Headlines lately are full of stories about the Iranians advancing their nuclear capabilities, in spite of the recently signed prohibition agreement against it. There are also stories covering the North Koreans threatening the US and our allies while they conduct ballistic missile tests with their developing first strike capabilities. There are even stories about the Chinese occupying an island that they themselves built, within Japanese territorial waters, and then covering it with military material. Each one of these headlines carries with it an element of risk that will have an effect on the price of crude oil here in the US and abroad. These types of risk are called “Geopolitical Risks.” Geopolitical risk adds a level of premium to the price of any commodity that is traded on a global basis, due to its dependence on free and open trade and the availability of uninhibited trade routes. They even have an effect on global currencies.
I have been an economist for over 30 years, and I’ve been involved in every step of the international trade process, whether it was serving as marketing director for a commodity group shipping grain to Sub-Saharan Africa, or the owner of my own applied economics shop, evaluating trading metrics that affect the price of US-produced crude oil. While the business sectors may be different, the issues are the same because they are US dollar-based commodities. In the oil and gas sector, we are most vulnerable to anything that artificially adds to the price of a product or supports the price of a product by implying some threat that may interrupt trade… and we are at that point now!
Energy has its roots planted deeply in the international trade arena providing the “lifeblood” for the world’s economies. Energy is extremely sensitive to anything that threatens free and open trade. Threats from places like Iran, North Korea, China or even threats from OPEC can add a level of risk to the price of crude oil. One headline that I read, related to the fact that the North Koreans have the “will and the determination” to step into a war with the US and its allies. While the US continues to eye sanctions against the North Koreans and their secondary allies China, all options are on the table for the US, and this is adding a layer of risk to the marketplace. These few words have had the effect of placing a floor underneath the price of crude oil for the short term. If the North Koreans actually attempt to launch a missile, the markets will react sharply, and we’ll see a price spike in crude oil and refined products like gasoline, diesel and jet fuel. This is a dangerous situation, as the threat is now increasing daily. Here’s what can happen…
First & Second Oil Shocks
In October 1973, we saw our first major oil crisis, also known as the “First Oil Shock,” when prices of crude oil rose from $3 per barrel to over $12 by the end of March 1974. This was due to the US support of Israel in the Yom Kippur War. OPEC took this as a direct threat to its membership and placed an embargo on all oil shipments heading to the US. While it only lasted five months, we felt the impact of the embargo and prices exploded. This geopolitical disaster also took a toll on the US economy, as the US GDP dropped from 5.6% annual growth in 1973 to a negative .5% at the end of 1974. These types of economic disruptions take a toll on an economy.
Not too long afterward, in 1979, we saw the “Second Oil Shock” that took prices from $55.97 per barrel all the way up to $118.78. This was due to the Iran-Iraq War. Oil production in Iran nearly stopped, and Iraq’s capability to produce crude oil was severely diminished as well. The US GDP suffered again as it dropped from a 3.2% growth rate for the year in 1979 to -0.2% in 1980. When a geopolitical event occurs, prices spike on fears of a disruption of supply, or they spike on fears of a disruption of trade. See the graph below that gives a picture of just how deeply geopolitics affected prices in the US crude oil market.
This graph shows how quickly geopolitical risk can push prices up. Upward price spikes are the direct result of a geopolitical threat. You also see that there are price drops in this graph. They are more closely associated with oversupply and overproduction in a marketplace, in an environment of little to no geopolitical risk. You can see where the price dropped from $68.86 in November of 1985 to $22.95 in March of 1986 when production was at its second highest level in history. Once again, geopolitical risk created volatility and when the risk subsided, prices normalized and reverted back to moving on supply and demand.
What we’re concerned about today is that any one of the scenarios can create volatility that will push prices through the roof once again. The North Koreans, for example, have been testing a number of different ballistic missile platforms, some successfully, some not. Their commitment to keep tensions high not only on the Korean Peninsula but across the globe in the US, has every market alert to a possible threat and could very well be the reason crude oil prices have not dropped to where the inventory reports say they should be.
If the North Koreans do launch a missile into South Korea, Japan or God forbid, the US, the result would be catastrophic. Prices of everything, including food stuffs and energy products would skyrocket, and many of the world’s economies could begin to fail. We could fall into another world war. This time, however, the war would begin with nuclear exchange, not end with one!
These threats are creating a new kind of “Cold War,” one where all the players, including the US, have an “economic” chip in the game. The only thing holding North Korea’s finger off “the button” is China. The Chinese can’t afford to let the North Koreans start a war, and they themselves need to be very careful how they continue to expand their empire, lest they upset their own economic applecart. They are perfectly capable of starting their own trouble without the assistance or a first move by the North Koreans.
The Russians are involved at many different levels as well, and are at the top of the heap adding fuel to the fire. They believe a weakened world gives them an opportunity to rekindle Russian imperialism. This is evidenced by their annexation of Crimea in 2014, and the Iranians have made it above the fold with their missile tests and rhetoric threatening the US. The proof of this is missile technology being delivered to Tehran by the Russians and the Chinese. Any one of these issues can destabilize the entire world crude oil price balance. What’s of great concern is if one of these threats actually materialized into an attack, the others may well follow; it’s the domino effect.
The bottom line here is that the world is destabilizing politically, and the US better be well-prepared to protect itself and protect the free and open markets of its allies. We’re often told “timing is everything,” and the timing right now couldn’t be worse. This entire scenario is occurring during a time when the US military deterrence is at its lowest level since the beginning of World War II. We simply don’t have the critical mass in Navy or Air Force assets to protect the high seas and open sky trade routes, as has been our charge since the end of the Second World War.
Lastly, we’re at a time when covenants in trade agreements can threaten the status quo and have a detrimental effect on the price of crude oil. Just this last weekend, as the US participated in a G20 meeting (a meeting of 20 industrialized and developed nations) the US Treasury Secretary leaned on membership to remove a policy statement that would have disavowed a policy of protectionism. Put simply, the US is no longer going to allow what is perceived as unfair trade practices. They are protected by a treaty, no matter who the trade partner is. This sent a shudder through the energy complex, as it signaled that the US would be free to use sanctions against a US trade partner that thwarts the economic trade policies of the current administration. This is a significant change from previous administrations, and reflects the “popular opinion” within today’s rank and file that, to quote a famous line from the 1976 film Network, “We’re mad as hell and we’re not going to take this anymore.” The days of ridiculous trade deficits are over.
As you might imagine, this policy change struck the political press crossways, and was parsed to mean the Trump Administration was leaning the US toward isolationism. Declaring that the US was leaning away from trade that was not mutually beneficial, somehow struck some as isolationism but nothing could be further from the truth. It represents the simple fact that, as the world’s largest economy, we will no longer stand for currency manipulations that hurt US dollar-based commodities and trade agreements that increase the US trade deficit and assure a not-profitable trade arrangement for US corporations.
Even though we have only scratched the surface of geopolitical risk contributors, you can see that even the threat of an attack is having an effect on the price of crude oil today. As for the language in trade agreements, they can and do affect prices of US commodities even in light of the fact that we still hold significant influence as the world’s de facto consumer of last resort!
If you want more information on the energy markets and what is making prices move every day, go to our website www.crudefunders.com and scroll down to where it says “Subscribe”. There you will find our link to the daily commentary “Energy Wise”, a comprehensive piece that includes both fundamental and technical analysis of the day’s energy markets and provides you with the detail that you need. For more on Energy Economist Tim Snyder and his company, go to www.matadoreconomics.com .
By Tim Snyder