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Geopolitical Risk Isn’t Driving Rising Oil Prices

Commodities / Crude Oil Dec 05, 2017 - 12:05 PM GMT

By: John_Mauldin

Commodities

By GEORGE FRIEDMAN AND XANDER SNYDER : At the end of October, Brent crude prices crossed $60 per barrel for the first time in two years. They peaked at around $64.

Experts explained the spike with vague references to “geopolitical risk,” without really detailing what those risks entailed. Such explanations are not wrong, but they are careless.

A proper geopolitical risk assessment goes beyond vague wording. It contains a deep understanding of relevant economic, political, and military factors.


Threats to Supply Are Overblown

For weeks, events in Saudi Arabia have been cited in commentary on oil markets. It all comes down to the rivalry between Saudi Arabia and Iran. A rivalry that plays out throughout the region, in Yemen, Lebanon, Iraq, Syria, and elsewhere. (We wrote about geopolitical developments in the Middle East in our exclusive e-book, The World Explained in Maps, which you can download here.)

Saudi Arabia is trying to keep Iran preoccupied so that it cannot gain too much ground in Syria, where the Islamic State has now lost nearly all of its territory.

The Saudis don’t want the Iranians to develop a land bridge to the Mediterranean through Iraq, Syria, and Lebanon. This would threaten Saudi Arabia’s security from the north. It would also give Iran access to the Mediterranean, and with it, the ability to export more to Europe.

What does this have to do with the price of oil?

For one thing, in the course of their quarrel, Iran and Saudi Arabia could destroy infrastructure, affecting the ability of oil producers to get oil to market.

How likely is this?

With a great deal of effort, Iran’s proxies could damage a small portion of Saudi Arabia’s infrastructure, but they couldn’t take on Saudi Arabia in an all-out fight. On the flip side, while some Sunni extremists have carried out terrorist attacks in Iran, their ability to damage Iran’s oil infrastructure is limited.

Another event that would restrict oil supply would be if a ground war were to break out between Iran and Saudi Arabia. This is highly unlikely. Iran doesn’t control the territory it would need to supply any sort of war effort in Saudi Arabia, and Saudi forces would struggle mightily to overcome the Zagros Mountains, which shield Iran’s western flank.

The timing also isn’t good for either side to start a war. Iran is only just beginning to reap the economic benefits of the lifting of UN sanctions in 2015. Saudi Arabia is facing too many problems at home, not to mention the war in Yemen.

All of these factors must be considered in constructing a comprehensive picture of geopolitical risk. Once the implications of these developments are seriously considered, the geopolitical risk does not appear substantially altered.

US Shale Runs Into Short-Term Problems

But if events surrounding Saudi Arabia don’t substantially increase the threat to the oil supply, what explains the increase in oil prices?

For starters, OPEC has recently made supply cuts while demand has remained strong. US shale production will offset the strategy that OPEC has pursued for decades in the long run. However, in the short run, there are factors preventing shale drillers from expanding at the clip witnessed over the past few years. 

When oil was above $100 per barrel, shale drillers could focus on expansion, since profit margins were wide enough to sustain the growth. Lending to the industry financed the expansion. Advances in technology increased the yield that each well could produce, bringing the amount of oil that shale drillers could provide to the market even higher.

But when prices dipped, shale drillers began to default on their loans and go bankrupt. The ones that have stuck around either purchased locations where drilling had a lower break-even cost per barrel or had more productive drilling processes.

Bankruptcies are continuing, and drillers are being forced to focus on profitability rather than growth. Despite all this, advances in drilling technology continue to raise well yields—putting downward pressure on break-even costs. Plus, higher oil prices still raise the profitability tide for all drillers.

It’s Just a Matter of Time

Rising oil prices, then, cannot be explained solely by events in the Middle East or by OPEC’s cuts. Rather, it’s a combination of OPEC’s cuts and the inability in the near term of shale drillers to significantly expand capacity.

These limitations, however, don’t change the fundamental interplay of shale oil drillers and the global oil market. New drilling technology is continuing to lower per-barrel break-even prices. More shale companies will find their operations profitable when oil prices increase. This will increase oil supply and drive prices back down.

Benjamin Graham, one of Warren Buffett’s greatest influences, coined the term “Mr. Market” to describe a manic character who buys and sells shares depending on his emotions.

He drew a sharp contrast between this type of investor and the company analysis based on fundamentals that his methodology entailed.

Just as in business analysis, it’s not enough to acknowledge that world events are driven by more than financial considerations. Real geopolitical risk analysis requires a deeper dive into what drives geopolitical phenomena.

Grab George Friedman's Exclusive eBook, The World Explained in Maps

The World Explained in Maps reveals the panorama of geopolitical landscapes influencing today's governments and global financial systems. Don't miss this chance to prepare for the year ahead with the straight facts about every major country’s and region's current geopolitical climate. You won't find political rhetoric or media hype here.

The World Explained in Maps is an essential guide for every investor as 2017 takes shape. Get your copy now—free!

John Mauldin Archive

© 2005-2018 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


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