The Persian Gulf Quandary
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The Persian Gulf Quandary

by | published November 8th, 2019

When I was younger, I played a lot of chess.

The version of the game that was most demanding was called “fairy chess.” Here, the moves pieces can make change as the game proceeds, further complicated by what our opponent does. If a third dimension is then added to the board, the calculations needed become almost limitless.

What is currently unfolding in the Gulf reminds me of my earlier years of playing chess; of all the recent meetings I had in London, the most disquieting occurred over the ongoing crisis in the Persian Gulf.

We have entered a period in which all of the elements that produced previous attacks on oil tankers, pipelines, and fields/processing locations are still present. The added problem is the level of uncertainty surrounding them.

The most recent episode occurred on October 11, sixty miles from Jeddah off of the western coast of Saudi Arabia.

This time it was an Iranian target.

The tanker Sabity was hit by two missiles some twenty minutes apart. The damage resulted in oil spills, but no injuries to the crew, according to a statement from the National Iranian Oil Company.

At the time, my Saudi contacts did not respond to requests for comment, while those at the National Iranian Oil Company (NIOC) expressed an unusual restraint.

The situation continues today, almost a month after the episode…

The Geopolitical Effect on the Price of Oil

The Red Sea access attack followed upon the destructive September 14 drone and cruise missile launch against the huge Abqaiq crude processing complex and the Khurais oil field, both part of the primary oil production zone in eastern Saudi Arabia.

As with the earlier attacks on tankers near the Emirati port of Fujairah on the Gulf of Oman (just south of the strategic Strait of Hormuz), each event has spiked global crude oil prices. However, prices then adjusted downward after the market was “persuaded” that the episode was a one-off.

What ensues is the current quandary.

All the factors for conflict remain on the table and no path to resolution has emerged. Instead, market makers are building additional risk factors into their modeling.

The problem is what the prevailing uncertainty is doing to the setting of prices. The main instigators of huge spikes – a closing of the Strait of Hormuz, a sustained military attack in the immediate Persian Gulf region, or the overt entrance of Israel into the conflict – are not likely, at least in the short-term.

That means this is morphing into a sporadic increase in tension followed by an unsteady pause.

Normally, when his happens there is a slow but steady movement up in the price.

The reason is one I have mentioned often here in Oil & Energy Investor.

When Traders Become Chicken Littles

For the past three decades, daily prices are set by traders cutting futures contracts for consignments of oil to be delivered at a later date.Some of these are buttressed by options and used as hedges against pricing fluctuations by parties actually involved in the physical oil trade (suppliers, usually producers, and end users, almost always refineries).

However, most of the futures contracts are written by money folks interested only in making money off of the difference between what the contract costs them and what they can make before it expires.

In this scenario, traders peg the contract price to the expected cost of the next available barrel of crude. Whenever there is the prospect of an interruption in supply, that formula quickly becomes the expected cost of the most expensive next barrel of crude. The reverse happens if an excess in supply is seen.

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In an uncertain environment, the requirement that the trader insulate against the risk attendant from the most likely direction of price moves almost always leads to an overemphasis in that direction.

Normally, these aberrations are short-lived, as other counterbalancing factors emerge to revise the trader’s view of barrel pricing. Changes to existing contracts are then offset by options.

These days, “normal” is not the word participants describe the situation in the Persian Gulf. That’s because there the main drivers of available supply are not market dependent, rather they are determined by a tidal wave of regional political hatred.

And that has led to some unusual moves by those trying to set future oil prices.

Which brings me back to the meeting in London.

Changing the Rules of the Game

The membership included a scattering of oil company execs and policymakers, but most were traders and the financiers who orchestrate their futures contracts via The City (London’s financial district).

When you add up the futures contracts moving through The City from other parts of the world, this becomes the primary focus for international oil pricing. It is one of the lesser known reasons why the daily Brent benchmark price set in London has a greater command over worldwide crude trade than either the West Texas Intermediate (WTI) used in New York or, for that matter, the basket of North Sea oil grades upon which Brent is nominally based.

Enough oil is impacted by what is rolling out in the Persian Gulf, that what occurs there (or doesn’t) has a ripple effect. The London meeting clearly indicated new mechanisms have been established by oil traders to deal with the Gulf uncertainty.

There are three mechanisms that are most important, and each one carries its own level of risk and volatility.

First, additional layers of “insurance” are required, involving more complicated options strings, credit spreads, and contract swaps. This increases the cost of doing business while also lowering the reliability. That this process has obliged the development of new derivative paper hardly increases the reliability element.

Second, increasing funding is moving upstream to control more oil supply at its source. Initially, the fact that most oil from the Persian Gulf is provided by state-run national oil companies (NOCs) would seem to limit a London (or other)-based money move. Yet even Saudi giant Aramco has come into the international debt market for the first time in decades and is once again likely to offer a minority position in an IPO.

Provision of credit lines now has much more to say about either how much oil comes into the market and who controls it.

Third, some of the figures in the London session are discussing what I consider the most disturbing option. To flatten out the risk curve, providing the Iranians funding through intermediaries (read Qatar and others here) to lessen the incidence of attack on selected tankers and consignments.

A protection scheme by any other name…

The conversation in London also illuminated some rather curious conversations that occurred during my mid-September session in the Qatari capital of Doha. That just happened to be the only meeting during my Persian Gulf trip which included Iranian contacts.

Changing the rules of the game to make moves fit may make for a more interesting chess game, but it is not the way to run an oil market.

Sincerely,


Kent

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