Oil in the war zone

Just when we thought inflation was contained, along comes massive Chinese stimulus and the potential for a Middle Eastern war.

If iron ore was in the spotlight the last week or two, oil is centre stage now. The international benchmark is pushing US$80 a barrel and up 10% in recent trade.

We’ve been here before this year. Back in April the price looked like it might even threaten US$100. No dice. The demand pull just couldn’t sustain the rally.

That was then. This is now. The big question: do you go long oil?

It’s tempting. For example, coal stocks went on a monster rally in 2022 after Russia invaded Ukraine and cut the usual flow of energy trade. Coal prices skyrocketed and stayed high for some time.

Today, you need to ask yourself the following...

It’s this: how good is your war and geopolitical forecasting?

Why’s that? Because about the only thing driving the recent price rally is the Middle East conflict threatening to hit supplies directly.

If we go a little deeper into this line of thinking, we’re really talking about Iran’s approximately 3 million barrels of oil production.

However, here’s something you may not know. Iranian oil flows to China, mostly. That means the loss of Iranian oil would be China’s problem.

That’s not me being blasé. But it’s a known fact, at least last time I checked, that China has an enormous strategic reserve of oil. One recent estimate cited in Reuters put China’s back up at 290 million barrels.  

That mean China could cover the loss of Iranian oil comfortably from this alone for quite some time, presuming the stored oil can get to market reasonably quickly.

Even then, the market also knows that the US Strategic Petroleum Reserve is in play too. Biden used it in the last big oil disruption.

These observations about the strategic reserves are very important. Big oil spikes in past decades came from the urge of industry participants to hoard oil. The willingness of governments today to use strategic reserves modifies this risk.

Plus we have the spare capacity that OPEC can bring online in short order.

In other words, there’s very little reason to think oil is going to go into a massive spike toward US$150 again, unless we’re talking an extreme escalation in terms of the Middle East conflict.

We also need to make a distinction between the physical market for oil and the futures market.

Refiners ultimately drive the physical market for oil because they process crude into products. Refining margins look anaemic currently.

One research note I saw says there’s no evidence refiners are rushing into the market to buy and hoard oil. If there were, the spot price would trade at a higher premium to oil delivered in 3 or 6 months time.

That’s not the case right now. By way of contrast, in 1990, after the Iraq invasion of Kuwait, that premium reach as high as 20%.

I’m not saying there are no short term trades here. But they might be shorter than you think. I can speak from experience. Back in April I went long Karoon Energy [ASX: KAR] as it looked prime to jump higher as it followed the oil price up.

Except the oil price didn’t keep going. The market dynamic shifted quickly. I had to cut off the trade for a quick, sharp loss. 

It begs the question: Why didn’t oil keep rallying earlier in the year?

Because the move in the oil price at the time was based off speculation in the futures market. The real economic demand wasn’t there.

As soon as the speculation went away, the price reversed and stayed in a downtrend until now.

I can live with a dud trade from time to time. It’s also handily instructive for right now.

If you’re longing oil here, you’re speculating on trader positioning around an oil spike. Don’t fool yourself into thinking you’re doing anything else.

That’s perfectly fine to do, by the way. Just keep in mind my experience earlier in the year.

If the Middle East conflict doesn’t stay elevated, the oil price could reverse, and quickly. Speculators and traders could dump their positions just as fast as they’ve gobbled them up in the last week.

There are no certainties in the market, only probabilities. I expect this oil rally to be short lived…and here comes the key caveat…absent a large escalation of the current conflict.

Best wishes,

Callum Newman

Editor, Fat Tail Investment Research