Goldman On What Happens To Oil As Egypt Contagion Flares
A week after Zero Hedge first speculated what may happen to oil prices should the Suez Canal be shut down, Goldman arrives on the scene... And as expected, to Goldman it is all (mostly) priced in - the risk of contagion to Saudi is zero. After all, rich people never revolt... And things must always evolve according to what only Goldman Sachs has foreseen.
From Goldman's Jeffrey Currie:
Mass political protest spread from Tunisia to Egypt this past week, which raised concerns that the political instability may spread further and even into the energy-rich nations in the Gulf. Although commodity prices rose sharply, this rise in prices reflects concerns over political contagion and not direct physical disruptions as the impact on commodity fundamentals remains contained for now.
Recent events can impact commodity fundamentals via three channels
Although commodity fundamentals remain undisrupted, we see three channels that drive fundamental risks: 1) the risk of a disruption of commodity shipping routes posed by a further deterioration of conditions in Egypt, 2) the risk posed to crude oil supply should the political instability spread to the major producing countries in the region, which we view as unlikely given GCC affluence, and 3) the risk posed to agricultural demand should regional governments escalate imports of agricultural commodities in an effort to ensure local food supplies to avoid political unrest.
Oil impact determined by political and financial contagion risk
Ironically, while the impact on the crude oil market will likely be determined by whether or not the political contagion can be contained, the impact on the agricultural markets will likely be determined by the extent of the effort to contain the political contagion, with greater efforts likely leading to higher agricultural prices. Although we see the risk of political contagion as relatively low in the more affluent countries, financial contagion has already spread to these regions, raising the cost of oil production. Further, if these countries feel compelled to increase spending in the face of greater political pressure, it could lead to a rise in the oil price required to balance budgets in these countries.
Should political contagion risk ease, the oil market is vulnerable to a near-term but temporary correction
Net, we see the current political crisis as raising near-term risk to agricultural prices. For oil, should the political crisis spread to the oil producing countries of the Middle East, it would certainly send prices sharply higher. However, we see this risk as low at this stage, and current fundamentals suggest that Brent is vulnerable to a near-term price correction should concerns over political contagion ease. But a correction would likely be temporary, as we maintain end-of-year target of $105/bbl.
Some more trite details:
This past week mass political protest spread from Tunisia to Egypt, which raised concerns that the political instability may spread further across North Africa and even into the energy-rich nations in the Gulf. In commodity markets, Brent crude oil prices rose to just shy of $100/bbl ($99.74/bbl), agriculture prices jumped to new highs and gold prices rebounded sharply, reflecting concerns over political contagion as the direct physical impact on commodity fundamentals remains isolated and contained for now.
In fact, wheat prices traded off on Friday afternoon, as the negative demand effects from the 84 million populous and number one wheat importer Egypt are beginning to outweigh the risks of increased hoarding as the political contagion spreads. In contrast to the political contagion risk, which remains highly uncertain, we believe that physical commodity fundamental risk can be summarized into the following three channels:
Choke point disruptions. Should the crisis be contained to Egypt, the main commodity market impact will likely be a logistical one. Around 8 percent of world seaborne trade moves through the Suez Canal, and between oil tankers moving through the canal and oil flowing through the SUMED pipeline, roughly 2.0 million b/d or 2.5 percent of world oil production moves through Egypt. At this time, there has been no reported disruption to either the Suez Canal or the SUMED pipeline, which are interestingly running at much lower capacity utilization rates as most of the OPEC production cuts to Europe were concentrated through these routes. If the Suez Canal is disrupted, supplies would simply go around the Cape of Good Hope, which would add 15 days to the transportation time and modestly lengthen the supply chain.
Energy supply disruptions. In the oil market, the main risk is that of political instability spreading to Middle Eastern oil producers, such as Saudi Arabia. Egypt’s consumption and production are roughly balanced, creating little impact on oil supplies from the instability there. However, given the high level of affluence in the Gulf region, we see the probability of political contagion as relatively low. Instead, the focus should be on financial contagion, which is already happening in the CDS and equity markets, driving up funding costs and discouraging future investment in oil and gas in the region.
Hoarding of agriculture products. In the agricultural markets, the main risk is that, in an effort to contain political instability, regional governments will rapidly begin hoarding agricultural products in order to attempt to appease their civilian populations. It is important to remember that the protests in Tunisia began over high food prices, and with agricultural markets expected to remain tight, the acute political pressures generated by rising food prices will likely continue to pose political risks to the region. So far, hoarding of the two key food crops, wheat and rice, has only amounted to 2-3 million tonnes and would need to grow significantly more before we would be concerned.
Ironically, while the impact on the crude oil market will likely be determined by whether or not the political contagion can be contained, the impact on the agricultural markets will likely be determined by the extent of the efforts to contain the political contagion, with greater efforts likely leading to higher agricultural prices. Of course, the extent and type of effort made will likely also have an impact on crude oil prices. Already, borrowing costs to oil producing countries in the region have jumped sharply, raising the cost of oil production. Further, if these countries feel compelled to increase spending in the face of greater political pressure, it could in the near term lead to increased crude oil production in order to raise additional revenues, and in the medium term lead to a rise in the oil price required to balance budgets in these countries.
Net, we see the current political crisis as raising near-term risk to agricultural prices for the key food crops, wheat and rice. However, the wheat market remains amply supplied and in our view this stockpiling will not shift the overall global wheat balance. For oil, should the political crisis spread beyond Egypt to the oil producing countries of the Middle East, it would certainly send prices sharply higher. However, we see this risk as low at this stage, and current fundamentals suggest that the oil market is vulnerable to a near-term price correction should concerns over the potential for political contagion ease.
Not only have Brent crude oil prices moved above our near-term targets, there has also been some evidence that OPEC countries have already begun to bring spare capacity back to the market (see January 24, 2011, Energy Weekly), which further raises the near-term risk of a correction, particularly should production increase further in an effort to generate more revenue to help quell potential political unrest. Supporting this view was Friday's price action, when the call skew for oil increased sharply. However, the fact that the market still favors the put skew after the move underscores how ample levels of inventory may still insulate the world market from these events.
However, the impact of the current financial contagion on funding costs, combined with a potential rise in the breakeven price to balance regional budgets, will likely provide longerterm support to oil prices. Accordingly, any near-term correction would likely be temporary as we maintain our end-of-year oil price target of $105/bbl.
Although the current situation remains highly uncertain and the risks to physical disruptions relatively low, we see three key risks that need to be monitored: political contagion, potential energy supply disruptions and precautionary inventory building of agriculture products driven by increased political concerns, which could kick off broader and more widespread hoarding if security of supply issues become more concerning.
To be sure, Goldman is certain that what happens in a poor Egypt will never happen in a very rich Saudi Arabia. Because rich people never revolt against the status quo: after all just look at America... We'll remind them of this assumption when it collapses in tatters.
We see the risk of political contagion spreading to the GCC as relatively low
The risk of further turbulence and contagion within the broader region could be significant, particularly in its poorer and politically less stable parts. However, similar disturbances in the more affluent Gulf Cooperation Council (GCC) economies, which have relatively stable and popular governments, seem unlikely. The main problem in GCC could potentially be the sectarian fault lines dividing the ruling Sunni majority and the Shiite contingent, particularly in Bahrain and certain parts of Saudi Arabia. However, in our view, this is unlikely to play a significant destabilizing role, particularly at a time when oil prices remain elevated.
The main reason for this is that the avenue for political unrest to spread is likely through the young, urban poor who identify themselves with the demands and the concerns of the protestors in the neighboring countries, and have been suffering from poverty, unemployment and a rising cost of living, especially in the context of rising food prices. As a result, the more affluent GCC countries are much less likely to have problems than the less affluent North African countries (see Exhibits 1).
What happens in Egypt will be extremely important for the rest of the region. Egypt has historically served as the vanguard of Arab nationalism and its charismatic and powerful political leaders (from Nasr to Sadat and finally President Mubarak) have assumed key leadership positions within the Arab World over the past 50 years. Egypt has also been a close ally of Western powers and played an important balancing role in Arab-Israeli relations since late the 1970s.
An update on the Suez and SUMED situation:
The risk of supply disruptions remains limited with future investment being the main risk
The current disruptions in energy supplies are extremely small, which underscores that the real risks are that the political problems spread to one of the large energy producers in the GCC or Algeria and Libya in North Africa. However, it is important to emphasize that even if the problems spread to one of these countries it is not necessarily the case that energy supplies would be disrupted, as history has shown that energy can still flow even under very adverse political conditions. This suggests that ultimately the real risk that current events disrupt supplies is either by discouraging future investment and/or substantially raising the cost of investment, like what is already happening with the sharp rise in regional funding costs. This risk was captured in the equity market on Friday (January 28) as oil companies with exposure to the MENA region sold off while producers without exposure to the region traded up.
The current situation in Egypt underscores how energy can continue to flow even under very adverse political conditions. Even though Egypt does not produce or export a large amount of oil as some of its neighbors do, it is home to the Suez Canal and the SUMED pipeline which between them have nearly 4.5 million b/d of global transportation capacity (see Exhibit 3).
Interestingly, much of this capacity is not currently being used as this is the avenue where much of the OPEC production cuts to Europe have occurred, leaving only about 1.0 million b/d of oil going through the Suez Canal and 1.1 million b/d of oil flowing through the SUMED pipeline in 2009. As of the morning of Sunday, January 30, 2011 however, most of the reports show that 38 vessels versus 47 vessels on Saturday are still going through the canal.
For the relatively small number of vessels that are not going through the canal, they are likely being redirected around the Cape of Good Hope, which adds an additional 6,000 miles to the journey, or 15 days. Although insurance companies may charge higher rates now to go through the canal, this must be weighed against the risk of Somali pirates and the extra cost in transportation. So even with very adverse political conditions in Egypt, the vast majority of energy is still flowing as normal.
Although larger energy producing regions do remain at risk (see Exhibit 4), history suggests that even if political unrest spreads to a region, disruptions are likely to be minimal. For example, even during the most recent war in Iraq, oil supplies were only disrupted for three weeks. In fact, the only two times in recent history when oil supplies were significantly disrupted due to political unrest was in Iran in 1978 and Venezuela in 2002, when the unrest impacted the workers in the oil fields who simply left their positions and/or the country, which required finding and training new workers.
And much more typical sell side behind the curve stuff.
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