By Shahab Jafry –
The hard to grasp mechanics behind oil prices
Like all bulk oil importers, Pakistan remains hostage to geopolitical drama far removed from its shores, presently manifested in the who-blinks-first around the straits of hormuz, the strategic bottleneck through which gulf light sweet crude must pass before feeding a western market on the brink of double-dip recession. The slightest overreach in any of the many pieces scattered across the board – Israeli military designs, a rearmed Hezbollah, Iran’s blockade of shipping waters, uncertainty regarding Tehran’s Alawite allies in Damascus – and oil will rise $50-60 per barrel (probably more) in a heartbeat in the international market. America’s soft recovery will be ruined, Europe’s sovereign debt crisis will worsen, emerging markets in Asia will slow further, compounded by China’s PMI contraction for six months running.
For even smaller economies like Pakistan, an abnormal oil price hike will present an immediate existential dilemma. It would’ve helped if the reserves were a little healthier, deficits a little less outrageous, growth higher and employment a lot better. But as things stand, a stagnant economy drowning in debt with chronically low employment and high inflation will simply collapse if energy becomes any more expensive. And since oil, in various forms, is an essential input in practically all industrial processes, the possibility of a frenzied electorate choked with stagflation around election time cannot be ruled out.
Interestingly, oil remains elevated despite sagging demand across the globe. The American recovery has been exposed as weak as best, with the Fed recently betraying possibility of more quantitative easing. Europe is a disaster, where sovereigns and giant financial institutions alike face imminent collapse. And if France falls from Sarkozy’s hands, the Franco-German arrangement is over, and defaults will follow. In Asia, China’s sudden discovery of green shoots will not ease market concern regarding continued contraction, compromising the commodity supply chain all the way to Australia and New Zealand in Asia-Pacific. All demand depressing factors, yet oil remains high, the market/speculator premium to war clouds darkening over Tehran.
The market has a simple, cold logic. In times of uncertainty, especially war, its futures curve begins registering the next most expensive price per barrel possible. Uncertainty drives up insurance premium, security costs, etc. Simple enough, and a message that should resonate loudly in place like Islamabad, where the intricacies of financial markets run on sentiment are seemingly lost on decision makers.
Rush to supplies
So far, market buoyancy is no doubt pricing in geopolitical trauma and the price remains divorced from depressing fundamentals. Yet all oil spikes eventually lead to their own destruction. Price rises too much, pushing giant western economies into recession, with its own negative spillover on emerging market exports, growth and employment. That is why even Saudi-led gulf cartel lobbies do not advocate dramatic price bids. However, there are elements about the current situation that indicate things might be different this time around.
One, the traditional swing producer and central bank of black gold, Saudi Arabia, is no longer in a position to influence prices like it could. It is producing at peak quota and its willingness to produce more has had no impact on market trends. Two, unlike before, Saudi’s base price has come up to around $90 per barrel. It cannot let prices drop too much, or its own deficits will rise to red. Arab spring compulsions have led to an official $130 billion social uplift plan, changing Riyadh’s break-even point. Three, opinion remains split regarding the impact of Europe’s sanctioning Iranian oil, which will come into effect on June 1. Despite western capitals’ repeated assurances, market observers, including big investment banks, expect a jump when it happens.
Still, the market is in backwardation – when futures prices drop below current spot price. Even Saudi oil minister Ali Naimi’s comments implying no justification for increasing prices failed to interest the immediate market. And with the trend bordering on bullish, countries like Pakistan must be rushing to secure long term contracts. However, there is an uneasy second thought; what if the Iran situation subsides as election season comes one after the other to most of the western world, and oil drops like a brick? While it is a pretty good bet to secure futures contracts, there is always the chance of a big loss, as countries and corporates found out during and after the mad bull run of ’08, when oil rallied to near 150 and dropped to near 40 in a matter of six months.
Going forward, who wins
At the end of the day, a call will have to be made with respect to immediate and medium term oil prices. Neither governments nor big firms can afford to sit and wait as the market eases or contracts. And one call is as good as its opposite.
Does the strain in the gulf warrant further aggravation of price trends, or have Ben Bernanke’s easy money policy and Iranian ayatollahs’ uncompromising position on nuclear power set up the most lucrative oil short of the year?
For the moment, it seems the market is pricing in some sort of movement on the Iranian issue, and the price will react according to what takes place, weather it is outright military conflict, or more controlled attempts at regime change. Either way, though, any initial movement will be to the upside, as even an inward collapse of the government will give rise to enough uncertainty to be reflected in a steep price rise. The only people with an assured bounty because of this whole mess will be speculators, the real force behind price fluctuations, not supply-demand dynamics. Only and only if there is a quick, sudden diplomatic de-escalation will there be swift downward movement.
All the while the oil narrative unfolds, the future of economies like Pakistan’s hangs in the balance. Perhaps it is only fitting that countries that have failed to posture in accordance with post ’08 demands be punished by market trends. The government made few efforts to check unnecessary influences on its fiscal position, hence the little buffer in case of awkward price oscillation. If the fateful roll of the dice in the Middle East results in a diplomatic arrangement, we will continue as we are. If not, it will deliver lasting changes to our way of life.
The writer is a finance and economics journalist