC in Vienna failed to rally the market, underlining the degree to which speculation not only broke all the rules in forcing the market up, but is now having to reinvent itself on the way down in order to restore a semblance of rationality, albeit with enormous volatility as investors are freed of the shackles of subprime debt.
The eventual re-entry of shorter-term price signals “pegged” to underlying fundamentals will come as welcome news to OPEC, and in particular Saudi Arabia, which prizes notional control over the oil market more highly than revenues.
But this still brings us to our second inconvenient truth — OPEC is highly unlikely to put more oil onto the market any time soon.
This is either because most members of the cartel are already producing at maximum capacity, or more pertinently, because all producers (including Saudi Arabia) are enjoying elevated prices and are becoming increasingly confident that demand will remain relatively strong through Asian demand.
Admittedly, Saudi Arabia might increase output on an ad hoc basis to cool the political ardor of Iran, but this will remain a short-term play rather than a revision to flooded markets in the 1980s.
The days of “price moderates” within OPEC could thus be over.
Yet short term output restrictions also point us towards our third inconvenient truth — the frequently quoted International Energy Agency (IEA) figure that $22 trillion of investment will be needed in resource development, generation and infrastructure in order to meet global energy demand by 2030. This fact remains as distant as it is daunting.
This is because of cost inflation and, more importantly, demands in producer states to ramp up production given that IOCs are currently only able to vie for around 10% of global reserves.
Of the major producers, Kuwait and Iran had tried to encourage IOC investment, but the process has stalled because of domestic politics or international friction.
Saudi Arabia refuses to allow investment from abroad in upstream oil, while it remains particularly challenging for IOCs to make concrete commitments in Iraq. Russia has made a habit of cutting IOCs out of Production Sharing Agreements once the oil starts to flow — an “art form” that is starting to be perfected in other producer states.
The point here is not to champion the relative merits of IOCs or NOCs, but to highlight that without a seismic shift in political capping of reserves, we are likely to meet our final “inconvenient truth.”
Speculators may have used geopolitics to push the market up, just as readily as they have dumped geopolitics on the way down to allow for market corrections. However, financial investors remain the last thing the world needs to worry about as supply-demand fundamentals run headlong into the limits of a geopolitical peak in the coming years. This is where politics will still ultimately drive the market.
Editor’s Note: This feature is co-authored by Tariq Akbar, a Senior Energy Analyst at Datamonitor in London. Mr. Akbar focuses on global commodities markets, with particular reference to oil and gas. He holds an MSc in Industrial Strategy from the University of Manchester and a Postgraduate Certificate in Finance from Birkbeck College, University London.