From the February 2014 issue of Futures Magazine • Subscribe!

The New World of energy

When writing about energy fundamentals, a key component over the last few decades has been geopolitical risk. But while in the past geopolitical risk meant one thing — fear of a disruption in the Middle East, or another of the world’s hotspots that also  produces crude oil, because of a threat of war — today it represents two-way risk. It is not only war that poses a threat to the supply/demand status quo, but peace. 

Yes, there is still a threat that Israel will attack Iran over its nuclear enrichment program, and Iran will retaliate by mucking up oil transport through the Straits of Hormuz. But that threat has been reduced, and there is the hope of peace as the tentative agreement between the United States and Iran over its nuclear program eventually could lead to more Iranian oil on the global market. 

 “There always will be geopolitical risk. Iran seems to be cooperating with the U.S. and the world is pleased. I don’t think the Saudis and Israel are pleased,” says Todd Kramer, general partner at Blueshift Capital Group.  “Can crude oil crash? Don’t know, but the path of least resistance is lower.”

Most analysts agree, but are cautious. “There is a lot of skepticism on how the Iran talks will go,” says Phil Flynn, senior market analyst at Price Futures Group. “One of the things that is going away is the fear that there will be an imminent attack on Iran. For years there was this thought that an attack on Iran from the Israelis was inevitable.”

The point being, when you talk geopolitical risk, it now cuts both ways. “[That’s] exactly right,” says Dominick Chirichella, founding partner at Energy Management Institute. “Sometime within the next six months we are going to see more Libyan oil coming back. That is bearish.”

In fact, with so much production shut-in, the risk is on the side of a supply spike.  

Flynn says, “There is still instability in Iraq, but if the political instability calms down there is a possibility of a major increase in both countries. This is causing concern within the cartel on how they are going to handle increased production.”

The last time we discussed energy fundamentals, we noted how the increased U.S. production had offset the impact of production disruptions in the Middle East (see “Top dog once again,” below). We did not see a massive reduction in price with increased U.S. production; however, we did not see a huge spike in prices despite most of Libyan production being shut-in, a worsening Iraqi situation, continued sanctions on Iran and the threat of a U.S. strike against Syria. 

Those factors still exist and U.S. production continues to increase. So for the first time in a long time, there is perhaps more risk of a sudden increase in production than a shortfall. 

While this is not yet being reflected in the price of crude, it certainly is showing up in the options market according to Kramer, who trades a volatility program. “We are definitely seeing more put buying,” Kramer says. “This is a relatively new phenomenon. The put skews are steep while call skews are quite negative.”

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