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After the suicide of the fruit grocer in Libya against the corrupt Government, majority of the East Asian nations have picked up movement against the ruling autocratic Governments. Whenever such calamities happen, they lead to uncertainties in the functioning of the trade leading to scarcity or supply side crunch of crude oil. Looking at the historical patterns, during Gulf War, crude oil prices shocked up in3-stages according to the research.
Majority times during such unrest, OPEC used to dominate the pricing of oil. In 1973 Arab-Israel War, OPEC increased price of oil by 6.5 $ / barrel or 128%. Also in the case of Iranian Revolution and followed by Iran-Iraq War Oil prices surged 77% higher in the phase.
The paper compares various phases of unrest in Oil Producing OPEC nations and their implication on global economy. The paper covers Oil Embargo in detail and tries to correlate the MENA crisis prevailing in global market today.
During Israel-Arab War, Jewish, Muslims and Christians evoked religious arguments in order to increase their stake in the area. This lead to religious and political tension in the region leading to the War. The war lead to an opportunity cost for Middle East in the decade to go to 12 trillion $. In the time, Israel had lost around 1 trillion $ whereas Saudi Arabia and Iraq shed another 2.3 trillion $.
Also in the prevalent times, OPEC in order to increase their strength in global trade increased the prices of Oil by nearly 70% in a short span of time. This was basically done to encourage West nations to decrease their production by 5% annually. The reason also included US relations with Israel which was not a state in friendship ties with Arab. This basically was done by reducing the total production of Oil monthly to a level which would lead to lower spare capacity scenario in the prevailing times. Starting from US it spread to Netherlands which then lead to a far widespread Oil demand in European Region. The effect of Embargo was Immediate. OPEC countries demanded companies to increase payments drastically. The price of Oil increased by nearly 400% to nearly $12 per barrel. The result was also the transfer of the power which initially rested in the hands of the West developed nations to the oil exporting nations. These nations gained a lot from the hike in oil prices. The amount would then also be sent to other under-developed nations. These economies included the ones which were affected by the hike in oil prices. A 25% oil cut was the consequence of the embargo leading to break in the global development.
US Government had to suffer huge losses internal as well as external. The process lead to massive inflationary pressures in the economy spreading unrest. A Major problem with the US companies was to
Find new avenues of Oil Exploration which essentially was a 5-10 years process. In the process of embargo US, Netherlands were totally shattered. Also countries like UK, France had uninterrupted oil supply.
The embargo marked an end after the Washington Oil Summit was commenced and the deal was signed through. In matter of settlement Nixon Govt also had issues arising out in Latin America. Along with the third world, Latin America was the next region where Embargo policy was utilized against the government. The problem with the US was extra care and facilities to China. Soviet Union including selling of Oil Forwards at cheaper rate making it a loss for the oil nations. Chile and Venezuela started a movement against the West to cut their production export for some time. This was in lesser concentration but was capable to create another Oil disaster. In the course of events, Japan was understood to have been impacted the most as they used to import more than 70% of their oil from Middle East. Sooner in 1981, OPEC lost its prominence with the increasing tensions in the member nations as well as new avenues for oil exploration had been found and used.
After member nation conflict Saudi Arabia in order to gain more orders started producing more oil at cheaper rates leading to major downfall in the prices of the commodity. This made high cost oil production a distant process to be advocated. The price of Oil which once surged to as high as $80 per barrel came down to $ 38 per barrel. Oil briefly fell to its post war, 1973 price ranges.
In this graph we can see the Oil prices surged higher in 1970s and after the Washington Oil Pact the prices came down drastically s the OPEC became weak and other countries providing oil at cheaper or competitive rates.
This embargo leads to drift in US and Soviet Union, Oil available at cheaper rate. Being so cheap that alternatives were not even classified as energy sources. This also lead to increase in wealth for Middle East with moderate economic growth and a very strong international bargaining power.
PRESENT GULF CRISIS - MENA
The present crisis looks similar in nature but the magnitude may be very higher as the oil producing economies are struggling in their internal governments making the international trade sceptical about the stability of the regions. This has lead to speculation of instability in Oil production leading to spike in oil prices. The price hike can be observed to be in 3 phases. In the prevalent circumstance we are just at the initial stage where economic unrest is just erupting in the Middle East. The eruption can be very dangerous if it falls in hands of other major oil producers.
During initial stage of the famous Gulf War, prices increased by nearly 21%. A 13% spike in Oil prices in MENA unrest shows just the initiation of the unrest in the price of the commodity. In the nest stage the damage can be predicted to be more harmful and contagious. During Gulf War, the prices went up by nearly 130%. If the unrest spreading from Egypt to Libya and Algeria doesn't stop it may intensify another bull run in the price of the commodity.
In the present situation, Open Interest of WTI has surged 2.6% indicating significant open positions in the market leading to major writes in puts (displaying upward trend). Open Interest in Brent Crude contracts has fallen by nearly 7%. The irregularity was displayed because of the differential of WTI-Brent in the period.
Brent Crude always use dot be at discount if at lower price to WTI index. But due to unrest in Libya, which exports majority of production to European Countries (80* or more), the shortage lead to more speculation in decreasing supply unable to reach the demands. This has lead to the surge in Brent Oil price faster then that of WTI which imports majorly from Saudi Arabia and uses it in Texas which has a better Efficiency.
Looking at the level of unrest present, Yemen, Egypt, Syria, Libya have already surpassed the UN level of danger. The citizens have been appealed to maintain calm and composure but the efforts have been in vain.
Potential Shut-ins because of Unrest:
In Jan-2011, Libya produced around 1.58mmbbl/d while Algeria produced 1.27mmbbl/d of oil. So far, Libya National Oil Company has been to its commitment with no shut-ins but Al-Jazeera has reported a potential shut-down of production in Libya due to the crisis. Shell has also stopped any production of oil in Libya since Feb-2011. Carrying on Algeria, Oil producers have been threatened by terrorist to stop production of oil in Algeria leading to a direct shortage of 2+mmbbl/d of oil. The above displayed table shows the monthly supply of Oil by Middle East Nations. This also includes Sustainable production capacity which is one of the highest in Algeria. Hence any unrest in the economy of Algeria can send massive shocks to entire word hampering international trade. The only good thing has been that Saudi Arabia has not yet come under a bigger influence of such unrest. Saudi account to nearly 20% of Oil production in OPEC and any imbalance in that region will cause Oil prices to shoot up above 200 $ per barrel.
ANALYSIS OF PAST CRISES IN MIDDLE EAST - ITS REACTION OIL SUPPLY AND PRICE
Here during the period from 1971-1980 we find that there is a very high positive correlation between crude oil and gold. There can be many reasons for that but some of the really important reasons are given below:
1971: OPEC mandates "total embargo" against any company that rejects the 55 percent tax rate.
1972: OPEC threatens "appropriate sanctions" against companies that "fail to comply with . . . [OPEC] decisions."
1975: Iraq completes nationalization by taking over the BP and Shell shares of the Bharat Petroleum Company.
1978: OPEC decides on a 14.5 percent price increase for 1979, to be implemented quarterly
1980: Iraq breaks 1975 treaty with Iran and proclaims sovereignty over Shatt al-Arab waterway; Iraq invades Iran.
And because of all this reasons gold was also demanded and this lead to the price rise in gold as well as crude oil.
Here during the period from 1981-1990 we find that there is almost no correlation between crude oil and gold. There can be many reasons for that but some of the really important reasons are given below:
1982: Iraq declares unilateral cease-fire; Iran launches first attack into Iraq.
1984: OPEC cuts production to 16 MMB/D.
1985: Nine OPEC members adjust prices to cut gap between light and heavy crudes from $4 to $2.40 per barrel. Saudi light price cut one dollar to $28 per barrel.
1987: OPEC price accord begins to deteriorate.
1989: Exxon tanker Valdez runs aground, spilling 11 million gallons of crude oil in the waters of Price William Sound. Oil prices react upward to news of the spill and to potential shortages on the west coast cased by refinery fires there.
1990: Iraq invades Kuwait.
So because of these reasons mentioned above there were ups and downs in the prices of crude oil and therefore we find that there is no correlation between crude oil and gold.
Here during the period from 1991-2000 we find that there is a negative correlation between crude oil and gold. There can be many reasons for that but some of the really important reasons are given below:
1991: Reports Iraq will accept U.S. offer for talks in Geneva; Gulf war at its peak. U.S. draws Strategic Petroleum Reserve (SPR). Crude oil prices drop $9-10 per barrel in one day after having risen $3-5 per barrel during the first half of January.
1997-1998: Asian Crisis which lead to recession stopped the flow of the Asian economy and that is why the crude oil demand was rising.
Gold demand decreased rapidly due to Asian Crisis and so we can see a negative correlation.
Here during the period from 2000-2008 we find that there is a very positive correlation between crude oil and gold. There can be many reasons for that but some of the really important reasons are given below:
2001: OPEC agrees at a meeting of ministers in Vienna, to reduce members' production quotas by 1.5 million barrels per day. The move comes in response to OPEC members' concerns about declining prices.
2003: US-Iraq Relations; Raise OPEC quota excluding Iraq
2004: Political Stability in Iraq
2005: Dispute, Strike in Nigeria; OPEC decides to leave its crude oil production quotas unchanged at 27 million bpd after a meeting in Vienna.
In the year 2007-08 the gold prices shooted up, but in the middle of 2008 because of economic crisis the prices of gold and crude were affected drastically.
During our analysis of Gulf War the three stages identified had drastic results where first stage marked the uncertainty lead prices, second was the consequential shoot up due to rapid unrest and the third stage is the stage of stabilization in which either the price drops or intensity of upward trend reduces. In the first and second stage of Gulf war a total of 150%+ of oil prices had risen. This leads to a new theory which states more than 100% rise in crude oil prices by the end of second phase which may hamper the global economy big time. If the situation worsens the price may go up to 220$ per barrel which is exactly twice the present prevailing rates.
Currently, OPEC spare capacity is around 5.2mmbbl/d and an agreement has been met to increase production in case required if the member nations face unrest. In the above case if Libya and Algeria go out of production, the total spare capacity gets reduced to 2.1mbbl/d which is lower then the levels during 1990-1991 imbalances. Even in 2008, when oil prices surged to high of 148$ per barrel OPEC had a spare capacity of 2.3mbbl/d. This caused a spike in prices a month later. A similar situation may come in front this time too. With increasing unrest and reducing spare capacity, the equation does not favour any downtrend in price of Oil.
From the figure, Spare capacity is highest in the years when economic stability is present. But as the spare capacity got drowned below 3%, world economy has seen sudden shocks of unrests. These imbalances have also been due to forecasts developed of bullish trend in oil prices as spare capacity has seen a decline. The spare capacity can majorly be attributed to Saudi Arabia and any impact in that place may cause unrest and thus more trouble for global economy.
Correlation between Oil Prices and Wars:
From the below given graph it can be easily spotted out that during uncertainties (Iraq invades Kuwait), the oil prices have surged up. This was followed by the Gulf War which had drastic implications with the end of bullish run during negotiation talks offered by Saddam Husain. This lead to stability in the region as there was no war in place. As soon as the war went off, UN sent its military to redeem stability in affected countries showing a positive sign leading to further fall in prices. In the process as US started the air strike, oil prices jumped. This was short and UN sought control over the mess. This then resulted in stable environment. The next few years, Oil remained flat and had minimal appreciation to be in with nominal rates.
After spreading of protests against the existing Govt., Muammar Quadaffi has dropped every chance of resigning from the government and has started posing threatening consequences if the riots don't stop.
Such a rift has lead to major unrest spreading where government has stepped in war but in a different manner and idea. Such an upbringing has lead to UN Security Council posing economic and commercial sanctions against Libya. UN has also directed its council to investigate in any of the casualties which took place during the riots.
As a result of such distress, workers have started fleeing out of the country to safe lands. This has lead to drop in production of oil products in the country. The biggest oil terminal of Brega has felt the unrest of the riots taking place. There has been a drop in production and shipment of oil products which initially scaled to around 1.6 million barrels have been reduced to mere 850000 barrels. In Brega huge spherical containers have been full of oil products but the transportation has been a big issue. With no transportation and no excess storage capacity more production will just lead to more disaster and wastage of resources.
Ports of Al Brega, Tobruk, Al Sabina have seen a drop in exports by nearly 80 %. Such turmoil will not lead to major distress as the Libyan production won't be that huge. But still it may hamper the spare capacity in OPEC, and if other countries default, it can lead to serious disaster.
High Inventories - Positive for near term:
Even if there is supply disruption from Libya and Algeria, OPEC has a huge amount of inventory to carry out normal trade in near term. OECD Crude inventory is about 1000mbbl/d whereas governments own nearly 1400mbbl/d of oil reserves. These are enough to facilitate oil usage for next 2 months. As discussed earlier, OPEC has to keep Saudi away from Crisis as it not only supplies 20% of the oil production but also has the largest spare capacity present. It has a 3.5mbb/d of reserves followed by Nigeria with 0.26mbb/d of reserves. Strategically if Saudi enters the crisis, the pieces may shoot up unimaginably.
High Price - Reduce Demand:
With soaring Oil Prices, the demand of oil by under-developed nation may be written off. Also major oil importers would also then constrain themselves from buying oil at such higher rates. The demand for each quarter is around 66mbb/d as per the statistics available.
Spread between Brent and WTI:
Riots have spiked major oil producing nations leading to uncertainty in index movements like Brent and WTI.
WTI (West Texas Intermediate) - This index covers US region of usage. Brent is not as light or as sweet as WTI but it still is a high grade fuel. The Index covers Texas and other US states where Oil is produced or consumed.
Brent - Its basically used to source Oil from North Sea.
The recent turmoil has affected the index prices as the spread between the two indices has been irregular and uncertain.
Historically the spread has been because of Middle East Turmoil. The spread between the index Brent and WTI has widened to nearly 20 $ per barrel. But in recent times, Libya unrest has lead to increase in demand for Brent Crude as Libya used to majorly export oil to Europe. Hence shortfall in Brent Crude has lead to the spread getting diverged as Brent who usually used to be lower in value then WTI is now higher.
After riots in Egypt the spread between Brent and WTI Index has widened indicating further stress in the global economy. This is as Commodity traders would then look for Arbitrage opportunity in the whole scenario.
In stable stages both the Indices have moved in similar range with minimal spread. Only during unrest there is a spread developing. In 2008 when Oil prices turned out to 140$+ per barrel, the spike can be observed. Similar is the situation present now with spread more widening and more challenging. In majority of cases WTI has been higher then Brent but presently due to Libya unrest, this has got inverted. Such a spread has never been witnessed in last 23 years. Hence prediction of the upcoming events has become difficult but they
are not good for world economy for sure. The spread has always come in consideration either when there was unrest in US - leading to price hikes in WTI (Texas and Oklahoma). Where as this crisis has entered into water territories of oil market which basically include the European Markets. This unrest in Brent can be showcased in the price trends present in the market.
Since Brent Oil is more inclined and correlated to Middle-East (WTI Worldwide), the prices are more in correlation with the Middle East health. For WTI the position is hedged with other global producers present.
Since the spread of the unrest in Middle-East in Jan 11, the spread between Brent and WTI can be seen to be widening. Also since Recession, the spread has been either null or inclined towards WTI, but since last 2-3 months the Brent index has taken over and is now having a Spread over WTI of nearly 20%.
Also if the situation in Middle-East doesn't get better, the spread may increase much higher, leading to more variation in prices. The variation may lead to increase in price of WTI as the ratio of WTI and Brent has to be kept in a check. This would them lead to overall price hike. The estimation can be nearly 200 $ per barrel.
Changes because of USD/EUR exchange rates:
The demand of Oil in US and Europe has been just one reason for spread in the price of the Brent and WTI. Another reason has been the USD/EUR exchange rate. The rate after the European crisis has been decreasing making it easier for traders to buy oil in WTI and get it converted into Brent Index Crude at lower exchange rate. This has also lead to increase in demand for Brent Crude other then WTI. This is because the traders get more of Dollars per Euro in the transaction as in recent times the USD has become stronger then the 19 nation currency.
Speculation of Brent-WTI spread - Investor Perception:
In such a speculative move, the investor should carefully look for the pitfalls present in the spread. The spread can be highly rewarding, and in similar other case can lead to disastrous consequences if not monitored carefully. The profit can be maximized if the trader is able to understand the direction where the gap would proceed in some given circumstances.
In order to do this we exactly need to understand the Index features.
Brent - Supplies majorly to North Sea. The route is major exporting index for European companies. Libya which provides more than three-fourth of its oil to Europe has a bigger significance in the Index.
WTI - is majorly a global index with base in Texas and Oklahoma. The price is centred to North American Crude Oil Market.
Main variables include:
Oil Stocks in US
Euro/USD exchange rates
Differential consumption pattern in US and Europe
99 00 01 02 03 04 05 06 07 08 09 10
There has been minor correlation between the two indices. Pre-Recession, the exchange rate increased as US dollar strengthened in European Market. The reason was more and more swaps present leading to more demand of $ in European Market. Since 2008, a positive correlation can be observed as Brent increases in its value more and more Dollar is pumped in Europe leading to depreciation. This is because investors buy Oil in WTI and sell it off in Brent increasing the concentration of Euro in Trader's hands.
Also Oil Companies have hard times when there is any uncertainty in the global markets as their production gets hampered. Also in cases of demand increasing in Brent Crude, Oil companies don't show a bigger mismatch in the price differential. In early 2000s, when US used to consume huge amount of Oil for development, the Oil companies had good time but still the ratio of Brent and crude was stable in middle years. This shows low correlation as Oil companies earned huge profit with little or no impact on ratio of two indices.
Last is the consumption pattern of consumers. It can be related that if the consumption increases, it leads to higher demand for such products. Companies in order to meet such huge demand pump out more oil. This huge demand adds to more upward pressure in oil prices. Also with shortage in supply and similar demand may lead to higher prices. Hence an analyst has to keep into consideration the demand side and supply side perspective while trading in the spread. In times of warm winters, the demand has to come down; hence he has to hedge his portfolio with the help of Weather derivatives.
If steps are not taken the prices may soar higher then historical figures. This may lead to decrease in Gold-to-Oil ratio. The historical benchmark of 16 if broken will lead to uncertainties. This will then lead to investors again going for Gold investment as its perfect Inflation hedge and keeps away from any such uncertainties. Again Investing in gold would mean higher prices of some linked commodities. If this happens, US dollar will again loose its value sending entire World economy into another black collapsible recession. Governments have to keep effective and strict control on the price of Oil as it would then lead to spike in prices of other commodities as each and every commodity produced requires energy which mainly comes from Oil products. The impact can be seen in emerging economies with India and China most affected by rising crude oil prices. This may add to more misery if Saudi Arabia enters into such unrest as the spare capacity may get totally washed off making it difficult for countries to manage Oil shortage.