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Oil Market Gets a Russian Lesson: Sell on the Sound of Cannons – Jinjoo Lee and Carol Ryan/WSJ (video)

Gasoline was scarce during the energy crisis of the 1970s. Photo: Owen Franken/Corbis/Getty Images
Amid ongoing attacks on a vital energy shipping corridor, the oil price is stuck in peacetime.Gasoline was scarce during the energy crisis of the 1970s. Photo: Owen Franken/Corbis/Getty Images

By Jinjoo Lee and Carol Ryan, WSJ

It has been two years since Russia invaded Ukraine and about four months since Palestinian militant group Hamas attacked Israel. Sparks from these wars have recently spread to an oil refinery in Russia and to tankers crossing the Red Sea. Meanwhile, clashes between Israel and Lebanon threaten to boil over to another full-blown war. Yet the price of oil, a commodity that sits in the crosshairs of these conflicts, is around 12% lower than on the eve of Russia’s invasion.

Source FactSet:

Markets have developed a “very thick skin” when it comes to geopolitical disruptions, notes Bob McNally, founder and president of energy consulting firm Rapidan Energy Group. And perhaps understandably so: The barks were a lot worse than the bites on nearly every geopolitical threat to oil in the past 40 years.

Based on the historical record, betting against oil when geopolitical threats send the commodity’s price soaring would seem to be a proven way to make money. But energy traders are conditioned by the twin oil crises of the 1970s to do the opposite.

Back then, the price of oil tripled to more than $11 a barrel, and Americans faced long lines at gas stations within months of the Organization of Arab Petroleum Exporting Countries, or OAPEC, slapping an oil embargo on the U.S. as punishment for sending military aid to Israel during the 1973 Yom Kippur War. Prices stayed high for the next five years because there was so little spare supply. 

Source: San Luis FED

Then the 1979 Iranian revolution delivered another blow. Oil more than doubled to $33 a barrel within a year after political unrest caused a drop in Iran’s production. However, prices began to drift lower in the early 1980s as more supply flowed onto the market, including from new non-OPEC oil discoveries such as in the U.K.’s North Sea.

This happened even as Iran and Iraq went to war with each other and began attacking ships in the Strait of Hormuz—the world’s most important oil transport chokepoint—in what became known as the Tanker War. The supply glut eventually caused the oil price to collapse in 1986. 

Other shocks since have turned out to be a blip. Traders shook off their fears about the First Gulf War within five months. After Iraq’s invasion of its neighbor Kuwait in August 1990 sent the oil price soaring, oil futures had their largest single-day drop in history as a U.S.-led military campaign to push back Iraqi forces began in January 1991.   

 Source: San Luis FED
Source: San Luis FED

Two more recent oil market “head fakes” may have contributed to the market’s skepticism. The most recent was Russia’s invasion of Ukraine. Brent crude settled at a price as high as $127.98 a barrel in March, but prices returned to prewar levels less than six months after the invasion once it became clear that Russian oil could be rerouted. 

The second was in 2019 when Iran-allied Houthis conducted drone attacks on Abqaiq, a key Saudi oil-processing facility, and Khurais, one of the kingdom’s largest oil fields. The attacks caused oil prices to surge 14.6%, but prices returned to pre-attack levels in less than two weeks after it became clear that they caused relatively light damage. Still, the event was a “spectacular warning” that showed that Iran proxies could successfully attack key sources of supply, said Helima Croft, head of commodity strategy at RBC Capital Markets.

Source: San Luis FED
Source: San Luis FED

By many metrics, the global oil market is more resistant to shocks than it was in the past: Production has diversified away from the conflict-prone countries that are part of the Organization of the Petroleum Exporting Countries. OPEC’s share of oil production shrank from nearly half in 1971 to about a third in 2020, according to data from the International Energy Agency.

OPEC 2020: 35.566%
Rest of the world 2020:34.7515%
OECD 2020: 31.6825%
Source:International Energy Agency - IEA
OPEC 2020: 35.566%
Rest of the world 2020:34.7515%
OECD 2020: 31.6825%
Source:International Energy Agency – IEA

There was about 5 million barrels a day of spare capacity as of year-end 2023, or about 5% of global production, according to data compiled by Rapidan—a decent cushion relative to recent history. 

Better access to data makes it easier for energy traders to keep cool heads, according to Gary Ross, chief executive of Black Gold Investors. Real-time tracking of oil cargoes means they can quickly spot whether or not tensions are affecting energy flows. “The market won’t usually react until it sees a material loss of supply,” he says.

Analysts think one of two things would need to happen for a geopolitical threat to have enduring effects on the oil price. First is an actual disruption to spare capacity, which today is concentrated in Saudi Arabia and the United Arab Emirates. Second is a credible threat to the flow of oil tankers through the Strait of Hormuz.

These risks might seem far-fetched in some ways. The U.S. and Iran have both signaled reluctance to escalate the conflict. But oil watchers warn that the markets could be too complacent. Croft points out that Iran has varying levels of control over its proxies and that its relationship with the Houthis is more transactional. “Even if Iran wants to keep things on a low boil, it can’t ensure that the Houthis do,” she said.

McNally, meanwhile, said the market might be discounting the way the Oct. 7 attack has changed Israeli public sentiment on Iran proxies. “In my view, the [Israeli] public is not going to tolerate Iranian proxies on its borders,” he said.

A shadow fleet of oil tankers is forging closer ties between Russia, Saudi Arabia and the U.A.E. WSJ explains how oil-rich nations in the Middle East are facilitating Russia’s oil trade despite Western efforts to curb the Kremlin’s energy revenues. Photos: Planet Labs PBC
Watch video: A shadow fleet of oil tankers is forging closer ties between Russia, Saudi Arabia and the U.A.E. WSJ explains how oil-rich nations in the Middle East are facilitating Russia’s oil trade despite Western efforts to curb the Kremlin’s energy revenues. Photos: Planet Labs PBC

A second-order risk is the possibility that Saudi Arabia doesn’t step in with spare capacity if there are supply disruptions elsewhere in the world. “Saudi Arabia has made it very clear that it is after high prices, not market share,” said Ilia Bouchouev, managing partner at Pentathlon Investments, pointing to the country’s recent decision to suspend its planned oil-production-capacity expansion.

A third risk? That computer algorithms, now responsible for most trading in energy futures, haven’t adequately priced in geopolitical threats. “We just don’t have enough episodes in history to train those models,” Bouchouev said, noting that these so-called commodity trade advisers’ net positioning on WTI crude futures has generally been getting more bearish since October 2023. Net positioning remains much shorter relative to its average over the last 10 years. That means if any catalyst sends prices up, the surge could be amplified by the effect of these players covering the shorts. 

Fading scary headlines has been a winning trade for decades, but it isn’t for the faint of heart.

Write to Jinjoo Lee at jinjoo.lee@wsj.com and Carol Ryan at carol.ryan@wsj.com

Appeared in the February 24, 2024, print edition as ‘Oil Is Still Priced for Peace’.

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