Oil After US Hegemony

Via BofAML's Global Commodity Research team,

Oil after US hegemony

Volatility of global oil output has fallen to historic lows...

We recently discussed how a confluence of factors had pushed oil price volatility down in recent years (see “OPEC discord and oil stability”). Macro drivers such as massive monetary easing have helped, but a collapse in global oil production fluctuations to historic lows has been perhaps the key micro dampener of oil price volatility (Chart 2). The elimination of individual OPEC country quotas has led to increased operating flexibility for Saudi, Kuwait, and UEA. This shift has resulted in higher output swings at an individual OPEC country level, but lower vol for the cartel as a whole (Chart 3). In our view, the three swing suppliers have enough operational and financial bandwidth to keep going, and we have previously stated that Brent prices will not fall for long below $100/bbl unless Saudi wants them to.

...even though individual country disruptions skyrocketed

What are the limits of this operating bandwidth should geopolitics worsen? With Saudi theoretical spare capacity at 2.4 million b/d, the scope to accommodate the next major geopolitical event may be limited. In fact, supply disruptions are already at a very high point, as noted in our analysis of OPEC production volatility. Libya and Iran combined add up to 2.2 million b/d of oil supply lost, but many other countries have also failed to increased supply as expected (Chart 4). When looking at supply disruptions historically, we find that we are currently at the highest level since March and before that since the Gulf War of the early 90s (Chart 4). If we dig further and break down this data into violence and nonviolence related oil supply disruptions, we can clearly see how armed conflict has become a major driver of global oil output swings (Chart 5).

Geopolitical energy risk has risen a lot in recent years

From Arab Spring-related uprisings in Libya or Egypt, to a civil war in Syria and now violence in Iraq and the Ukraine, geopolitical tensions have been on the rise across many key energy production and transit countries (Chart 6). This increase in violent conflict has religious, ethnic, cultural, political, or economic roots, among others. Even climate change and the fight for increasingly scarce resources may be leading to more wars and conflict, according to a recent Pentagon report. And looking back in history, wars and conflict such as the Iranian revolution or the Iraqi invasion of Kuwait are easy to spot on a simple oil price series (Chart 7). But not every conflict around the world impacts oil markets in the same way.

...as evidenced by the link between conflict and output

Increased geopolitical risk, measured by combat deaths around the world, does not even correlate particularly well with oil market volatility or even oil price fluctuations (Chart 8). This is partly because not every country has the same importance for the oil market. If we adjust conflict deaths in key areas, the historical relationship between oil production and armed conflict strengthens significantly (Chart 9). After all, as many historical episodes suggest, oil development and distribution systems are hard to keep running when countries are immersed in civil wars or wars with neighboring countries. The recent trend in armed conflict deaths in the Middle East, North Africa, and Eastern Europe is therefore very worrisome, particularly in the light of the limited appetite the Obama Administration has shown to keep American boots on the ground.

US military spending still high, but risk appetite is low

The world remains mostly unipolar from a hard power standpoint (Chart 10) and the US still takes up about 38% of global military spending as of 2013. American defense capabilities cannot be matched by any other nation and no conventional army would risk direct confrontation. But, the American public has shown very limited appetite for foreign military adventures in recent polls. The withdrawal of US ground troops in Iraq and soon Afghanistan, the limited involvement in Libya, and the lack of action in Syria and the Ukraine points to a much more cautious stance on military intervention abroad. Even the recent announced operation to help contain Islamist insurgents in Iraq will not involve US ground troops. Yet, this military retrenchment may not be helping curb global violence. Quite the contrary, a continued decline in US combat deaths in recent years has been mirrored by a rise in combat deaths elsewhere (Chart 11).

American energy independence may bring isolationism...

Perhaps it has become harder to use hard power in the era of Facebook and WikiLeaks. Perhaps the American public or the Obama Administration has lost interest in exercising it. Or perhaps US energy independence has brought American Isolationism back to the fore. Following long and arduous wars in Iraq and Afghanistan, public opinion has firmly moved against military action that puts American lives at risk in recent years. Over the decades, different US Administrations have kept different positions on international conflict. Yet many military decisions in US history have been heavily influenced by the most recent prior experience as well as by the state of the economy at the time.

...as the economic case for military conflict has weakened

The American experience in World War I, for instance, resulted in a meaningful reversal of the Wilson doctrine of intervention. Thereafter, the Great Depression of the 1930s, coupled with memories of war casualties, further bolstered the case for isolationism and prompted Congress to initially even reject US participation in the League of Nations. Back then Congress even passed several Neutrality Acts in the run up to World War II, just as geopolitics turned increasingly virulent in both Europe and Asia. Recent US military adventures may have had a similar effect on public opinion. Plus the economic case to spend US tax revenues in military conflicts abroad has weakened after the deepest recession since the 1930s, a sharp decline in US crude oil and refined products net imports from countries outside North America (Chart 13), and a stagnating share of trade in US GDP (Chart 12).

...opening the door to turmoil in oil producing countries...

Against this growing reluctance to intervene, it is important to reiterate that the US still plays a key role in securing global trade and energy supplies for the global community. American military bases around the world are strategically located in nearly 30 countries or territories across six continents, compared to more limited and regional French military deployments in 15 countries, UK military in 10, or Russia also in 10. China, the world’s largest consumer of most commodities, is the only Permanent Member of the UN Security Council without significant military presence abroad. Yet, while there are no official plans to dismantle American presence abroad, the US military budget has been put on a diet (Chart 14). Key allies France and the UK have also seen their military spending decline on the back of deep austerity programs (Chart 15) and ageing populations.

...as regional powers try to fill the void left by the hegemon

Worryingly, as the hegemon retrenches, it has become apparent that other regional and local powers will come to fill the void. Russia’s attempt to increase its influence in Eastern Europe or ISIS’ run on Syria and Iraq are some of the most recent examples. Given the relatively strong link between war casualties in energy producing countries and oil output (Chart 16), we believe oil markets should prepare for more turmoil after US hegemony.

For now, Saudi and the other key swing suppliers within OPEC have the ability to respond to unexpected supply disruptions amounting to about 2 million b/d. But conflict deaths have quadrupled in the last 10 years and the trend is not particularly encouraging.

Following a structural decline in price fluctuations to multi-decade lows, implied volatility in long dated crude oil options at 15% is starting to look cheap (Chart 17).

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As they conclude:

US reluctance to use hard power could exacerbate this trend Perhaps it is hard to deploy hard power in the era of Facebook and WikiLeaks. Or maybe US energy independence has brought back American Isolationism. Surely the economic case for war has weakened. Military spending is being cut back. Yet the US plays a key role to secure trade and energy supply for the world. Inevitably, as the superpower retrenches, other regional and local powers will come to fill the void. Russia’s attempt to exert influence on Eastern Europe or ISIS run on Syria and Iraq are recent examples. Following a drop to multi-decade lows, implied vol in long dated oil options at 15% looks cheap. Oil after US hegemony may not be as steady.