$100 Oil?

Are you ready for the possibility of $100 oil?

This weekend, drone attacks against two critical Saudi oil production facilities produced extensive damage.

The attacks took out roughly 5.7 million barrels of daily crude production. That’s about 50% of Saudi Arabia’s oil output — and more than 5% of total global daily oil production.

Jeff Currie, head of commodities research at Goldman Sachs, said the attacks amount to a “historically large disruption on critical oil infrastructure,” adding that the attacks represent “a sharp escalation in threats to global supply with risks of further attacks.”

Yemen’s anti-Saudi Houthi rebels, who are supported by Iran, claimed responsibility for the attacks and warned that further attacks can be expected.

Saudi Arabia has pledged to retaliate against whoever is responsible. Reading between the lines, that means Iran.

So today the chances of a regional military conflict are greatly increased. That could include not only Iran and Saudi Arabia but their regional proxies as well.

Not surprisingly, U.S. Secretary of State Mike Pompeo also accused Iran of being behind the attacks, a claim which Iran has denied. And President Trump hinted that U.S. military action is a possibility.

Stay tuned, as this developing situation has the potential to snowball.

What does this weekend’s attacks mean for oil prices?

Brent North Sea Crude (the international oil market benchmark, which is about two-thirds of all oil pricing) immediately spiked 19.5% to nearly $72 per barrel. That’s the largest intraday surge on record. Today it’s trading at a little over $67.

West Texas Intermediate (the index tracked in U.S. markets) is trading above $61 today. For technical reasons, Brent crude usually trades, say, $2.50–4.00 higher than WTI. So today’s disparity is somewhat higher than normal, but not excessively so.

But if the Saudis cannot repair the damage from this weekend’s attacks rapidly, or if more attacks against critical Saudi oil facilities continue, we could see a dramatic rise in oil prices.

And in the event of a wider conflict that shuts down oil traffic through the critical Strait of Hormuz, oil could easily spike to $100 per barrel.

The global economy is already slowing down. Europe, for example, is close to recession, if not already in recession.

In the U.S. the economy seems to be chugging along. But beneath the surface, debt is rising to dangerous levels, consumers are maxed out and signs of distress are appearing in the credit marks.

Can the economy withstand an oil shock?

If oil prices do spike, consumers won’t just be paying higher prices at the pump. The effect will ripple through the economy, since oil prices impact transportation costs for all goods.

My models do not have the economy slipping into recession before next year’s U.S. presidential election. But dramatically higher oil prices are a variable that can change that. They can tip the economy into recession if higher prices are sustained.

No one is more aware of that than President Trump because his reelection chances in 2020 may hinge on whether the U.S. can stay out of recession.

Generally speaking, presidents who seek a second term are always reelected unless they have a recession late in their first term. This happened to Jimmy Carter and George H.W. Bush. Both lost reelection bids because of recessions on their watches.

Trump knows this and he is taking steps to fend off a recession should one appear on the horizon.

Trump wants to rely on Fed interest rate cuts to prop up stock markets and postpone any recession. But if the Fed does not cooperate or interest rate cuts don’t work, Trump’s tool kit includes massive infrastructure spending, possible tax cuts and industrial bailouts.

Trump could also reverse course on the trade wars. But an oil shock would prove too much.

We’ll have to see how the current situation in Saudi Arabia plays out. But if it escalates in a meaningful way and oil prices move dramatically higher, things could get very interesting very fast.

$100 oil? Don’t rule it out.

Get Ready for Higher Oil

My model for forecasting oil prices has three top-level factors, represented graphically by arrows pointing up, down or sideways. An up arrow is coloured green and points to higher oil prices. A down arrow is coloured red and points to lower oil prices. The sideways arrow is coloured grey and suggests that the relevant factor is neutral with respect to oil prices.

Of course, there are innumerable subfactors behind each of the main factors that form a framework of cause and effect. Still, the top-level “three arrows” predictive analytic model has served me well when it comes to oil prices.

I should first point out that developing economies with large energy reserves such as Saudi Arabia and Russia are generally motivated to maintain output at high levels in order to finance ambitious internal development budgets, social spending or simple corruption.

But with my models, the first factor is basic supply and demand. Just a 1–2% change in the supply/demand equation for oil can move the price by $40 per barrel or more.

If global economies are growing strongly or if supply channels are jammed or restricted in any way, that arrow will be green, indicating higher prices. Conversely, in a global slowdown or a situation in which Russia, Saudi Arabia and the U.S. have their taps wide open, the arrow will be red, pointing toward lower prices.

Global demand is expected to come from China, India, other parts of Asia and Africa during the next 20 years, while demand may actually drop in the U.S. and the EU. But those drops would be dwarfed by the increased demand from the other parts of the developing world.

And my models show that demand for energy from oil will remain robust for decades to come.

Right now, my analysis shows that demand for oil (and gas, combined) will grow 40% over the next 20 years despite the increase in renewable energy sources, even assuming conventional combustion engine cars achieve a fleet average of 50 miles per gallon.

These are the most conservative demand assumptions produced by my models and they assume a much higher shift to renewable energy and electric cars than standard models. In other words, these demand figures assume the electric car and solar revolutions will succeed and not fail.

We’re still going to use massive amounts of fossil fuels even with the success of renewables.

If electric vehicles, solar and wind do not live up to their potentials, the demand for oil will be even greater.

Your correspondent inside the Grand Mosque in Kuwait City, Kuwait. The Grand Mosque is one of the largest mosques in the world. My frequent visits to the Middle East are useful for understanding the extent of Arab cooperation in setting oil prices and the geopolitics of oil output in the Persian Gulf region.

The second factor is inflation/deflation, which can influence oil prices independent of growth. It’s entirely possible to have inflation in a recession (called “stagflation”) or to have deflation in a growth phase.

Japan has experienced this since the 1990s, and the U.S. has had growth with disinflation at times from 2009 to the present day. Inflation/deflation respond to real interest rates, capital flows and exchange rates. Inflation is a green arrow and deflation (or strong disinflation) is red.

The third factor affecting my analysis is geopolitics. Any credible threat to close the Strait of Hormuz or attack oil production or shipment facilities will produce a green arrow pointing to higher prices. Guess what? We just got one of those this weekend in Saudi Arabia. Economic sanctions, a form of financial warfare, will also produce a green arrow. We’ve certainly seen that as well.

Likewise, cooperation and peace among major oil-producing nations — or at least the absence of hostilities — will produce a grey (neutral) or red (lower) arrow with respect to oil prices.

The geopolitical factor has to be treated carefully. Most analysts assume that a war among oil-producing nations is automatically a cause of higher oil prices. But that’s not necessarily true unless oil facilities are directly targeted. A war among oil suppliers actually results in higher output, not lower, as the warring powers are desperate to earn cash to fight the war.

The best example of this was the Iran-Iraq War of 1980–1988. From Sept. 1, 1983–Feb. 1, 1986, during the height of the war, oil prices plunged 67% from over $30 per barrel to $10 per barrel as both Iran and Iraq pumped oil furiously to earn hard currency to sustain their war efforts. Oil prices do spike when war is threatened but tend to fall once the war begins.

But with this weekend’s incidents obviously did involve an attack on the Saudi oil facilities, so we don’t need to be so subtle in our analysis.

Forecasting oil prices using this model is most difficult when the factors are sending mixed signals. For example, the model today shows that global growth is slowing, which puts downward pressure on prices. But Russia if Saudi Arabia, two of the world’s “Big Three” oil producers (along with the U.S.) cut output, that would tend to increase prices.

Oil and gold are two commodities that can properly be regarded as money or money substitutes in global currency markets. With this complex data landscape, what is the outlook for oil prices in the months ahead?

This weekend’s attacks definitely have the potential to affect supply. And the single most important factor in the analysis for oil is the supply/demand factor. If this weekend’s attacks blow over and Saudi production comes back on line in a timely fashion, then oil prices will not be dramatically affected.

But if production falls off or more attacks on Saudi oil infrastructure occur, you can expect sustained higher prices.

Meanwhile, global growth is slowing, which normally presages lower oil prices. In an extreme case, a global recession or financial panic would result in lower prices. But the growth slowdown is not yet at that stage. Even if demand for oil flattens, Saudi Arabia can single-handedly boost the price simply by cutting its output (which just happened, although not by choice).

The inflation/deflation factor is neutral at the moment. There is certainly fear of inflation among central bankers wedded to flawed Phillips curve analysis, but the evidence for actual inflation is almost nonexistent. A disinflationary trend is just as likely.

The geopolitical factor is also flashing a warning. A geopolitical shock in the Persian Gulf could send it back to $100, which now seems like a realistic possibility.

I’m not predicting it necessarily, but it cannot be dismissed.

With geopolitics and the supply/demand factor pointing to higher prices, with the inflation/deflation dynamic still pointing to deflation the net of the “three arrows” is higher oil prices in the near future. A conflict in the Middle East could obviously cause oil prices to skyrocket from here.

I’ll be keeping a very close eye on this space. So will President Trump.

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