On Tuesday of last week, the Syrian Government, led by its President Bashar al-Assad, used a chemical weapon containing the deadly nerve agent sarin gas against its own people. Then Thursday night, less than 72 hours later, President Trump ordered a measured military response and launched fifty-nine “Tomahawk” cruise missiles into the Syrian airbase that originated the chemical attack. Fifty-eight missiles found their targets, virtually destroying the base. This response caused an immediate spike in the price of crude oil of nearly $1.50 per barrel, sending a signal that there is fresh, unanticipated risk in the market. This new risk poses an interesting question: “What effect will this geopolitical conflict have on the price of crude oil, and for how long?” This week, we’ll examine these issues and explain how risk affects the price of crude oil.
This is not the first time we have written about geopolitical risks as they relate to the energy world. Three weeks ago, we wrote a piece on several geopolitical issues that could affect our markets. We discussed increased risks coming from countries like North Korea and Iran. We spoke a little on Russian aggression in the Ukraine, but we didn’t talk about Syria and the assistance they were receiving from the Russians. Nobody saw the Syrian attack or our response coming. As a matter of fact, we were guaranteed by some of the highest ranked members of the previous US administration that this threat had been dealt with and no longer existed.
Prior to this chemical weapons attack, the US and the Russians seemed to be cooperating. We agreed with the Russians to keep communications open, and a “special hot line” was installed to keep contact with each other during any military action, and out of each other’s crosshairs. That cooperation is now gone, and there is a new level of risk in our marketplace as a result. Today, the Russians are not responding to any communications coming on the special hotline, and the “saber rattling” continues to escalate.
Initial Risk Premium
At the time that the US sent a retaliatory strike into the Syrian airbase, the price of the May contract for West Texas Intermediate crude oil was trading right around $51.50 per barrel. Once news of the strike hit the financial markets, the price of WTI crude jumped to nearly $53 in about fifteen minutes. Below is a graph of the spike in prices when the US sent our measured response into Syria.
As you can see, immediately following the price spike, prices slowly drifted back to just below $52 by the beginning of the trading session on Friday, but not all the way back to where they were before the strike. The difference between where we started, and where we ended, is called a risk premium. Markets closed at $51.70 on Thursday, so the value of this initial risk premium, was about 30 cents per barrel. This risk premium will stay intact and could possibly grow until this conflict subsides.
You might ask yourself: What’s the big deal? Thirty cents a barrel is within a normal day’s trading range. While that is correct, the price will now stay artificially inflated by 30 cents, and the trading range is now adjusted upward the same value. This is what happens when risk premiums develop. As an unusual course of events transpires, risk tends to increase, and the premiums will increase as well. They did this back in 1973 when the US was the victim of an OPEC oil embargo. Let’s look at the Arab Oil Embargo of 1973 and watch what prices did when the risk of a geopolitical event developed.
In October of 1973, during the Yom Kippur War, The Organization of Petroleum Exporting Countries (OPEC) imposed an embargo against the US in retaliation for our support and resupplying efforts to the Israeli military during this conflict. The embargo lasted six months, but the effect of the embargo lasted much longer. When the conflict began in July of 1973, the price of WTI was trading around $19.58 per barrel. When the embargo was announced, the price of WTI had already risen to approximately $23 per barrel, so the initial risk premium was $3.44 per barrel. When the embargo was lifted in March of 1974, the price of WTI crude oil had spiked to $51.52 a barrel, a spike of $31.94 per barrel. Here’s a chart showing the initial risk premium and spike in the price of WTI, in 1973:
Price represents US dollars per barrel:
As we look at difference in initial risk premiums between October of 1973 and last week, 30 cents doesn’t seem like much of a premium as compared with the initial risk premium of $3.44 in 1973, but it’s about what happened after the initial news that has made our markets nervous. As seen in the graph above, prices continued to spike past the initial shock of the embargo from $23.02 in October of 1973 to $52.18 in February of 1974. Prices more than doubled during the embargo, and since history tends to repeat itself, traders are nervous about continued destabilization in the Middle East and Southeast Asia, leading to another spike in prices.
What’s Different This Time Around?
Today’s headlines are now filled with reports of increased geopolitical crises in other parts of the world as well, and we’re all reading stories like this one from a well known news agency, that reads, “Russia Forms an Alliance with Iran and Syria”. Today we read, “We are Sending an Armada,” says President Trump when asked about increased talk of aggressive action from the North Korean leader toward US interests, and risk continues to grow. What concerns markets now are multiple areas of instability that could erupt anytime and push prices up!
We can take a measure of comfort in the fact that this time around, the US is developing a new stronger ally in China. Add that to the fact that we have identified more recoverable reserves than we’ve ever had, and our recovery techniques of late make shale production easier to develop. It should be comforting to know, with all of this, our production stands at 9.235 million barrels per day, and is increasing every week. This increased production and the controlling hand of China over North Korea should assist in keeping a lid on prices for now. So, it makes sense that the price of crude oil shouldn’t react as much as they did back in the 70’s, but it’s early in the game this time, and nobody knows what’s in the mind of North Korean leader Kim Jong Un or that of despot Bashar al-Assad.
By Tim Snyder
Read More from Crudefunders
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- Geopolitical Risk and Its Effect on the Price of Crude Oil
- What Can We Learn from Crude Oil’s First Quarter Report Card?
- Crude Oil: What is the Future
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 .