A Closer Look. Why Are Oil Prices So Closely Tied to Geopolitics? W. Preston Stahl, Portfolio Manager and Commodities Specialist

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1 July 2013 A Closer Look Why Are Oil Prices So Closely Tied to Geopolitics? W. Preston Stahl, Portfolio Manager and Commodities Specialist Oil and Today s Reality Economies depend on oil more than any other commodity Oil supplies are limited and in unsettled areas Transporting oil is susceptible to serious disruption Key Insights Markets will always apply a premium to the price of oil for its inherent risks Oil s predominance as a transportation fuel is unlikely to change Although the U.S. depends heavily on the Middle East for oil, a recent energy revolution may change that dynamic On the evening of October 5, 1973, oil traded at just over $4 per barrel. The next morning, a coalition of Arab states launched a surprise attack against Israel in what would become the beginning of the Yom Kippur War, a 19-day conflict that pitted many of the world s most powerful nations against one another. Although the war lasted only three weeks, it was a defining event for the energy market. To side against the U.S. and Israel, Saudi Arabia and other Arab states enacted an oil embargo that cut the U.S. s imports of oil by one-third. When the embargo was lifted five months later, oil stood at more than $12 per barrel triple its price before the conflict. Time and again, we are reminded by events like these that oil is unlike any other commodity in the way it influences and is influenced by geopolitics. A disruption involving key energy-producing countries can quickly cause oil prices to rise. Then a fairly predictable series of events tends to follow: Gasoline and other energy costs rise, which forces many businesses to raise their prices, which sparks fears of broader inflation, which puts pressure on political leaders to address the source of the problem before it cripples the global economy. These geopolitical crises are often in, or connected to, the Middle East (Exhibit 1). Exhibit 1: Price of Oil During Periods of Conflict Beginning of Conflict Peak During Conflict 205% $4.12 $12.57 Yom Kippur War/Oil Embargo $15.14 $39.89 $ % 132% Iranian Revolution $17.07 Invasion of Kuwait 1990 Price of oil refers to West Texas Intermediate crude oil. Prices are monthly. Source: Global Financial Data Why is it that oil influences geopolitical events so heavily, and vice-versa? In this paper, we lay out three key reasons: 1) To run effectively, economies rely on oil more than any other commodity, 2) Oil supplies are limited and in particularly unsettled parts of the world, and 3) Transporting oil is susceptible to serious supply disruption during conflicts. Then, after discussing these factors, we ll address why the U.S. s seemingly permanent dependence on the Middle East for oil may change in the years to come.

2 Oil literally drives the global economy Without oil, the global economy would come to a screeching halt, because over half of all oil is consumed by the transportation market (Exhibit 2). Today there are 1 billion cars on the road, 3 billion people traveling by air per year, and in the U.S. alone 11 million recreational marine craft. All of these modes of transportation are powered by fuels made from oil. If trains and cars did not have fuel, people would not be able to get to work. The food chain would break down: Grain would be trapped in the Midwest, unable to be transported to the major feedlots in the coastal areas and plains that feed animals. Blackouts would become commonplace. Commerce would essentially stop and life as we know it would hearken back to a prior age. Exhibit 2: Percent of Global Oil Consumption by End User Residential & Commercial 8% Industrial 32% Electric Power 6% Transportation 54% Data is shown in quadrillion British thermal units and based on information contained in the International Energy Outlook Source: U.S. Energy Information Administration Despite the technological advances that have improved the efficiency of oil usage and allowed for new energy sources such as solar power, the world s thirst for oil continues to grow. As shown in Exhibit 3, global oil consumption today is nearly 30% higher than it was in 1990, thanks mainly to growing emerging-market demand. This trend is unlikely to be reversed: Oil is easy to use and easily transportable, there s already an abundance of filling stations worldwide, it is safer than alternatives like nuclear energy, and perhaps most importantly it is reasonably cheap. Exhibit 3: World Oil Consumption Millions of Barrels per Day As of December 31, Source: U.S. Department of Energy As a result, countries such as the U.S. that rely on oil imports operate on a key assumption: oil supplies cannot run dry. If they do, the damage to the economy can be debilitating. For instance, U.S. GDP fell in both 1974 and 1975 in part as a result of the rise in oil prices stemming from the oil embargo. In addition, U.S. politicians do not want to see a repeat of the anguish experienced by U.S. consumers as they waited hours in line for fuel during this period. Part and parcel of the desire to keep oil supplies abundant is the desire among importing countries for energy to be affordable. Economies perform best when fuel is relatively inexpensive. When fuel prices are low, consumers do not have to spend as much money filling up their cars and have more discretionary income to spend on other items. If fuel prices rise, consumers are effectively hit with an additional tax, thereby reducing discretionary income. To put the impact of fuel prices on U.S. consumer spending in context, based on current U.S. daily demand of roughly 9 million barrels of gasoline per day, a $1 per gallon change in gasoline prices alters consumer discretionary income by $138 billion on an annual basis. Oil prices can also have a significant influence on importing countries trade balances and budgets. In the case of the U.S., oil imports have been responsible for, on average, one-third of the U.S. trade deficit over the past 30 years (Exhibit 4). 2

3 In 2008, the year that the price of oil reached an all-time high of $147 per barrel, the U.S. spent nearly $400 billion on petroleum imports. For this reason, economies are highly dependent on oil and have an extraordinary incentive to keep it abundant and reasonably priced. As long as oil supplies are adequate and prices are affordable, economies can keep moving, consumers are happier because they have more discretionary income, and a country s balance sheet and trade balance are in better shape. Exhibit 4: Petroleum Imports Percent of Total U.S. Trade Deficit % As of February 28, Source: FactSet, U.S. Bureau of Economic Analysis, U.S. Census Bureau Oil supplies are limited and in unsettled parts of the world Despite growing global demand for oil, there is only so much of it in the world. How much there is, however, is up for debate. According to the Organization of Petroleum Exporting Countries (OPEC), proven oil reserves those that can be recovered at today s prices stand at 1.5 trillion barrels, which would not even meet the world s current needs for the next 50 years. To be sure, the world will not likely run out of oil by the 2060s because the energy industry continues to grow production and add reserves through advancements in technology and a greater understanding of the earth s subsurface. History serves as a helpful guide here: In 1974, the geoscientist M. King Hubbert theorized that oil production would peak by Today, however, oil production is one-third higher or more than 20 million barrels per day than in This year, a well was drilled off the coast of India at a water depth of nearly two miles a feat likely unimaginable when Dr. Hubbert was alive. However, this doesn t take away from a crucial point: Though oil reserves may not be as scarce as they seem, they are nevertheless not infinite because oil is a non-renewable commodity. Perhaps more critical for the outlook of oil supplies is where oil reserves are located. As can be seen from Exhibit 5, not only does the 12-nation OPEC control the vast majority of world oil reserves, but these supplies are really controlled by just a select few countries namely Venezuela, Saudi Arabia, Iran, and Iraq. Exhibit 5: Global Oil Reserves Rest of World 11% Former Soviet Union 8% OPEC 81% Billions of Barrels Venezuela 298 Saudi Arabia 265 Iran 155 Iraq 141 Kuwait 102 UAE 98 Libya 48 Nigeria 37 Qatar 25 Algeria 12 Angola 10 Ecuador 8 Source: Organization of the Petroleum Exporting Countries (OPEC) Although Venezuela has more proven reserves, Saudi Arabia is the most important player because it has by far the most capacity to produce more oil if the world needs it. That makes it especially influential over the world oil market which means that any disruption in or near Saudi Arabia has implications for global oil prices. Unfortunately, Saudi Arabia and the nexus of OPEC happen to exist in a highly charged region with a history of religious conflict, war, civil uprisings, and nuclear armament ambition. Although Saudi Arabia is the most influential producer in OPEC, other member countries can also have a profound impact on oil markets. For instance, 3

4 during the collapse of Muammar Gaddafi s regime in Libya in 2011, oil production in the country dropped more than 1 million barrels per day in two months, which resulted in a $25 per barrel rise in oil prices. History suggests that Middle Eastern conflict isn t likely to go away, which means that the rest of the world will likely continue to experience price volatility at the pump. Oil supply routes are susceptible to disruption Finally, the path that oil typically travels is one of the chief reasons why oil is so closely tied to geopolitics. Because the vast majority of oil has to pass through just a handful of narrow, strategic chokepoints, any global conflict that shuts off one of these chokepoints would end up essentially trapping oil where it is produced. That s particularly important because, in the oil market, there is an imbalance between where oil is produced and where it is consumed. To put this in perspective, consider OPEC again. In 2011, OPEC produced nearly 36 million barrels of oil per day, but OPEC countries consumed less than 9 million. Conversely, the countries in the Organisation for Economic Co-operation and Development (OECD) which includes nations such as the U.S., Japan, and Germany consumed approximately 46 million barrels per day, but produced less than 19 million. To meet their needs, these countries have to import more than half the oil they consume. China the fastest-growing oil consumer also cannot meet its needs by itself and is increasingly dependent upon imported oil. In other words, oil has to move from producing countries to consuming countries. Because of the long distance between them, approximately half of the world s oil supply travels on tankers through maritime routes. The majority of the oil that travels by water must go through the strategic chokepoints shown in Exhibit 6. By far, the most critical chokepoint is the Strait of Hormuz, located between the Arabian Peninsula and Iran. Roughly 20% of the world s oil flows through this waterway daily, more than what is consumed by all of Europe. It would be nearly impossible to bypass the Strait of Hormuz. As can be seen in Exhibit 7, most of Saudi Arabia s oil fields (depicted in green) are located in the northeastern part of the country, tucked back in the Persian Gulf behind the Strait of Hormuz. Exhibit 6: Oil s Maritime Chokepoints Panama Canal Danish Straits Suez Canal/ Sumed Pipeline Turkish Straits Strait of Hormuz Bab-el-Mandeb Percent of Strategic Chokepoints World Supply* Strait of Hormuz 19.3% Suez Canal and Sumed Pipeline 3.8 Danish Straits 3.6 Turkish Straits 3.5 Bab-el-Mandeb 3.3 Panama Canal 0.8 As of December 31, *Refers to percentage of world oil supply passing through each passageway daily. Source: U.S. Department of Energy 4

5 Saudi Arabia can transport oil via pipeline, but doing so in large volumes is fraught with risk. Constructing and maintaining pipelines over the distance and of the capacity necessary to move Saudi Arabia s enormous volumes would be challenging. In addition, for the oil to get to a destination port, the pipelines would have to cross politically volatile countries like Yemen or Iraq, which would raise the risk that the oil would be stolen or knocked off line. That s one of the reasons why Saudi Arabia decided to stop using the 754-mile Trans-Arabian Pipeline two decades ago. Exhibit 7: Major Oil Fields in the Middle East Iraq Saudi Arabia Persian Gulf Source: United States Central Intelligence Agency, Norman B. Leventhal Map Center For all intents and purposes, for the world economy to function, the Strait of Hormuz has to stay open. An ever-present risk for the oil market is if the flow of oil from this trade lane gets cut off from the rest of the world. With Iran bordering to the north, this risk is real. Fully aware of how important the strait is to the world economy, and particularly to the United States, the Iranian leadership often threatens to disrupt trade through the waterway when tensions flare with its western adversaries. Although the Strait of Hormuz is a fairly wide 24 miles at its narrowest point, Iran has the military capability to halt trade along the route at least temporarily. Shutting down the Strait of Hormuz is arguably a more powerful weapon for Iran than the threat of nuclear armament. Iran Strait of Hormuz U.A.E. Oman Gulf of Oman For these reasons, the price of oil is heavily dependent on its ability to be transported through narrow passageways whose gatekeepers many of whom are in the Middle East can block oil s path to the rest of the world. Oil, U.S. Foreign Policy, and the Future From a foreign policy perspective, oil is one of the most important influences behind U.S. political and military involvement in the Middle East. Although the U.S. articulated a host of reasons for entering into conflicts such as the Iraq/Kuwait war and the invasion of Iraq, there is little doubt that protecting oil supplies or preventing the price of oil from escalating was a critical factor. A stable and secure Middle East remains central to U.S. foreign policy in the region. It is no coincidence that the United States Navy s Fifth Fleet, comprising one-sixth of U.S. naval strength, is located in Bahrain, in close proximity to the Strait of Hormuz. Of OPEC s members, the most important to the U.S. from an oil market perspective is Saudi Arabia for three reasons: the amount of oil they produce, the extent of their reserves, and most importantly their control over the world s excess supply. The relationship between the U.S. and Saudi Arabia has been strained at times, but the two countries have remained necessary allies since they forged a relationship for strategic reasons during World War II. The defense of Saudi Arabia, President Franklin D. Roosevelt said in 1943, is vital to the defense of the United States. The wealth of oil held by Saudi Arabia binds the U.S. to Saudi Arabia, and demand from the United States provides a guaranteed outlet for Saudi oil. However, the alliance may not always be as strong as it is today. While U.S. foreign policy toward the Middle East is unlikely to change in the near term, the U.S. is quickly becoming more self-sufficient in supplying its own energy needs, and oil is no exception. Thanks to a recent energy renaissance 5

6 powered by hydraulic fracturing (or fracking ), the U.S. is one of the fastest-growing oil-producing countries in the world. As a result, the U.S. is becoming less dependent on foreign oil imports (Exhibit 8). If this trend continues, the dynamics of the U.S./Saudi relationship and the importance of the Middle East for oil reasons seem destined to change. Exhibit 8: U.S. Oil Imports Millions of Barrels per Day Conclusion Of course, greater energy independence for the U.S. will not come overnight. Even at its current production levels, the U.S. still has to import more than half the oil it consumes. As a result, oil will continue to be crucially important to both consuming countries like the U.S. (because it powers their economies) and producing countries like Saudi Arabia (because it finances their economies). Moreover, the combination of limited oil reserves, volatility in the Middle East, and supply routes that are particularly vulnerable to disruption, adds a unique element of volatility to oil prices. Indeed, for these reasons, the price of oil is likely to always have an additional premium in it above where it should be priced, based purely on supply-and-demand fundamentals Data reflects rolling 12 months. Source: U.S. Department of Energy Mr. Stahl is a Portfolio Manager and Commodities Specialist of Bessemer Investment Management LLC, a member of the Bessemer group of companies. This material is for your general information. It does not take into account the particular investment objectives, financial situation, or needs of individual clients. This material is based upon information obtained from various sources that Bessemer Trust believes to be reliable, but Bessemer makes no representation or warranty with respect to the accuracy or completeness of such information. Views expressed herein are current only as of the date indicated, and are subject to change without notice. Forecasts may not be realized due to a variety of factors, including changes in economic growth, corporate profitability, geopolitical conditions, and inflation. The mention of a particular security or asset class is not intended to represent a specific recommendation, and our views may change at any time based on price movements, new research conclusions, or changes in risk preference. Atlanta Boston Chicago Dallas Denver Greenwich Los Angeles Miami Naples New York Palm Beach San Francisco Washington, D.C. Wilmington Woodbridge Cayman Islands New Zealand United Kingdom Visit us at Copyright Bessemer Trust Company, N.A. All rights reserved.