Forget $4 Gas – Can the US Handle $6 at the Pump?

The short answer is likely no, at least not at any time soon. That’s not to say, however, that middle east contagion fears are completely overblown.  The fact of the matter is that I believe that potential worst case scenarios are not as bad as many have come to believe long-term; but short-term, as we all know, anything is possible.

In the short run:

  • Muammar Gadhafi is a deranged lunatic, believed capable or anything from setting his nation’s oil reserves ablaze to genocide.
    • With sanctions having been imposed against Libya, their assets frozen, and the nation effectively divided in two, further escalation in violence may be imminent.
  • Saudi Arabia – given their enormous reserves, and that they have stepped up oil production to offset losses from Libya, concern of stability in Saudi escalates anytime the youth of the region so much as sneeze’s in its direction, it is understandable that the world’s eyes are focused turmoil in nearby Bahrain, Oman, and the country’s Shiite minority.
    • Bahrain and Oman will both be focal points in determining potential swings in crude, as worries of unrest spreading to Saudi grip the market
  • Algeria strikes many as a likely candidate for contagion due in large part to being situated in North Africa, near Egypt and Libya, considering it’s extremely high unemployment rate amongst the youth, and after having been run under a state of military emergency for 40 years – not to mention large oil reserves.
  • Though Egypt has been somewhat removed from our radar we must remember that they are essentially leaderless as a nation (with no president), and no elections scheduled until September of this year.
  • Iran. Appropriately one of only two ‘four-letter’ words on my list.  We know they’ve had issues, and we now know (courtesy of Rajat Gupta) that it’s easier to get information out of Goldman Sachs than it is from Iran.  Over the past two weeks rumors of Iranian warships entering the Suez tore through worldwide oil markets intra-day.  It is hard to assign credibility to any breaking news from Iran, and therefore I assign Iran as my ‘sleeper’ major headline-risk from the middle east (with Saudi being the 800 lb gorilla).

Of the above issues the most pressing is clearly that of Gadhafi in Libya, as history shows it’s difficult to assign probabilities to the potential actions of madmen – they’re literally capable of anything.  On the other hand, the President of Saudi Arabia was recently greeted with jubilation as he returned from medical treatment abroad, promptly instituting further benefits for the unemployed, and pledging to increase oil production to offset losses from other key mid-east nations.  Meanwhile, Algeria preempted many fears of further contagion by ending its 40-year old military sate of emergency – a state of control that Egypt had been under, until after their uprising.  This past week, further protests in both Tunisia and Egypt proved both successful and peaceful.

Though the future of the region as whole may be much brighter than many might believe, that doesn’t negate a few other pressing issues we’ll have to deal with.  With US forces having approached the shores of Tripoli amidst reports of Gadhafi  loyalists massing near rebel strongholds, and with substantial sums of Libyan assets having been frozen, full-scale escalation appears imminent if the US is unable to dangle their $30 Billion ‘carrot’ of seized assets and execute some sort of negotiated exile.  While any escalation would likely come in the form of a UN led security force (or at least for once a UN approved one), it will set an interesting precedent of supporting such uprising.

If Gadhafi has to go the hard way everything changes, and I mean everything.  If Gaddafi choses not to leave I believe that verifies that he is devoid of any logic or sound reason, and they since he doesn’t care about his money he therefore may no longer care about his oil reserves – if Gadhafi pulls a Saddam and starts lighting oil well on fire I don’t want to think about filling up my gas tank, let alone where crude might trade.  Longtime Gadhafi friend and Libyan ally, Hugo Chávez of Venezuela, has recently made news calling for negotiation with the Libyan madman, and has historically stood at his defense.  Rather then speculate further, suffice it to say that it is more than disconcerting having a Gadhafi supporting dictator with his own sizable oil reserves on this side of the planet.

Given the number of oil-producing nations currently, and potentially, experiencing upheaval it is not difficult to imagine crude surging to its previous highs; even if contagion does not spread further, if we were to get a meaningful and prolonged drop in production (or in the case of Egypt, transportation) of oil in most of or all of these nations, it would have a profound impact on oil prices in the short run – particularly in Brent crude, and with a disproportionate effect on the European economy as compared to the US.  Excess US supplies have been able to hold back WTI crude, and may very well continue to, but a prolonged shock could stifle recovery here as well.

Increased margin requirements at commodities exchanges (like CME) have curbed leverage that traders may use, and while in theory this should limit overall speculation, in practice, during times of heavy speculation, volatility may be heightened (particularly when requirements are altered during said speculative period) – so oil may not trade as high, but boy is it going to trade! The last time around when oil peaked we didn’t see gasoline prices above $4.00 f0r long, and that’s because oil prices didn’t stay that high for long (nor were they expected to, if you look at futures) – had oil prices even just hovered at $147  longer, gas would climbed further.

As a general rule always remember that for every $25/barrel of oil you can add $1.00 gallon at the pump.  Long story short, oil may or may not go higher than the famed $147  per barrel high in the next few months, but I can tell you that if prices stay at or near $150 per barrel for more than just a few months that we’ll see US gas at the pump surge to near $6.oo per gallon.

In the long-run:

This could be the best thing to happen to the middle east since air-conditioning.  The eventual outcome might be the best that Americans (though not necessary Dick Cheney) could have hoped for in the Middle East.  If we, as a nation, were actually trying to do anything more in Afghanistan and Iraq than playing “where’s the WMD?” then I think we waned Democracy to be contagious.  OK, yes to be fair let’s acknowledge that in a couple of instances here we have rebellions against US sponsored (or at least funded) dictators/monarchs (Egypt and Bahrain) – but if any President in US history was ever going to be able to look the Middle East in the eye and honestly say “that was then, this is now – we’re different” it’s probably the one named Barack Hussein Obama.

Oil production?

These people aren’t mad (again, with the exception of Gadhafi) – they don’t want to stop producing and selling their most valuable asset.  Understand that, if anything, you could argue that all of this turmoil is centered on dictators and monarchs who hoard, and do not distribute or utilize effectively, their vast oil wealth.  If anything I would believe that after a new government is installed, Libya will be capable of producing more oil with a competent government and improved infrastructure, for example.

The enemy of my enemy is my friend…

One thing worth noting in the negative column might be Gadhafi’s own comments this week that Osama bin Laden was to blame for the uprising in his country, and that Al Qaeda had drugged the youth of his country.  This gives me pause in the same way a parent might expect their child to spend time with the exact people they had told them not to associate with – to be spiteful.  I’d be at least mildly concerned that the youth of a country who hates their leader (Gadhafi) might be drawn to the person/group he seems to fear most, Al Qaeda. Whether or not they’re the ramblings of a lunatic, I pay some heed to the fact that someone with that much to worry about right now is having delusions about Bin Laden and his effect on the youth of Libya.

A crude reality

While I would characterize almost any continued spike in oil prices as just that, a spike, I am certain that the future of crude prices is elevated. Though we continue to improve fuel efficiency and are beginning to offer alternatives, it is not enough – and certainly not considering the forecast for increased global energy consumption. Without an energy policy the US is unlikely to make much headway and, even when we make the necessary switch to using more of our abundant natural gas resource, oil prices are likely to remain elevated.  Given global supply, geopolitical concerns, and that after shale is exploited most of our sources of crude will be more and more costly, I believe that in the next few years we may see oil below $100 per barrel for the last time in our lives.