Oil Prices Spike as Chaos Takes Hold
First there was the crisis in Ukraine. Then seemingly out of nowhere, Iraq exploded into chaos again.
Both testify to one simple truth about today’s energy sector: Geopolitical factors are the quintessential wild cards when it comes to estimating energy prices.
As for crude, prices have been subdued both yesterday and this morning following a crisis-related spike. But with two full-blown crises now looming, you can bet that’s not going to last.
Oil prices are now likely headed higher.
In this case, supply and demand only works in the textbooks. These days, geopolitical events can quickly outdistance the “market-only” factors.
That’s especially true in Iraq, where ISIL insurgents are still on the move…
The Dangerous “Balance” in Iraq
Of the two crises, this is the one that concerns Americans the most. It may be only 275, but troops are moving back to Iraq.
On top of that, Washington is going to start consultations with Tehran. The entire region – from Riyadh in Saudi Arabia, through Amman in Jordan, to Ankara in Turkey – is in turmoil following the Sunni insurgency.
But when it comes to the impact this crisis has on oil prices, this is one of those classic cases where the unfolding events have more to do with perceptions than reality. So far, the fighting does not affect oil production or export routes.
Northern oil, accounting for about 20% of all national extraction, is centered around Kirkuk with the export venue being a major pipeline system to Ceyhan in Southeastern Turkey. This area is now controlled by the semi-autonomous Kurdistan Regional Government (KRG) in Erbil and its very effective militia (the peshmerga).
The absolute majority of Iraqi oil comes from the south. To the extent that ISIL (the Islamic State of Iraq and the Levant) has Baghdad as its objective, the southern oil fields are not in danger.
ISIL is a Sunni uprising in what is a Shiite dominated country. The southern region centered around Basra is heavily Shia and becoming closer with each passing day to neighboring Iran, also a Shiite country.
The south also has its own militia and they will present major problems to any further ISIL advance. In addition, there have been reliable reports over the past few days that detachments of the Iranian Revolutionary Guard and other “volunteers” have been moving into Southern Iraq.
Just yesterday it appears an Iranian general arrived in Basra to assist in the coordination of Shiite defenses for the area. The reality of what is happening on the ground will dictate that Washington bow to the inevitable and accede to some enhanced Iranian presence.
The Sunni Insurgency and Oil Prices
This will initiate the first of three factors that will impact global oil prices. And you won’t need to have the uprising take over oil fields for this to have an effect.
First, the Iranian moves and what will now be an intensifying drive for outright independence in northern Kurdistan run the risk of trifurcating the country along ethnic and religious lines – Kurds controlling the far north, Sunnis the central portion of the country and Shiites the south.
Second, Abu Bakr al-Baghdadi has proclaimed the objective of his ISIL uprising is to unseat the Shiite government of Prime Minister Nouri al-Malaki. That objective is actually shared by the KRG, Turkey, and other elements in the region. Yet, paralyzing the government in the capital city would create significant problems for both the production and export of oil. There would be no administrative structure, no reliable regulatory oversight, and a rising inability for operating companies to budget and plan.
Of course, the other ISIL goal of setting up a Sharia (Islamic religious law) caliphate on the border between Iraq and Syria would fundamentally shatter any possible stability in the entire Gulf.
Third, should any of the international majors working in southern Iraq reduce or suspend field operations in the wake of all this uncertainty, the knock on effects on wider oil prices would well exceed the actual loss of production.
Remember, we are moving into an environment in which perception is more important than reality. In normal times, a trader determines the price of an oil consignment on the expected price of the next available barrel. In uncertain times, that level is determined by the expected price of the most expensive next available barrel.
Oil prices will rise beyond what the market really justifies, and then take a breather, to start rising again in the absence of any resolution of the crisis at hand.
Not One…But Two Full-Blown Crises
Meanwhile, in Ukraine, Russian natural gas dominant Gazprom (OTC: OGZPY) has cut off exports to the country while pledging to keep flow across Ukraine to Europe intact.
This will begin having a major impact as we move closer to September. Currently, European demand is low as summer sets in and Ukrainian underground storage facilities have ample supply to meet reduced need at home.
That will change as fall arrives. Kiev said yesterday that it had enough gas to last until December but that does not address the need to pump supply into storage wells before that.
As this energy problem deepens, there is widespread belief that Ukraine will begin siphoning off throughput bound for Europe for its own use. The real crunch, therefore, is several months away.
And Europeans remember all too clearly two weeks of freezing during a dreadful winter in 2009, the last time Russian gas was interrupted crossing Ukraine. The European Union has been successful in diversifying its supply sources since then, and now only relies on Ukrainian throughput for just 15% of what it needs on a daily basis.
Still, the possibility of another interruption of that delivery obliges Europe to rebalance its delivery venues now. The Nord Stream pipeline from Northern Russia to Northern Germany via the Baltic Sea floor is uninterrupted. But the rising political animosity between Brussels (the seat of the EU as well as NATO) and Moscow will add some pressure even though there is no indication long-term contracts are likely to be impaired.
Additional consignments of liquefied natural gas (LNG) from Qatar and North Africa are possible, although the latter is always subject to the vicissitudes of a morphing Arab Spring. So Europe has to balance its rising distrust of Russian intentions with its own energy requirements.
Longer-term solutions involve LNG deliveries from the U.S. and development of domestic shale gas. However, American deliveries are at least eighteen months away while local shale gas supplies are further down the road and still must face major political opposition and technical challenges.
But make no mistake. Neither the Ukrainian nor the Iraqi crisis is going to be a short-lived event. Both Kiev and Baghdad will emerge as significantly weakened seats of government.
All of which makes the period we are moving into a very chaotic one for oil prices.