Andreoli on Oil &Fuel: Turmoil in Middle East/North Africa has taken oil markets by surprise

In the previous Oil & Fuel column, I explained that throughout 2010 and early 2011 tight diesel markets had been pressuring the price of crude in much the same way that they did during the 2008 price run. My intention was to write a follow-up article this month that compared the factors underpinning tight diesel markets then and now. However, the rising turmoil in the oil-rich Middle East and North Africa (MENA) region has taken the markets by surprise, and thus deserves attention.

The uprisings that have swept through the MENA region caused the front month WTI contract to jump nearly 20 percent from $88 per barrel (12/17) to over $105 (3/7). Some of this jump can be explained by the loss of Libyan oil production, but the majority of the jump is due to the rising risk premium on the future supply of oil.

This risk premium represents the balance that is struck between sellers, who believe prices will fall, and buyers, who believe they will rise. These counterparties are acting largely on gut instincts and are guided by a constant flow of incomplete information about geopolitical events (e.g. the Libyan crisis and the Japanese earthquake), economic news, and the like.

In order to understand how the oil futures markets have reacted to geopolitical events in the MENA region, we need to understand the risk equation: Risk = Threat x Vulnerability x Cost

Threat represents the estimated frequency of a potentially adverse event—like a political demonstration or a magnitude 9.0 earthquake. Vulnerability is the probability that a threat will cause a disruption, and cost is the measure of impact of the disruption (e.g. the amount of oil production lost, or demand destroyed by the earthquake).

When it comes to applying the risk equation to the MENA crisis there are plenty of ‘known unknowns’ and ‘unknown unknowns’; and as a consequence, risk premiums vary widely. Throughout the MENA crisis, the frequency of potentially adverse events rose; the perceived probability of an event having an impact similarly rose; and the amount of oil at risk is staggering. As such, the crisis deserves attention.

The seeds of the MENA crisis have been fostered by persistently high unemployment, racing food inflation, suppressed political rights, and endemic political corruption across these countries. These frustrations erupted into protests in Tunisia on December 17, 2010, after a street vendor set fire to himself to protest harassment by Tunisian authorities. This act of self-immolation inspired Tunisians to flood the streets, and Tunisian authorities attempted to quell the uprising through force, thus initiating a positive feedback loop.

By the end of December, the Tunisian protests had spilled across the Algerian border. Algeria is a significant oil producer; and behind Russia and Norway, Algeria is the third largest supplier of natural gas to Europe. The oil markets began to react.

From Algeria and Tunisia, the unrest spread east with protests erupting in Libya and Egypt. Both countries have since undergone major revolutions. Presidents Mubarak and Ben Ali have been ousted and provisional governments are beginning to take root. The short/medium-term prognosis in these countries will remain uncertain so long as the socio-economic problems that led to the unrest persist.

Meanwhile, Libya has devolved into an armed rebellion, causing Libyan oil production to fall by 700,000 to 1.2 million barrels per day (mbd). The other half of Libya’s oil production and the nation’s oil infrastructure (pipelines, ports, and refineries) remains at risk of attack by rebels and Gaddafi loyalists alike. Saudi Arabia and other OPEC member countries claim that they have lifted oil production to meet this shortfall, but OPEC production is far from transparent so it is difficult to verify these claims.

Further to the east, Iran—the world’s fourth largest oil producing nation—has not been immune to the wave of unrest. Thus far, the Iranian government has successfully suppressed the revolution, but the seeds of unrest are growing.

Violent protests have also erupted in Iraq, prompting a wave of resignations of provincial governors and other authorities. Prime Minister Maliki announced that he will not run for a third term, and given the delicate situation, Iraqi oil exports are threatened. Bear in mind that Iraq was one of only eight oil-exporting nations that was both willing and able to lift oil exports to meet rising demand through the 2008 price spike.

As of the writing of this column, the situation in Bahrain has reached a fevered pitch. Sensing that the tension in Bahrain could reach a tipping point further destabilizing the region, Saudi Arabia has preemptively sent troops across the border to contain the Bahrainian uprising. While Bahrain is not a large oil producer or exporter, it functions as one of the Middle East’s most important financial hubs.

Perhaps most troublesome, at least from an oil supply perspective, were the calls for a Saudi ‘day of rage’ on March 11. Acting preemptively, Saudi King Abdullah made a $35 billion ‘royal gift’ to his subjects in hopes of quelling dissent. But despite the hundreds of billions of petrodollars that Saudi Arabia has earned, the country remains poor by global standards, and many Saudis hunger for freedom and democracy. Spontaneous protests on the March 10 were forcefully suppressed, and at least a few protestors were shot and wounded.

The Saudi carrot and stick approach appears to have been successful. The turnout for the ‘day of rage’ was inconsequential, and rather than creating havoc on the oil markets, the ‘day of rage’ in fact caused the front month WTI futures contract to drop below $100 per barrel. The market has clearly discounted the probability of disruption there.

The MENA crisis is not over yet, and the Saudi royal family is not out of the woods. As we can see, the MENA crisis is very complex and the threat of major disruption persists. The amount of oil production and oil exports at risk is staggering.

Armed rebellions have pulled more than 1 percent of the total world supply off the market, though this amount has been replaced by increased production elsewhere. The Libyan rebellion threatens another 1 mbd of oil production and exports.

An additional 1.6 mbd of oil production is at risk in the recently revolutionized Egypt and Tunisia. Even more importantly, the Suez Canal and the SUMED (Suez-Mediterranean) pipeline – both major oil transit chokepoints – are at risk in Egypt.

On top of that, major protests in Iran, Iraq, Yemen, and Algeria threaten 9.1 mbd of production and 6.74 mbd (14.8%) of world exports. On March 9, crude stopped flowing through the Iraq-Turkish pipeline after an explosion on Iraqi soil.

Minor protests have occurred in Saudi Arabia, Syria, and Sudan, putting an additional 10.6 mbd of production and 7.68 mbd of oil exports (17% of world exports) at risk.

Overall, political unrest in the MENA countries has, to varying degrees, put 16.8 mbd of oil exports at risk of disruption.

So why have oil prices have not climbed even higher? After all, there were no major political events that threatened oil production in 2008, and many of the other price pressures that were present in 2008 have reemerged.

What gives? The answer is spare capacity. In April 2002, OPEC surplus production capacity was nearly 7 mbd. By May 2004 spare capacity had fallen to 2 mbd and by July 2004 it had fallen below 1 mbd. By March 2007, surplus production capacity had rebounded slightly (climbing to 2.3 mbd), but by July 2008 – the height of the price spike – spare capacity had fallen back below 1 mbd.

As a consequence of the recession, oil consumption declined and Saudi Arabia completed a number of important new projects. By December 2009, spare capacity was back up to nearly 4.8 mbd, but as the world economy recovered, demand grew and spare capacity to 4.1 mbd by February. Then the Libyan uprising knocked surplus capacity down to somewhere between 2.9 mbd and 3.4 mbd.

Since the beginning of 2010, surplus production capacity has declined between 30 and 40 percent. The Libyan impact on surplus production capacity has put the world in the danger zone. As surplus production capacity declines, the risk premium increases, and markets become more volatile and reactionary.

Of course the devastating earthquake in Japan has adjusted the oil demand outlook, but to what extent the destruction to Japan’s economy will eat into global oil demand is another one of those ‘known unknowns’ that the market will price.

With so much uncertainty, and such strong forces acting in opposition, it is impossible to know what is going to happen with oil prices. Given this uncertainty, now is the time to shore up supply chains against the upward trends in both fuel price and fuel price volatility.

Derik Andreoli, Ph.D.c. is the Senior Analyst at Mercator International, LLC. He welcomes any comments or questions, and can be contacted at [email protected].