Wednesday, August 13, 2014 - Oil, At Least in Theory

Financial Review with Sinclair Noe

DOW + 91 = 16,651
SPX + 12 = 1946
NAS + 44 = 4434
10 YR YLD - .03 = 2.41%
OIL - .04 = 97.33
GOLD + 3.70 = 1313.20
SILV - .11 = 19.91

The economic news today did not point to a positive session for Wall Street. Retail sales for July were flat compared to June. Excluding autos and gas, retail sales were up just 0.1%. Clothing sales increased 0.4% but that was primarily due to extreme discounting. That report was confirmed by an earnings report from Macy’s, which missed expectations on earnings and revenue, and then lowered guidance. In after-hours trade, Cisco reported better than expected earnings and revenue.

The US has deployed 130 Marines and Special Operations forces to northern Iraq to help assess ways to rescue thousands of members of the Yazidi religious group taking refuge on Mount Sinjar. Those military advisers will not have a combat role, but the Defense Department left open the possibility that US troops could help create a safe passage for the Yazidi off Mount Sinjar. That might put US troops in direct combat with the ISIS militants trying to kill the Yazidi, a proposition President Obama has not signed off on, but one the military advisers are exploring.

The US and Iran don't agree on much, but it appears the two countries are backing Iraqi Prime Minister Nouri al-Maliki's replacement, Haider al-Abadi. Iran's endorsement on Tuesday means that Maliki, who has indicated he won't go quietly, will have an even harder time holding onto his position. The United States and its allies hope that replacing Maliki, who alienated the Sunnis of Iraq, will undermine support for the militant group the Islamic State in Iraq and Syria (ISIS). For now, Maliki is trying to cling to power, but his days appear numbered.

There are daily multiple sorties by US fighter bombers flying off a US Navy aircraft carrier in the Gulf, some resulting in airstrikes on advancing ISIS forces that have threatened civilian refugees and the Kurdish capital of Erbil. Unmanned US drones are in the air gathering a constant stream of intelligence which is being fed back to a US-manned operations center in Baghdad and then shared with America's allies.

There are close to 1,000 US military advisors in Iraq, including Special Operations forces, divided between Baghdad and Kurdistan and the CIA is believed to be running an operation to supply Kurdish forces, the Peshmerga, with arms and ammunition. Iraqi Kurds have overtaken 2 northern oilfields.  The two oilfields are said to have a combined daily output capacity of some 400,000 barrels per day. The operations are most certainly not entirely humanitarian. France and Germany both say they will send military equipment to help the Kurds defend themselves. Hercules transport planes have been dropping aid to civilians fleeing from the onslaught of ISIS.

While the case for intervention on humanitarian grounds to save the lives of thousands of fleeing refugees is overwhelming, there is now the risk of what is known as "mission creep"; of a small, narrowly defined operation ballooning out of control, sucking in Western countries into a lengthy conflict with no clear exit. Politicians are fond of saying "there will be no boots on the ground" but in practice there are already growing numbers of US military personnel deployed to Iraq behind the scenes. The ISIS fighters are now embedding in residential areas like Mosul, essentially using civilians as shields. Already Iraqi government airstrikes around Mosul have led to reports of civilian casualties. What if advice and air power alone are not enough to prevent the ISIS from taking more towns in Iraq and Kurdistan? What if Baghdad itself or the cities of Kirkuk or Irbil look threatened?

The militants from ISIS have been causing problems in Iraq and Syria for several months, but then they took control of the area around Kirkuk, a gigantic oilfield; then they captured the Mosul Dam, which controls electricity and might serve as a weapon; and then they encroached on the Kurdish capital of Erbil, an oil boomtown which happens to have a US consulate but also has hundreds of employees of companies like Chevron and ExxonMobil; that’s when the airstrikes against ISIS started. To be fair, it was also when ISIS became especially barbaric, and tens of thousands of Yazidi refugees became stranded. The current US intervention certainly has humanitarian purpose, but it would also be wrong to pretend that oil is totally irrelevant to the larger crisis in Iraq.

Meanwhile, the markets are discounting any disruption in distribution in Iraq; Iraq is currently the world's seventh-largest oil producer, churning out some 3.3 million barrels per day; Kurdistan in the north is only responsible for about 10% of the national production; most Iraqi oil exports come from the southern part of the country, and those oil fields are far away from the current fighting, so it’s highly unlikely that there will be a disruption, at least in theory.

In theory, all oil sales in Iraq are supposed to be handled by the central government in Baghdad, which then splits revenues among the various regions according to an existing agreement. Iraqi Kurdistan has been pushing to sell more of its own oil directly to other countries, bypassing the central government entirely, because Kurdish officials claim that the central government hasn't been sending Kurdistan its promised share of oil revenue.

The United States is officially opposed to Kurdistan's direct sales of oil abroad because it might undermine the unity of the Iraqi government. There's currently an oil tanker filled with about 1 million barrels of Kurdish oil parked about 50 miles offshore from Houston that can't unload its crude. State Department officials have been quietly warning any potential buyers of the Kurdish oil that they could face "serious legal risks." But now, the Kurds are stepping up the fight against ISIS.

Iraq has scheduled to export about 2.4 million barrels per day of Basra Light crude in September, up from 2.2 million in the previous month. Libya has resumed shipments of crude. According to the IEA: "The Atlantic market is currently so well supplied that incremental Libyan barrels are reportedly having a hard time finding buyers." If Iraqi oil goes offline, even for a short time, the rest of the world does not have enough spare capacity to replace that production; that would likely push oil prices over $125 a barrel, and that might then increase the leverage for Putin.

And it had been thought that sanctions imposed on Russia over its support for Ukrainian rebels might cause disruptions in oil distribution. Russia is the largest oil producer in the world, at over 10 billion barrels equivalent per day or 13% of world supply. However, the markets are looking at Russia and saying that Putin needs to sell oil even more than the EU needs to buy it. Russia turning the taps off would cause an oil shock in the West as it would cause a steep rise in prices and significant disruption, however it would also bankrupt Russia. At least in theory.

Ukraine vows to stop Russian-supply convoy unless conditions are met. Wary that the Russians may be trying to move military supplies into their country to aid pro-Moscow separatists, Ukrainian officials said they would not allow a convoy of 280 Russian trucks to cross the border unless the Red Cross took over the delivery. Ukraine says the cargo, which Russia insists is humanitarian aid, must be loaded onto other vehicles by the Red Cross. It will take the trucks about two days to make the 620 mile trip from Moscow to eastern Ukraine.

Ukrainian state-run energy firm Naftogaz said yesterday that the ongoing dispute over natural gas prices between Kiev and Moscow may lead to disruption in Russian gas transit to the European Union (EU) countries. Kiev and Moscow have been locked in a dispute for three years over a 2009 contract under which they agreed to tie the price of gas to the international spot price of oil. In June, Russia's energy giant Gazprom has cut all gas supplies to Ukraine after the two sides have failed to reach an agreement on payments. The dispute between the two former Soviet countries triggered fears that Russian gas transit to Europe may be halted. Currently, around 15 percent of EU gas supplies flow through Ukraine.

Yesterday, the International Energy Agency (IEA) said: "Oil prices seem almost eerily calm in the face of mounting geopolitical risks spanning an unusually large swathe of the oil-producing world." Global oil prices have fallen to their lowest levels in 13 months. Brent crude is trading around $103 a barrel, and WTI is around $97, then 10^th straight session with prices under $100. Retail gas prices have dropped about 23 cents a gallon since April.

 

And you probably remember back in 2008, when tensions with Iran helped push oil prices up to a record $148 a barrel. So, with all the problems around the world now, why are oil prices dropping? The US is pumping the most oil in 27 years, adding more than 3 million barrels of daily supply since 2008. 

 

Supplies from the Organization of Petroleum Exporting Countries, which pumps about 40% of the world’s oil, rose to a five-month high of 30 million barrels a day in July as Libyan output recovered and Saudi Arabia increased production. At the same time, global demand is weak, although it is expected to pick up towards the end of the year. Meanwhile Mexico has privatized its oilfields, at least partially. The state-owned energy group Pemex will lose the monopoly it has held since nationalization in 1938. Mexico’s oilfields had been under-performing and production dropped by more than a million barrels per day in the past few years. So, if we can just hold it together for a couple more years, North America could become energy independent. Until then, it could go either way, at any moment, and send the economy into a tailspin in a heartbeat, at least in theory.