ISIS and the Price of Oil

Andy Waldock |

Every market has built in fear premium. This shows up empirically through the skew of an option chain. The idea is that two strike prices with the same expiration date that are an equal distance away from the market's current price should have the same value, everything else being equal. We can also measure this through common sense. The skew is aligned with a market's fear. This is what creates the fat tails on index put options as well as call options in the grains. Historically, fear in the Middle East leads to higher oil prices as the possibility for supply disruptions increases in times of uncertainty. This week, we'll examine how oil prices affect ISIS and how this could affect the oil market as a whole.

ISIS is by far the most profitable terror organization in the world.  ISIS has claimed many oil fields in eastern Syria and along the Iraqi border. These are their most productive wells and are believed to be filling their coffers to the tune of more than $1,000,000 per day. This number is a bit conservative as some estimates suggest they're earning more than $40,000,000 per month. Recently, news reported in The Guardian quoted our own Undersecretary for terrorism and financial intelligence at the U.S. Treasury, David Cohen, “several million dollars per week from the sale of stolen and smuggled energy resources.” I always find the context interesting when foreign papers quote our own leaders. ISIS oil money has been a much bigger talking point internationally than it has been domestically. We see this dialogue as the basis for building a cooperative agreement to drive down the price of oil rather than driving out ISIS via boots on the ground.

ISIS is becoming a full fledged business. They're paying not only fighters and commanders but also engineers and roughnecks. Their purpose so far has been clear; capture oil fields they can easily bring online. Once up and running, they're selling oil on the black market. Based on a range of estimates, they're getting between 20%-40% of the oil's value. That is too big of a discount for end users and smugglers to pass up. Ironically, many reports including The Wall Street Journal report that ISIS is selling the captured oil back to Syria's President Assad. I think this bears testament to two things. First, it shows how quickly deals can be made when it involves daily energy needs. Secondly, it shows how deeply entrenched ISIS has become in the Middle East oil markets. Other destinations for smuggled oil include Turkey, Jordan and Iran. I'd expect Turkey's purchases to increase as they feud with Russia. Much to my surprise, Israel is claimed to be the number one importer of ISIS oil as a percentage of total imports. A recent article in the Arabic paper, Rai al-Yum cites Russian sources and a paper trail leading from the Iraq/Syrian border through an individual broker and ending up at the same collection site as open market oil. This provides Israel with some degree of plausible deniability even if their books show this oil was purchased at black market prices between $15-$18 per barrel.

ISIS oil routes according to The Guardian.
ISIS oil routes according to The Guardian.

Shifting gears from the problem and moving towards the solution brings up the laws of economics. There are two options. The first, we're already employing. Air raids have increased considerably since the Paris attack. Previously, these have been only mildly effective due to the rapid movement and re-deployment of the portable refineries ISIS had been operating. Recently, as they've expanded their production base to include fully equipped oil fields pumping as much as 30,000-40,000 barrels per day, Western strategy has shifted its focus. Thanks to precision guided bombs and missiles combined with a working intelligence of the primary ISIS held oil fields, the new plan focuses on hitting high value, hard to replace sections of the oil drilling and refinery works rather than the wholesale bombing of the fields in general. The purpose behind this is to force these primary fields to shut down production for months, rather than days. We'll see how effective this tool is in fighting ISIS.

This leads us to the second option for fighting ISIS. Where the first option focuses on impacting the supplies they can sell on the black market, the second solution takes the opposite approach by limiting demand. The world has never been more efficient in its total operations or had access to as much petroleum and petroleum products as it does, now. This is why oil prices fall from $150 a barrel to less than $40. Roughly speaking, ISIS appears to be selling for a 50% discount. The discount is so steep because they need to make their product economically attractive in a negatively politically charged environment. Returning to economics, increasing the global supply of oil would squeeze the margins ISIS is receiving from their ill gotten sales. Considering the major backlash of doing business with ISIS, those countries may be interested in open market oil at a lower price. The global production capabilities are certainly in place. What would happen if OPEC, Russia and the U.S. agreed to glut the market thus, limiting both the profit potential for ISIS as well as courting their black market destinations back towards open market oil without the negative political context of doing business with ISIS in the first place? I'm no politician but if we continue to coordinate ISIS oil attacks at their critical components thus increasing their cost of production while flooding the market with oil and driving down the price of free oil on the open market then, maybe we can stem the tide of the growing movement and return to focusing on individual terrorists rather than watching a terrorist organization lay claim to large swaths of economically important sovereign lands. This could be the first time in history that a Middle East oil war sends oil prices lower.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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