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Oil Prices Being Driven Higher by Supply Concerns

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The surging price of oil has market and political commentators buzzing. At the time of this writing, West Texas Intermediate (WTI) crude is trading north of $110 per barrel and Brent Crude is hovering around $125 per barrel. You know the likely questions. What type of economic impact will an increase in oil prices have? How will rising gasoline prices effect the presidential election? What does Iran have to do with prices at the pump in America? How does speculation affect the price of oil?

The questions above aren’t easy to answer as there are many factors, economic and political, which influence the price of oil. Many people (especially politicians) are quick to accuse specific parties for price fluctuations, whether it be speculators, OPEC, the Federal Reserve, the President, etc. However, assigning blame in such a manner is short-sighted, as all factors contribute in one way or another. As President Obama and others continue to emphasize, there is no “silver bullet” for battling high oil prices.  Given how important oil is to the world economy, it’s important to be able to recognize the various metrics at play.

An escalation in oil prices is usually looked at as a net positive, as increases usually correspond with strong economic growth, which spurs demand for oil. Economic growth was the main rationale used during the 2000s oil boom which saw global demand for oil increase roughly 15 percent and prices rise from $20-$30 per barrel to around $70-$90 on average by the end of the decade. Fluctuations in price were common, as in any market, but the overall pattern was strongly to the upside.

Without question, demand is part of the overall story driving oil prices currently, especially with high-single digit growth rates being seen in emerging markets, driven by Chinese demand growth. Emerging market economies tend to have a greater proportion of their economies in manufacturing industries, which are more energy intensive than service industries, which dominates the majority of U.S. and European economies. Automobile ownership per capita is also strongly correlated with rising incomes and has much room to grow in emerging countries as consumers move into the middle class. China’s strong economic growth has made it the largest energy consumer and second largest oil consumer in the world.

However, oil demand in Europe is falling and consumption in the United States – the world’s top consumer – has hit the lowest level in nearly 15 years, a report from the Energy Information Administration (EIA) showed this past week. At a lower level, looking at the American consumer, gasoline demand is down 6% YOY, which makes the recent rise in gasoline prices even more frustrating to bear. EIA’s current projections show that virtually all the net increase in oil consumption in the next 25 years will come from emerging markets. The long-term demand story for oil from emerging markets is intact, but not a convincing argument when explaining the 30-cent increase in gasoline in the last month.

The main focus in oil markets today is centered on supply concerns, and rightfully so, as tensions in the Middle East, specifically Iran, have become increasingly stressed. The United States and its allies believe Iran is building nuclear weapons, which Tehran has denied for years. Iran is OPEC’s second-largest producer after Saudi Arabia, and exports 2.5 million barrels of oil per day, or roughly 3 percent of global oil supplies. 500,000 barrels or so go to Europe and the rest is sent to China, India, Japan and South Korea, amongst others. Any removal or reduction of Iranian crude from the market would be very harmful; as it’s unlikely OPEC has the resolve to dip into spare capacity to increase production levels to fully offset a loss of Iranian crude.

Recently, the European Union (EU) enacted a ban on Iran oil imports effective July 1, and placed sanctions on Iran’s central bank, essentially freezing its assets.  Also, in December, the United States warned companies in its market that it would “blacklist” them if they did business with Iran’s central bank.

In a move of retaliation, Iran announced that it halted oil exports to the United Kingdom and France, while warning European companies that it would halt their supplies unless they sign longer-termed contracts. The actual impact of this move is small, considering that France and the UK don’t import a significant portion of crude oil from Iran. It’s assumed they will look to Saudi Arabia or Russia to make up for the lost imports. However, the move signifies the tenacity Iran continues to show in defying sanctions, and highlights the current instability of the diplomacy process.

In an attempt to calm fears, Iran oil ministry spokesman Alireza Nikzad’s issued a statement stressing that Iran “will sell our oil to new customers.” However, according to Financial Times, Tehran is “struggling” to find a new buyer for the estimated 500,000 barrels of oil per day left as surplus from its decision to halt sales to France and the UK.

Also clouding fears is the latest report from a U.N. nuclear watchdog that showed a large expansion of uranium enrichment in Iran. This news, coupled with the heightening rhetoric emanating from Israel has increased the likelihood of an Iranian-Israeli conflict within the next few months.

U.S. Defense Secretary Panetta believes there is a strong likelihood that Israel will strike Iran in April, May or June, which is before Iran enters what Israelis have described as a “zone of immunity” to commence building a nuclear bomb. The main fear out of Israel is that the Iranians will have stored enough enriched uranium in underground facilities to make a weapon by then, which will result in only the United States being able to stop them militarily.

The U.N. report comes as European buyers of Iranian oil cut back on purchases ahead of the EU embargo effective July 1. Some of Iran’s biggest customers in Asia including China have also reduced purchases. Japan, the world’s third-largest oil importer, may cut Iranian crude imports by a more-than-expected 20 percent as it seeks a waiver from U.S. sanctions. In 2011, the country bought almost 9 percent of its crude from Iran.

Finally, there’s the concern that Iran will retaliate against sanctions imposed by Western nations and attempt to close the Strait of Hormuz — a vital waterway that carries about 20 percent of the world’s oil supply. If action is taken, successfully or unsuccessfully, oil would skyrocket, potentially challenging the $147 mark not seen since the summer spike of 2008, or even higher. It’s a waterway that’s “absolutely critical to the world economy…the most important chokepoint in the world,” according Dr. Daniel Yergin, energy expert and Pulitzer Prize winning author of The Prize and The Quest.

U.S. Treasury Secretary Timothy Geithner told CNBC on Friday that “Iran can do a lot of damage to the global economy.” Geithner also touched on U.S. options for containing rising gasoline prices, but admits the ability to affect short-term prices is limited. The biggest impact would come from releasing reserves from the Strategic Oil Preserve (SOP). At the G20 meeting this past weekend in Mexico City, there was no formal discussion for doing so. However, one would expect the SOP to be drawn down during 2012 in a price spike occurs, given the influences of an election year.

To complicate things, a few other political hotspots are fueling the supply side-story. South Sudan has suspended its 350,000 barrels per day of oil production in a row with over pipeline payments with Sudan to the North. The two sides have failed to reach an agreement. The dispute came to a head in January when South Sudan shut down oil production after Sudan began taking oil from a connecting pipeline to compensate for what it called unpaid transit fees. South Sudan has said the fees are too high.

Staying in Africa, concerns around Nigerian crude oil have ebbed and flowed throughout the past year. The country has seen massive labor strikes and continued terrorist attacks against the country’s oil infrastructure. The politically unstable country produces almost 2 million barrels of oil per day and will have an even greater influence moving forward. Licenses for major energy companies like Shell and Chevron for work in Nigeria are expected to be renewed for 20 years, and analysts expect the country to eventually produce 4 million barrels per day.

Also, continuing conflicts in Syria and Yemen are also being monitored by energy analysts, but these stories have been mostly pushed aside as Iran concerns have come to center stage. Overall, the estimated geopolitical premium in the crude oil market is estimated to be $10-$25 per barrel, depending on which energy analyst is polled.

As the Iranian crisis continues to unfold, the oil market will be watched, analyzed, and scrutinized from every corner. The emphasis should be on pace. If gradual increases in price occur, the U.S. economy can hold up. Growth will slow marginally, but an outright recession can be avoided, as long as oil prices stay range-bound around current levels. No doubt consumers will complain about paying more at the pump, as they have started to already, but stronger employment and economic reports seen recently will buoy optimism for a while. If we start to see gasoline prices either approaching the 2008 highs or continue moving higher at the current pace, then there is major cause for concern. Fortunately, that doesn’t look to be the consensus projection at the moment.

My personal prediction is that oil prices will continue moving higher in the short-term, but will level off or even fall in the second half of 2012. Unfortunately, my conviction on this view has lessened, given the price spike of the last month. Five main factors are driving my take, among others: 1) The Federal Reserve will not enact another round of quantitative easing, which will lower investors’ appetite for risk and give strength to the U.S. Dollar 2) Oil revenue’s importance to the social and political fabric of Iran (makes up 20% of Iranian GDP) will lead to an eventual compromise on economic sanctions and the future of Iran’s nuclear program 3) The oil market will once again trade on fundamentals as the geopolitical premium in crude falls, and realize current demand doesn’t justify such high levels in crude 4) Europe’s debt crisis is not over and many EU countries will be in official recessions by year-end 5) Emerging market growth (China), although still impressive, falls below analyst expectations in the second half.

Whatever happens to the price of oil during the next few months, it will have major repercussions on the economic and political scene around the world. It’s not time to panic yet, but there are legitimate reasons oil is becoming front page news again.


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