Iran Oil Price Risk Returns

Between the Libyan revolution and the shaky US and European economies, oil markets hadn't been paying much attention to Iran's nuclear program until last week's release of a new report from the International Atomic Energy Agency (IAEA.) For the first time, the IAEA presented a detailed picture of a well-organized Iranian effort encompassing projects and technologies that go beyond what could reasonably be construed as having purely civilian purposes. Traders are once again talking about an "Iran risk premium," though the market's initial response has been sufficiently muted that it's hard to distinguish from other factors, such as the narrowing of the spread between West Texas Intermediate and Brent crude and worries about the Euro. As long as the international reaction to Iran remains confined to the well-worn pattern of diplomatic protests followed by incrementally tweaked sanctions that dampen speculation about military options, oil will probably just exhibit some extra volatility.

I've been following this issue for a long time, and almost from the start I've been skeptical of the Iranian government's insistence that their nuclear effort was aimed only at producing electricity. Iran has cheaper and less controversial energy options in abundance. Perhaps the biggest surprise in the IAEA report was that the agency would risk the controversy inherent in releasing a thorough accounting of Iran's efforts to develop capabilities unique to designing and building a nuclear warhead that could be mounted on a missile. Moreover, the report suggests that at least some of these activities did not end in 2003, as the controversial US National Intelligence Estimate of 2007 concluded, but "may still be ongoing."

The oil market risk has several dimensions, the most obvious of which relates to a preemptive attack by the US or Israel. Yet even a stepped-up sanctions regime might either directly impede oil exports from Iran or provoke an Iranian reaction having the same effect, at a time when oil prices are already relatively high. Either scenario might trigger an oil price spike that would largely undo recent efforts to revive the global economy. At the moment, however, neither outcome seems very likely to me.

Whatever the IAEA's findings indicate about Iran's intentions or proximity to becoming a nuclear weapons state, the US has little appetite for initiating an attack with such uncertain outcomes on the basis of intelligence that remains incomplete. The public is hardly clamoring for another war, and the administration seems understandably reticent to take such a step, particularly going into an election year. Israeli public opinion--and even its leaders--appear split on the advisability of independent action against Iran's nuclear complex. Even in terms of sanctions, I would expect a response with more bark than bite that stops short of antagonizing Iran's regime to the point at which it might use its oil weapon. Unfortunately, the longer this protracted confrontation over Iran's nuclear program drags out, the greater the risk of one or more parties miscalculating, with results that could spin out of anyone's control.

The Council on Foreign Relations has put out some useful interviews and analysis on the IAEA report and the possible responses to it. Have a look and draw your own conclusions.

Dark Clouds

Two of yesterday afternoon’s panels at the Herold Pacesetters Conference really epitomized why I love to attend sessions like this. They dealt with geopolitical risks to energy supplies and the “megatrends” facing the entire energy industry and the wider world. In the interest of time, since I’ve ducked out of another session to write this posting, I’m just going to list some of the insights and sound-bites that caught my attention from these panels:

• The panel on geopolitical risks included a presentation on an interesting tool for quantifying those risks objectively, and I plan to come back to that in a later posting. But another presenter provided some useful advice about not getting so focused on understanding the risks that we fail to plan our responses to common outcomes that could arise from a number of different events. If the market is short a million barrels per day, how important is it that it happened because of country X’s policies or because of a natural disaster, compared to making sure we can handle such a shortfall from any cause?
• Cliff Kupchan of the Eurasia Group provided some insights into the upcoming transfer of power in Russia, suggesting that President Putin may surrender the Presidency, but that wherever he ends up may become the new center of power. This has implications well beyond energy.
• Mr. Kupchan also discussed Iran. He sees two competing clocks ticking down in that country, the nuclear clock and the reform clock. Whether we end up with an application of “kinetic policy”—a euphemism for military force—may depend on which clock is running faster.
• In the panel on megatrends we heard about resource depletion and the prospects for Peak Oil, which hinges not just on the oil in the ground but on the capacity to produce it. If the international oil companies can’t access those resources, and OPEC lacks the internal funding or motivation to build capacity, we could end up with a peak, regardless of the remaining reserve levels.
• One indicator of the progress towards such a state is the steepening curve for per barrel capital costs in the oil industry. This suggests diminishing volumetric returns ahead, and the prospect of really severe price increases to destroy the demand that can’t be met. That could be especially painful for the US, since so many consumers around the world are buffered from oil price changes by controlled markets and high taxes.
• There was also a brief discussion of a recent prediction that oil prices could be about to peak and return to $45/barrel, though that view didn’t get much credence on the panel or with the audience.

If this all sounds like doom and gloom, that’s the nature of the way we tend to look at risks. If there are bright spots in this outlook, they may have to come from non-conventional hydrocarbons and alternative energy, the subject of my panel this morning, which I’ll cover in tomorrow’s posting.

Global Energy Security

A few weeks ago, when the National Petroleum Council's report on the US energy future was released, I promised to devote several postings to its chapters on supply, demand, geopolitics and technology. Geopolitics, covered in Chapter Four, it seems like a good place to start, because many of the issues with which it deals underpin the study's discussions of supply and demand. It is also extremely relevant to pending energy legislation, and perhaps even to election-year politics. As best I can tell, there's no way to download this chapter separately from the entire document, and I'd be remiss if I didn't point out that this is a very large file. The key message of the Geopolitics section is that a multilateral, market-based approach benefits the US much more than the pursuit of isolation and energy independence. That's hardly a surprising view for a body like the NPC, but the report grounds it in a realistic view of the current global situation.

Some of the key trends that the report's authors address include the challenges to globalization and expanding trade--of which they see energy as an integral component--and the growth of energy bilateralism and resource nationalism, both of which threaten the post-World War II international system that has benefited the US so much. They also look at some very interesting shifts that are taking place in long-established energy trading patterns, with the emergence of large developing countries as markets for the energy supplies of other developing countries.

The main focus of this chapter is energy security, and it applies a very global perspective to that concept. The US is hardly the only country in which this idea is gaining favor, and if we all pursued a go-it-alone mentality in this area, the resulting clash of consuming nations' energy interests would only benefit energy exporters. The study provides a useful set of criteria for energy security:

• A competitive market
• Stable and diverse supply with minimal disruptions
• Low price volatility
• Adequate spare capacity and logistical infrastructure
• Diverse energy mixes
• Protection of the global environment, including climate consideration
• Flexibility to accommodate shifting demand pattern
• Transparency and reliability of commercial relationships.

Interestingly, none of these seems restricted either to oil or to the US. Most could apply equally well to LNG, electricity, biofuels or any other form of energy that can cross international boundaries. Unfortunately, many of these principles are not reflected in the current US approach on ethanol, as embodied in both existing policy and the recent House and Senate energy bills. I have to wonder whether a global free market in biofuels might achieve more leverage on oil exporters than our heavily protected domestic ethanol program.

Like any overview, the 26 pages of the NPC study devoted to geopolitics skate over a number of issues that could have been explored in greater depth, not the least being its underlying assumptions about the superiority of a market approach in an energy environment that is increasingly dominated by large state players. Although it cites the actions and aims of these national oil companies many times, it only mentions OPEC once, leaving it to other chapters to cover one of the most important geopolitical dynamics in a tight global energy market.

Overall, the view of the NPC on energy geopolitics is diametrically opposed to that of the "green hawks" who see it as a zero-sum game, in which suppliers must be starved into submission by our rapid conversion to alternative energy. Although the NPC's internationalist, pro-trade position surely reflects the mainstream of opinion within the energy industry, it is unfortunately increasingly out of sync with a public and political sphere that has grown suspicious of free trade. Despite being the largest single recipient of global energy trade--a ranking we may shortly lose to Asia--many in the US yearn to be self-sufficient in energy, a condition we haven't experienced in my lifetime. The authors wisely remind us that it's no longer possible for the US to have an internal conversation about this, without influencing the plans of our suppliers and competitors.