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Commodities / Crude Oil Aug 05, 2014 - 06:17 AM GMT

By: Andrew_McKillop

Commodities

Dangerously Converging Contexts
As of now we can at least theoretically scenarize a world oil shock at least equal to the so-called 'Arab oil embargo' of 1973-74. The chronology shows that Arab oil exporters joined by the Shah's Iran, from October 1973 cut their total supply by 5% a month to obtain their political-economic demand for much higher prices “for as long as needed”. By January-February 1974 they had started delaying or freezing the monthly 5% cuts in supply. By March when Israel withdrew the last of it soldiers from the Egyptian side of the Suez Canal the embargo started winding down.


The potential oil shock of 2014 concerns the threat or certainty of oil export supply cuts from several key regions and producer states – Russia, Iraq, Libya, Syria, Yemen and possibly the GCC Arab Gulf exporters. Other small producers similar to Syria and Yemen can be added to the list. The differences then-and-now are however massive, starting with the twin realities underlying the potential for a coalescing chaos-type oil shock of 2014.

The shock would only be in part politically-motivated on the blueprint of the 1973-74 embargo and would not rapidly unwind and return to normal afterwards. This will not be a six-month-only oil crisis.

The biggest convergent factor making a 2014 shock possible is the role of conflict, civil war and the potential extension of civil wars into full-blown international war. In that situation we get “force majeure” and oil supplies will be restored “sine die” or when  God chooses! This is not the same as a political embargo on oil supplies which can be restored by the stroke of a pen or snap of the fingers.

The ISIS Threat
As of August 3 newswires report, recent fighting in north and central Iraq results in ISIS fighters taking full control of Iraq's biggest dam at Haditha unopposed by Kurdish fighters who have made a strategic retreat to Kurd territory after losing three towns, and an oilfield to ISIS fighters. The Haditha Dam serving Baghdad, like a smaller dam serving Mosul which fell to ISIS fighters in June, was as early as 2007 identified by the US Special Inspectorate General for Iraq Reconstruction, a Pentagon watchdog, as a critical installation for enemy insurgent attack. This Agency highlighted structural problems at the two earthfill dams, needing constant grouting and backfill to prevent collapse, and warned of the catastrophic possibilities if either of them fell to insurgents – then called Al Qaeda in Iraq. Both of these dams are now in the hands of ISIS but claims by ekurd.net, August 4, say that Kurd fighters have thwarted or limited ISIS from holding total control of the Mosul dam.

Due to their construction method and need for constant upkeep, both dams are relatively easy to rupture using only low amounts of well-placed explosives. The US special agency warned that total rupture of the Haditha Dam could cause a 65-foot-high tidal wave in Baghdad City.

ISIS now has two powerful bargaining chips in Iraq. Its frankly apocalyptic general theory of forcing its Grand Caliphate into being would be served by the total destruction of Baghdad if the city and el-Maliki's government do not submit. ISIS in no way avoids the Apocalypse but welcomes it, and the effects on Iraq's oil production and oil exports of destroying Baghdad can be imagined. Comparable insurgency, civil riot and rebellion and destruction of government is under way in both Syria and Libya. The extreme fundamentalist Sunni ISIS movement makes no secret of “the prize” being the overthrow of albeit-Sunni ruling families, called “impious and heretical”, in the GCC countries.

The Ukraine Threat
Conventional or mainstream media has studiously avoided the “oil threat' of Russian counter-sanctions while the “gas threat” has been given large coverage. In fact EU28 countries source about the same amount of their oil (about 30% - 35%) as gas from Russia. Either “tap” can be turned off.

Sanctions to date are in a complex state of evolution and denial, leaving analysts with no clear track to follow but Russia's use of counter-sanctions including oil are more probable than only possible. One track that is already clear is that western oil company investment and holdings in Russia's oil-gas sector will tend to be whittled back in an escalation process. Russia has already launched a determined program to find oil buyers in China and India, not using US dollars as settlement currency.

Related events include increasing potentials for a major reheat of the Azerbaijan-Armenia conflict over the Nagorny Karabakh enclave with Russia backing Armenia and the west, predictably, backing oil-rich Azerbaijan. This time the fighting can overspill to attacks on the $40 billion oil pipeline of the consortium headed by BP.

The Ukraine threat to global oil is at least as serious as the ISIS threat in the Arabian peninsula and MENA region. This is primarily due to military action – attributed by western media and political leaders as due to the Russian state in general and Vladimir Putin in particular– being under way and hard to stop. In the ISIS case, however, there is no state which can be directly blamed for the process of civil strife, riot and rebellion and the collapse of government spreading across the MENA region.

Escalation in the Ukraine theater and conflict zone is therefore a more predictable menace. Collateral damage to oil supplies, as noted already, are probable rather than possible

Feast to Famine
Most certainly intensifying the shock-prone context for oil prices, and dramatizing them, current global oil supply-demand metrics point to major oversupply. When or if that context suddenly overturns or flips over to sharp undersupply, we can only expect “heroic daily trading”. Prices will seesaw in extreme fashion. The $4-a-day price change paradigm can be invoked.

As we know and simple energy economics proves this, oil cannot reach and then hold $150 a barrel nor $35 a barrel, but between the two extremes margin plays will run riot. The market will run into uber-opaque territory and may stay there longer than some experts might predict. Taking objective criteria and metrics, although these will be sidelined in the crisis, only Saudi Arabia has probable, or at least possible market-credible spare production capacity. The “potential spare” capacity that is represented by el-Maliki's Iraq with its claims of constant and massive yearly oil production hikes, will be made virtual and “sine die”. Dissolved by the Islamic revolution.

Added to the sure and certain decline of Libyan net export supply, we can increasingly forecast declining Iraqi supply - and the possible use by Russia of targeted cuts to oil supply to selected EU28 nations applying US-led economic sanctions – especially Germany - when or if these western sanctions become too arrogant and too insistent.

We have an oil market context that can turn on its head any day. You can expect big changes.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2014 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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