The Real Reason Energy Traders Are Losing Sleep

The oil crises of the 1970s taught Americans one of the iron laws of geoeconomics: that unrest in the Middle East can cause pain at the pump. But almost 40 years later, that law is blinding analysts to some of the most significant sources of market uncertainty — which are right here at home. True, Iranian bellicosity and broader regional storm clouds are adding froth to oil prices. But even more striking is how much market-churning uncertainty is emanating from Washington and Brussels, rather than Caracas, Baghdad, or elsewhere in OPEC. The ambiguous economic trajectories and fluctuating policies of major energy-consumers like the United States, European Union, and China are proving at least as unsettling to oil prices as any decisions under the control of Middle Eastern officials.

Ask the leaders of OPEC what it’s like to control the world oil market right now and they would probably laugh at your premise. Today’s market jitters are largely beyond their control. The U.S. Federal Reserve’s new open-ended commitment to expanding its balance sheet will likely push up the price of real assets like oil, even as White House chatter about dipping into the Strategic Petroleum Reserve (SPR) keeps the markets guessing about a sudden price collapse. At the same time, U.S. and European Union sanctions on Iran have crippled its oil exports, contributing to soaring oil prices and sparking demonstrations in downtown Tehran over the plunging value of the rial.

The potential for oil prices to shoot sharply higher or lower in the coming months due to events far outside OPEC’s control is real, though still improbable. An Israeli military strike against Iran has the potential to drive oil prices skyward, just as the spread of Europe’s debt crisis could cause oil markets to collapse. Add to this mix the threat of a so-called hard landing for China’s economy or Washington falling over the fiscal cliff, either of which could send oil prices sharply lower. Yes, unrest in the Middle East is a continuous threat to stable oil prices, but political decision-making in the West and China is injecting more than its fair share of uncertainty into the market.

Part of this uncertainty is the result of policy incoherence in Washington. There is more than a little irony in the fact that the White House may decide to tap the SPR, the nation’s 695 million barrel emergency fuel stockpile, to prevent a harmful rise in gas prices stemming in part from the decisions of the Fed. The mere announcement of the latest round of quantitative easing by Ben Bernanke, in addition to the already-loose monetary stance of other major central banks, was enough to send oil prices higher, only to crash shortly thereafter. The bounce would no doubt have been larger had many market participants not anticipated the Fed’s decision. But the Fed’s aggressive monetary easing is partly responsible for putting the Obama administration in the unenviable position of having to consider dipping into the SPR in order to keep a short-supplied market from pushing up prices too high.

And yet the policy dissonance in Washington has not been nearly so vexing to the oil market — or to financial markets more broadly — as the uncertainty surrounding the eurozone. Hardly a week passes without investors frantically buying or selling oil on the faintest whisper from the European Central Bank, Chancellor Angela Merkel, or the leaders of the most imperiled debtor nations. The unending lurch from Eden to Armageddon on trading floors around the world is typical of the so-called "risk on, risk off" capital-market mentality that has swept across every asset class — and oil is no exception. Demand for oil correlates closely to global economic growth. When Europe’s nagging ills appear on the mend, the outlook for growth appears brighter, causing oil prices to rise. Ditto on the flip side. But the sheer complexity of the problems facing European leaders, not to mention the uncertainty of domestic support for their policy prescriptions and the risk of cross-border contagion, mean oil prices have lurched to-and-fro with unusual velocity.

The prospect of a cataclysmic European tailspin is what economists call a left-side tail risk to prices: low in probability, but with the potential to topple the oil market should worldwide growth stall or even shrink. But right-side tail risk — that oil markets might spike — is also causing risk managers to lose sleep. The market’s primary worry is an Israeli air strike on Iran, possibly with backing from or in coordination with the United States. If that happens, Tehran may well retaliate by disrupting tanker traffic in the Strait of Hormuz, the passage through which 35 percent of all traded seaborne oil flows. These are not idle fears. U.S.-led naval maneuvers in the Persian Gulf, which have included mine-sweeping drills, are already underway, and Iran has test fired missiles at ship-like targets near the Strait. Were Washington or its allies to launch a pre-emptive attack on Iran, oil prices would soar. Though Iran may be setting the stage for a confrontation, Western powers may end up being the ones to pull the trigger, setting off energy markets.

Even if such a conflict never materializes, efforts by the United States and the European Union to curb Iran’s nuclear ambitions have already contributed to rising prices. Tightening U.S. sanctions and an EU ban on Iranian oil imports have caused the country’s crude exports to fall to less than half of last year’s average. This tightening of the screws has been disastrous for Iran, which depends on oil for 80 percent of its foreign revenue. By causing prices in the United States to rise, however, this strategy for bringing Tehran to the negotiating table has also been painful for American consumers. Whatever one thinks of the wisdom of sanctions in this or any other case, they have clearly caused global oil markets to labor under a strain that they would not have had to grapple with otherwise.

Still other wild cards remain far outside the control of OPEC. Market participants are already speculating about what measures Beijing will take to spur waning real economic growth. Oil has bounced along with other assets investors perceive as relatively risky, like emerging market equities, because of guessing about whether China might opt for more aggressive fiscal and monetary stimulus in the near future. Market fears persist about the possibility of a so-called Chinese "hard landing" and what it could mean for oil prices. Meanwhile, back in the United States, the much-discussed fiscal cliff looms. Its combination of tax hikes and spending sequestrations, due to drop in January if Congress fails to cut a deal, could weigh on domestic growth and hence oil demand. That loss could shave several percentage points off oil prices over the course of several years, according to a recent Citigroup analysis. Any mixed signals from Congress that cause Wall Street to question if or how it might tackle the approaching legislative deadline are sure to set off fireworks in the oil market in the meantime.

Make no mistake: Unrest in the Middle East has the potential to destabilize energy markets. With a civil war raging in Syria and North Africa in the midst of a trying transition period, it’s not difficult to see how oil supplies could be interrupted. Trouble elsewhere in Africa, in places like the Sudan and Nigeria, is not helping matters. Given these realities, it’s hard to imagine a scenario in which oil prices move significantly higher for an extended period absent something going wrong in that part of the world, which contains 70 percent of known oil reserves. Yet when it comes to sovereign decision-making, moves from Washington, Brussels, and Beijing may prove more unsettling to global energy markets in the months ahead than anything OPEC does.