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The Volatile Oil Market Is Bigger than Just the Middle East

June 18, 2017 Topic: Economics Region: Middle East Tags: OilEnergyQatarBusinessGeopolitics

The Volatile Oil Market Is Bigger than Just the Middle East

In the past, risk measurably increased when things got tense near the oil fields of the Middle East. Today, the world’s energy supply and consumption patterns are more complex.

On Friday April 7, a day after the U.S. missile strike against Syria, the global oil price did something it hadn’t done in months: it shot way, way up. By Monday morning, the West Texas Index, one of two major global benchmarks, had gone up by $2 to $53 per barrel, the biggest price increase since December 2016.

Analysts and commentators jumped at the chance to proclaim it: geopolitical risk in the oil market was back. All of a sudden, a few missiles launched from the decks of two American destroyers could do what OPEC bargaining and the shale revolution had failed to do: set the global oil price firmly north of $50. Oil was exposed, once again, to the mysterious “risk premium,” sending prices up from the historic lows that have mired the global oil-and-gas industry since June 2014, when global crude prices were still sitting above $100 a barrel.

Within a week, it grew apparent that the sudden price spike was a flash-in-the-pan, momentary jump. Prices responded to an unexpected action by a U.S. president still searching for a coherent approach to the Syrian debacle. But the sudden uptick in oil prices in the wake of Trump’s Syrian intervention has reopened the debate on how geopolitical events affect the international economy.

In early June, when Qatar was suddenly and unexpectedly isolated diplomatically and economically by the rest of the Persian Gulf—with American support—the question of how energy markets would respond was reopened. But this time, there was no spike. Growing instability near the Strait of Hormuz, through which a third of all globally-traded oil passes each day, elicited no more than a shrug from the markets. The geopolitical risk from this incident, unlike the Syrian missile strike, wasn’t enough to arrest a downward slip in oil prices.

Oil is seen as particularly sensitive to sudden shifts in geopolitical climate, and there is considerable discussion surrounding the geopolitics of oil.  But while the movement of energy resources from country to country, via pipeline or tanker, is very often influenced by political interests (the relationship between Russia and Western Europe offers a clear example), the relationship between petroleum prices and political events, be they wars, missile strikes, revolutions or sudden coups d’etat, has never been clear-cut.

Sixty years ago, in the summer of 1956, most of the world’s internationally traded petroleum passed through a single waterway, the Suez Canal. According to oil historian Daniel Yergin, oil accounted for two-thirds of the canal’s traffic.  Millions of barrels were loaded onto tankers in Persian Gulf ports and traversed the one-hundred-mile-long canal on their way to markets in Western Europe, which was heavily dependent on Middle Eastern oil for its energy needs. In July, Egyptian president Gamal Abdel Nasser nationalized the canal and declared it the property of the Egyptian people, infuriating the British and French governments, who felt the Suez Canal to be a vital European interest. In October, an Anglo-French force launched an attack on Egypt to retake the canal, prompting Nasser to block the waterway.

The result was a global-energy crisis, the first of its kind. At the time the international oil industry was tightly controlled by major companies that cooperated with one another to manage supply. Together, they worked with the American and European governments to avoid disaster. Supply disruptions were mitigated, existing supply was redirected, and several months later the situation returned to normal.

But the canal drama left a bad precedent. When war, revolution or some other seismic shock hit the Middle East, it seemed to pose a threat to the region’s oil resources. As the global importance of Middle Eastern oil grew, so too did fears that instability in the region would threaten future access to affordable energy.

In October 1973, a similar geopolitical shock struck the Middle East, as Arab armies launched an unexpected attack on Israel during the Jewish holiday of Yom Kippur. Acting together, the Arab oil-producing states declared an embargo on oil shipments to the United States, threatening to turn off the pumps unless the West ended its support for Israel.

 

In absolute terms, the “Arab oil embargo,” had little impact on the global oil supply. But the threat of a Middle East shutdown, combined with concerns over the global economy and the rising tensions between the United States and USSR regarding the war between Israel and the Arab states, prompted an international energy crisis. Oil prices quadrupled in a few months, throwing the industrial world into a prolonged economic slump. The “oil shock” was followed in 1979 by another calamity, when the Islamic Revolution in Iran shut down that country’s oil production, prompting another wave of panic and a doubling of oil prices.

The events of the 1970s seemed to confirm it: when geopolitical risk in the world’s major oil-producing region rose, so too did global oil prices. When war broke out between Iran and Iraq, both major oil producers, in 1980 the world braced itself for another round of price shocks.

 

But the events of the 1980s and 1990s confused the correlation between price and risk. Despite war in the Persian Gulf and Afghanistan, as well as civil war in Lebanon, prices fell for several years, eventually bottoming out in 1986.

In the 1970s, American oil output was declining while the largest share of international oil was produced by members of the OPEC production cartel, who had used the geopolitical crises to increase oil prices. But in the 1980s, U.S. production began increasing again, thanks to new discoveries in Alaska. Output from Canada increased as well, as did production in the Soviet Union. Oil’s share of global energy use declined slightly, reducing the worry that interruptions to supply would trigger major economic upheavals. The “tanker war” waged in the Gulf between Iran and Iraq didn’t stop oil prices from cratering due to overproduction by OPEC in 1986.

Even the 1990 invasion of Kuwait by Iraq, which placed one-third of global oil reserves in the hands of Saddam Hussein, caused only a minor shock. Prices rose from their late-1980s lows below $20 a barrel to $40 by the end of 1990, but shot back down below $20 within several weeks. When the U.S.-led coalition pushed Saddam’s forces out of Kuwait, prices fell once again, in the anticipation of Iraqi and Kuwaiti supply coming back online. By April 1990, they had stabilized, and while the shock did force the U.S. economy into a recession, it emerged relatively unscathed.

After 1990, the international petroleum market became increasingly volatile, with frequent and unexpected changes to the price. This was not because the world had gotten more dangerous; the “new world order” proclaimed by U.S. president George H. W. Bush presaged a more integrated, globalized world economy free of Cold War-era tensions. Instead, oil was now reacting to a vast array of new factors, beyond conditions in the Middle East. Oil was now being pumped out of new fields in Central Asia, Siberia, West Africa and Asia. The number of major oil companies had ballooned, as had the number of pipelines, refineries and export terminals.

Risk could arise from unexpected geopolitical events. Wars and revolutions in or near major oil-producing regions could affect prices. But the effects are less likely to be the seismic shifts of the 1970s. Instead, events with the potential to disrupt supply, or contract demand, produce immediate price volatility, followed by a period of correction that lasts a few weeks or sometimes just a few days.

This is what happened after the terrorist attacks of September 11, 2001 and again in March 2003, when the United States invaded Iraq. Yet in both instances, the risk of war sent prices down, rather than up: in September 2001 by $7, and in 2003 by almost as much. Within a few weeks, prices reset at or near their original level. Of much greater significance to prices was the 2008–09 global financial crisis, caused by a massive bubble in the American housing market: from a staggering high of $145 in July 2008, the West Texas Index price plummeted to $33 by the end of the year.

In the past few years, the forces that have shaped global-energy consumption have resided largely outside the bounds of geopolitics. High prices in the late 2000s encouraged investment in new, technologically advanced methods of extraction in North America: “tight” oil locked in shale rock or the Alberta tar sands. The rise in North American supply coupled with a slowdown in the Chinese economy created a market glut in summer 2014, sending the price tumbling.