The current mixture of strong macroeconomic signals and what is expected to be a strong showing from today's nonfarm payrolls report is flashing a "green light" to Federal Reserve hawks. Meanwhile, fear of Sunday's Italian vote seems to be fading.
Article / 27 February 2012 at 16:06 GMT

Asia worst off if Iran oil taken off market.

Head of FX Strategy / Saxo Bank

The world economy is in a fragile state despite a few promising signs here and there, and the last thing it needs is a new energy spike driven by the current situation in Iran. And Asia would get the worst of it.

Equity markets and riskier assets in general have been rallying of late on a combination of signs of stability (European core, if not periphery) and even recovery (USA) and because the major central banks are bent on printing enough money to flood the world with liquidity. The latter compels investors to buy “hard assets” and take on more risk and extend their duration to have any hope of scraping together just a few more bps of yield.

But the latest spike in oil prices threatens to derail the signs of recovery, whether it is for real or not. and send the world spiralling back into recession if prices don’t fall soon. And central banks have turned a blind eye to the risk that printed money is aggravating the wrong kind of inflation – cost push inflation that is destroying end demand domestically while aggravating the imbalances in oil exporting countries. As for the latter, the bonanza of oil revenues, in various shades of the behaviour made possible by Iran, discourages reform in oil exporting nations, and allows the continuation of massive, unrealistic subsidies to their economies and other irresponsible behaviour.

Asia worst off if Iran goes off-line
There are two scenarios related to a disruption in Iran’s oil – a complete shutdown for Iran exports due to a forced embargo (forced because it appears China is not interested in severing its links to Iranian crude) or due to military operations or both. That would see 2.5M bbl/day of exports taken off the market. The fallout is worst here for Asia in that scenario, as it receives the lion’s share of Iranian oil. Greece would be forced to scramble for a new supplier as well, as it relies on Iran for more than a quarter of its oil imports, so there is also a Euro Zone angle. This would result in a further aggravation of prices, though this would likely stop short of a doomsday scenario. That’s because Libya is coming quickly back on-line and could increase production another 750k bbl/day from here. And Saudi Arabia theoretically has 2 million further barrels of spare capacity, though it may be of suspect quality and it is key to note that Saudi is already producing at the highest level in decades. Elsewhere across the OPEC countries, production is likely more or less running flat out already as most OPEC members raised production as Libya went off line last year.

By far the more dramatic event would be an Iranian strike that halts shipping through the straits of Hormuz, as 20% of global oil supply, or some 17M bbl/day travels through the straits – and a stunning 85% of that crude is Asia-bound. Some have promised that any damage from such an attack could be cleared within a few weeks, but an attack and closure of the straits would inevitably trigger the release of strategic reserves globally (major consumers have at least a three-month supply, though China has been sorely lagging in building a reserve) and could see crude spiking to 150 to 200 dollars for a time before order is restored. Then those reserves would have to be rebuilt (and likely even expanded due to additional desire to hoard) on top of baseline demand in the wake of the event. A global recession would be virtually guaranteed in this event.

Chart: Crude Oil before and after Desert Storm I and II. 


As the chart above shows – anticipation of the Iraq conflicts of 1990-91 and 2003+ was far more damaging than the outbreak of conflict itself (x-axis is the number of days before and after the conflict) The question is how much spare capacity the world has to work with this time around (not much if economic growth is to continue) and how long the “anticipation phase” lasts and whether it results in a real disruption of supplies.

US far less vulnerable than in it used to be
While the US is more dependent on petrol prices as a unit of GDP than Europe and oil is typically seen as the US’ Achilles heel, the oil-related trade deficit in the US has improved radically over the last several years (around 11M bbl/day imported now vs. >14M bbl/day 5 years ago) and reliance on Iran specifically for oil is nil. The US only depends on Persian/Arabian Gulf oil for about 2 million barrels a day of crude, versus 2.5M bbl/day on average just a few years ago. Europe is far more reliant on imports as a percentage of oil consumed and import dependency is as higher than ever due to declining North Sea production, though most of that demand is satisfied away from the Persian/Arabian Gulf. Still, expressed in Euros and pound sterling, the price for crude in Europe recently notched an all-time high as most European crude is priced off the Brent crude benchmark, which currently trades at a 10% premium to the standard US WTI crude benchmark.

Again, worst hit by far by any disruption of Iranian supply would be Asia, and particularly China, as it is highly dependent on Persian/Arabian Gulf oil, has the highest dependency on energy prices as a unit of GDP relative to the other major oil importers, and has the least strategic reserves among the major economies.

Chart: US Gasoline PricesUSGas

By law, gasoline in the US switches from winter blends to more expensive summer blends starting in March and April as these blends create less pollution. The two previous massive spikes in prices at the pump in the US (barring the Hurricane Katrina event) occurred in the late spring and summer of 2008 and 2010, respectively. Already, prices at a record for this time of year, and the prices for April gasoline and beyond are about 20 cents higher per gallon than spot prices – just as seasonal demand ramps up in March and continues higher well into the summer. So assuming the commodity prices don’t change, US drivers will be faced with prices that nearly equal the highest prices from last May and are within 10% of the highest level in 2008. Every 10 cents that prices rise over the course of the year mean a drag of about $20 billion just from liquid fuels alone (gasoline and distillates like diesel), so a rise of another dollar per gallon in fuel prices could cost the US $200 billion and the rest of the world some $1 trillion or more.

What does further oil price spike mean for markets and politics?

  • Bond markets - The spike in oil prices is being completely ignored by bond markets, which are only fixated on the idea that central banks will print money to eternity and have completely control of the yield curve. The irony there is hopefully self-evident. Oil-induced inflation could gum up the central bank printing presses.
  • Equities – there is no upside from a further spik in oil prices – which are like a tax on everything non-oil related
  • Currencies – This is risk negative, which is to day, nominally USD positive and EM currency negative – particularly for oil importers like CEE countries and Asian currencies dependent on oil (note that some of the recent JPY weakness driven by oil dependency). The USD negative argument is that all of the US dollars needed to buy oil must be diversified, so there it is not robustly positive for the US case – though as we mention above – the emergency scenario is far less damaging to the US oil fundamentals than for the rest of the world. It is good as long as it lasts for oil currencies like NOK, MXN, RUB and CAD (why hasn’t CAD responded more, one can certainly ask!)

Crude oil – obviously, as long as the stand-off continues, the geopolitical premium for crude will remain very large. The only place bears can take heart is in the enormous speculative long position in the oil futures market (the ration of speculative involvement shown below) and in the event that a futures exchange hikes margins to “discourage speculation”.

Chart: US futures speculative ratioWTISpecs

The chart (Source: Bloomberg/CFTC) above shows the very high percentage of the US crude oil futures open interest is in speculative hands. This raises the risk of an exchange move to raise margins to avoid political fall-out.

  • Politics – or perhaps more importantly, “society”. Higher fuel prices are very tough on those who can least afford it, and this raises the risk of more social unrest. And for those countries that try to ease price rises with subsidies, the bill for these hand-outs is accelerating quickly. With every dollar that prices ratchet higher, social unrest will increase.

Someone once said that the quickest way to end low oil prices is with low oil prices, as production in a high cost environment quickly shrivels when the price drops . But since oil is the world’s most important commodity, the opposite scenario (high prices eventually solving high oil prices through demand destruction) is a far more painful one and must mean an even weaker environment, something the world can ill afford at this time. So hopefully it won’t come to this and oil prices will retreat at least 10-20% in the coming months.

And hopefully - the fears of an confrontation in Iran are exaggerated and hopefully the one side or the other backs down and this situation “just goes away” but the irony is that the higher the oil prices, the more it enables Iran to continue its brinksmanship and keeps the reins of power firmly in the regime’s fist. The quickest route to leadership change in Iran is likely weak prices, as the near-revolution in Iran in 2009 showed us. In the meantime, as long as the stand-off continues, high oil prices are already inflicting severe damage on the recovery.

That’s a lot of “hopefully’s” and hope shouldn’t belong in any trader’s or investor’s vocabulary.

goldfinger goldfinger
A very thoughtful piece, and thankyou for taking the time to put it together. Surely, it will not take long for demand destruction to take affect with brent at $120 plus?
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