Oil in the Crosshairs

For the last several years, the oil market has focused on the risk of a new conflict in the Persian Gulf, evolving from earlier fears of a direct US/Iranian confrontation to recent worries that Israel might attack Iran's nuclear program. I suspect that little of that oft-cited "risk premium" was devoted to the chances of a shooting war breaking out in the Caucasus, virtually on top of a key oil export route from the Caspian Sea. Yet here we are, with Russia intervening Friday on behalf of one of Georgia's breakaway regions, South Ossetia, and bombs apparently falling near the Baku-Tblisi-Ceyhan Pipeline (BTC) that carries oil to the Mediterranean from the giant "ACG" oilfields of Azerbaijan. If the pipeline, which suffered an unrelated fire last week, were forced to shut down for an extended period, about 1% of the world's oil production could go off line, at least until some portion of it could be re-routed. The market shrugged off this prospect initially, with WTI falling $5 to end last week at $115. I would be surprised if the reaction this week proved quite so blasé.

Georgia was occupied by Russia for nearly 200 years prior to the collapse of the USSR, and the Caucasus is at least as strategic today as it was in the time of the czars, considering its role in the transit of the hydrocarbon resources of the Caspian Sea region. Prime Minister Putin, who appears to be calling the shots in this matter, likely regards Georgia as a rightful part of Russia's sphere of influence, but that doesn't give us many clues about the true extent of Russia's war aims. Given the preparations apparent in the current offensive, these could extend to annexation of South Ossetia into the Russian Federation, regime change in Tblisi, or merely putting a good scare into any former Soviet territories flirting with the idea of NATO membership. Although Russia was hardly pleased with the selection of an export route for Caspian oil that deliberately avoided its territory and control, and has gone to great lengths to regain state control over its own oil industry, oil isn't necessary to explain the events in Georgia.

Unfortunately, the implications for oil supplies go beyond the immediate disruption of the roughly 800,000 bbl/day the BTC line was carrying prior to last week's accident. In its latest Oil Market Report, the International Energy Agency cited expected additions to Azeri production of 200,000 bbl/day this year and a like quantity in 2009. As tightly balanced as the oil market remains, with demand destruction largely responsible for the current slump in prices, it would be bad news if those extra supplies could not be accommodated via the BTC or other export routes. Even if the Caspian hasn't quite delivered the oil gusher some expected a decade ago, it is one of a small number of regions in which production trends have been going the right way.

Whoever threw the first punch--and so far neither side seems terribly credible concerning this--the timing of the conflict favors Russia's attaining its goals in this affair. The combination of high energy prices and a highly-distracted America shrinks the odds that either the US or EU will take on Russia in defense of a former Soviet republic, beyond issuing statements asking Mr. Putin to respect Georgia's territorial integrity. Even if the BTC pipeline survives unscathed and quickly resumes deliveries, political risk in the entire region has increased, and future development from this crucial non-OPEC source could slow. That would keep oil prices higher, for longer than otherwise. With roughly $300 billion per year in oil export revenues at current prices, Russia sits near the top of the list of beneficiaries from such an outcome.