🚀 go-pugleaf

By Marshall Auerback

"The combined effect of Venezuelan and Iraqi disruptions 
has the potential to be the biggest shock in oil market 
history, even allowing for offsetting supply increases by 
other players." 

               - Jim O'Neill, Goldman Sachs


Today's oil market is tighter and more geopolitically 
threatened than ever...and the markets are incredibly 
complacent about it. Somehow, investors still believe that 
supply is ample, that a potential war with Iraq will be won 
as easily as in the first Gulf War or Afghanistan, that 
foreign oil companies will invest after it's all over, and 
that Iraqi oil production will soar after the 101st 
Airborne sorts out Saddam Hussein. 

But in fact, capacity utilisation in global oil is almost 
as high as it has ever been. Crude oil supply is lower 
relative to consumption than at any time in recent decades. 
And in three of the six largest oil-producing countries, 
oil supplies are at risk due to geopolitical factors. 

Iraq's case is obvious. There is also ongoing political 
instability in Saudi Arabia, the world's largest producer. 
Venezuela's oil-dependent economy is staggering under the 
weight of a labour dispute, which has disrupted oil 
exports. In this context, a war in Iraq could tip the 
balance in favour of a sharply rising oil price, which in 
turn could be the nail in the coffin of a teetering global 
economy.

The prospects of an oil shock are as high as they have been 
in decades. According to a recent report by Goldman Sachs, 
"More Perfect Storm than Desert Storm", low global oil 
stocks and reduced exports from strike-torn Venezuela have 
boosted prices by more than 30% since late November. The 
Venezuelan 'outage' has cost 125 million barrels of 
production, already the fifth biggest supply shock in 
history, which the study cites as 'almost entirely explains 
the current high level of prices'. If the strike continues 
for a further two months, and an Iraq war lasts a similar 
time, the cumulative outage will be 600 million barrels - 
far more than the 400 million taken off the market in the 
Arab-Israeli war. 

Since the Goldman report was completed, the strike 
affecting the Venezuelan oil industry has begun to 
dissipate. But tightness in the global oil markets remains 
much as Goldman described. The Venezuelan government has 
sacked almost 10,000 striking workers, and its efforts to 
reactivate oil wells and refineries are achieving only 
limited success. 

In addition to Venezuela's problems, the increasingly 
tenuous position of the ruling House of Saud also weighs on 
the oil market. The ruling royal family of Saudi Arabia, 
which has enjoyed the lion's share of oil wealth, is 
perceived as corrupt - and domestic discontent is high. 
Saudi oil production is at risk because social conflict 
over oil, such as has materialised in Venezuela, is 
possible...and also because a global Islamic extremist 
movement, currently threatening terrorist action, calls 
Saudi Arabia home. 

The belief in an amply supplied crude market - whose 
current price just happens to be artificially propped up by 
a "war premium" - smacks of unwarranted optimism. 
Proponents see the impending war itself as the cause of the 
trouble...even though most stock markets peaked almost 3 
years ago, well before Saddam became an issue. Many even 
seem to welcome the prospect of war's outbreak, as they 
believe it would rid the markets of bearish uncertainty.

This is not to suggest that today's market practitioners 
are all bloodthirsty warmongers. Instead, what appears to 
be "priced" into the markets is an image of conflict 
(largely inspired by the television images of Gulf War I or 
Afghanistan) that now bears almost no resemblance to the 
bloody, chaotic experience that has historically been war's 
gory reality. 

Of course, if the first Gulf war conflict or the more 
recent Afghan experience has inspired such tremendous 
complacency, it becomes harder to argue that concerns over 
Iraq have been a major factor in discouraging investment. 
This paradox inspires us to sympathy with the view 
expressed by market commentator Richard Russell: that Iraq 
has become a "hook" inducing the public to hang on to its 
shares...despite the increasingly ominous 
political/economic backdrop and the catastrophic losses of 
individual investors over the past 3 years. The belief in 
an easy, relatively inexpensive war and the corresponding 
fear of missing a "war rally", maintains Russell, are the 
factors preventing a major sell-off...not fears of a 
bloody, messy, economically disruptive conflict.

But the more one draws comparisons to the period preceding 
Gulf War I, the less comforting appears the precedent. 
Consider the political context today: As the US 
contemplates a second Gulf war, it faces unprecedented 
terrorist threats, a fraying transatlantic alliance 
(including perhaps the biggest split in NATO's 50 year 
history), and antagonistic relations with virtually the 
entire Islamic world. None of these conditions pertained in 
1990/91. Nor is the economic backdrop remotely comparable: 
consumers in the US, Europe and Japan still have record 
levels of debt, accumulated long before any prospect of war 
with Iraq became a reality

The likelihood of a sharp price spike in oil being followed 
by a big decline (as was the case in 1991) is also much 
less likely this time around. Were the work stoppages in 
Venezuela conclusively ended, AND should all go well in the 
Iraqi conflict (i.e. no major supply disruptions occur), 
then much of the existing shortfall could be made up out of 
the world's Strategic Petroleum Reserves. Iraqi oil 
production will probably stabilise for a year and then rise 
by perhaps 1.0 to 1.5 million barrels a day over a two-year 
period. 

But over the longer term, it is unrealistic to expect huge 
amounts of additional Iraqi oil to come flooding onto the 
market. As a recent working paper co-sponsored by the 
Council on Foreign Relations and the James A. Baker III 
Institute for Public Policy maintains:

"Iraq's oil industry is unlikely to be able to immediately 
deliver recovery in oil production and, depending on damage 
sustained during hostilities, may find its ability to 
export oil reduced. It is in dire straits with existing 
production levels declining at a rate of 100,000 bpd 
annually...Notwithstanding the value of Iraq's vast oil 
reserves, there are severe limits on them both as a source 
of funding for post-conflict reconstruction efforts and as 
the key driver of future economic development. Put simply, 
we do not anticipate a bonanza."

In short, there is no quick fix to the problem of high oil 
prices, even if an oil shock is avoided. A best-case 
scenario allows for stabilisation and perhaps a modest 
decline in the price of crude, but an imminent return to 
sub-$20 oil, as was the case in 1991, appears unlikely. 
Venezuela adds to the severe problems of a market on the 
knife's edge of a price explosion. To many, Iraq remains a 
relatively untouched jewel in the crown of the Middle East. 
But this 'jewel' could yet prove no better than a crown of 
thorns, if invasion plans do not adhere to the optimistic 
outcome now assumed by the markets. 

Today's markets view war as something akin to a machine. 
Armchair strategists squeeze out the human element in a 
clash between independent wills to a point where it is 
almost invisible...or at least, until something goes wrong. 
Only the most deluded optimist would expect certainty and 
good times to return to the markets once the first cruise 
missiles are launched.


Regards,

Marshall Auerback,
for the Daily Reckoning

Editor's Note: International equities strategist Marshall 
Auerback is a frequent contributor to The Daily Reckoning. 
Specializing in international markets, Mr. Auerback derives 
his expertise from 9 years 'on the job' with GT Management 
in Hong Kong and Japan, during which time he covered the 
stock markets of Hong Kong, Korea, South East Asia 
(Thailand, Indonesia, the Philippines, Singapore, and 
Malaysia), Australia, and New Zealand, Japan.

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