Why Oil Prices Are Rising

Wednesday, 31 October 2007 22:12 |

Why Oil Prices Are Rising

Oil Traders Anticipating New War

(A-O Newswire - by R.A. Coombes) -- The oil market is signalling at tentative belief or serious fear that the another Mideast war is on the horizon. In case you hadn't noticed, oil reached an interday high on Wednesday of $94.53 or just shy of $95.00. In overnight trading, oil prices surged still further reaching $96.24. The latest surge in overnight trading was attribued to a drop in U.S. crude oil inventories, but that development is not the underlying reason for oil price hikes.

World economists are expressing shock and disbelief that oil prices would rise to this level, citing standard mathematical models with supply demand indicating that oil should be priced right now in the range of $50.00 In other words, according to standard economics of ordinary supply and demand, oil should be trading at about half of its current level.

So why is oil nearly double what it should be?

If you ask most trading technicians, they'll cite statistical price movements and mathematical price momentum models in which prices run solely on numbers or technical factors. A technician only looks at mathematical equations of volume and open interest statistics, along with bar charts and forumulas devoid of economics or politics. Oil traders who trade on fundemental issues such as events, and human reasoning will have various explanations. Some will point to supply demand factors and or economics, but the actual theoretical economists of the world can dispute that. Other traders though, are citing the geo-political issues and development in the most important oil-producing region of the world, namely the Middle East.

One thing that should be noted however, is that oil prices are based on the value of the dollar, but as the value of the dollar declines versus other monetary currencies, the price for oil in terms of dollars must also rise. So a falling value of the dollar plays some role in the latest price increases for oil. But the valuation of the dollar is only part of the reason for skyrocketing oil prices.

More specifically, more and more traders who deal in the 'fundamentals' of the oil market are citing worries and concerns that another war in the Middle East might transpire between the United States and Iran. Their reasoning is that in the event of a war, Iran might be able to interrupt the flow of oil from the Middle East to world markets, particularly the United States.

Oil traders are acutely aware that the key oil tanker route for nearly 25% of the world's oil supplies flow through the Persian Gulf's - Straits of Hormuz which has a very narrow shipping channel which functions much like a 2-lane highway. Should the Iranians sink one or maybe two oil super-tankers in that narrow shipping channel, no oil would or could flow out for perhaps months, even if a shooting war only lasted for a few hours or days.

The loss of that much of the world's oil supplies would immediately create severe shortages for many nations of the world, including the United States, Europe and the thirsty nations of Japan, China and India. Various pundits and "experts" in the past couple of years have predicted that a US attack on Iran could result in oil prices skyrocketing to as much as $200 to $250 per barrel. With oil now at $95+ for a barrel of oil we are seeing the market reflecting those war fears.

So What is the Oil Market Telling Us?

What the oil market is telling us, is that the market, the oil industry is preparing for the price shock of a war. The industry is becoming convinced, slowly, that military conflict in the Middle East is becoming more and more of a distinct possibility and if war is a distinct possibility, then more than likely there will be some sort of interruptions in the flow of oil supplies.

Now it is important to keep in mind that the oil market is not like the stock or bond markets. Oil prices trade on the basis of future production, delivery and consumption. How so? Oil trades as a commodity, meaning that you buy or sell oil for delivery to transpire in a given month into the future.
For that reason, oil is termed a "futures" commodity. Oil trading carries forward contracts for delivery to as far out as theDecember contract of the year 2015, or inother words 8 years out from now.

Because commodities trading goes that far out into the future, traders look at what future events might develop that could affect supply and demand, including the possibilities of war when such possibilities appear to exist.

Under the present circumstances, traders are paying close attention to news developments related to geo-political developments in the Middle East that might affect the supply and flow of oil to world markets such as military actions, and in this case, how military action might affect the flow of oil out of the Persian Gulf.

Traders understand that the supply of oil is most vulnerable at the Straits of Hormuz, but there is also concern that Iran might bomb key oil production and or transport facilities located throughout the Persian Gulf region, particularly in Iraq, Kuwait, and Saudi Arabia, Qatar, Bahrain, and the United Arab Emirates, not to mention Iran's own oil supplies. WIth 20% to 25% of the world's oil coming from those nations, a sudden stoppage of one fourth of the world's supplies would be an ecnomic catastrophe. The fact that oil is sold on what amounts to an "auction" basis every weekday means that in a crisis, the auction pricing would experience "panic" buying where buyers seek to buy oil at "any" price.

In the event of an actual war, Iran's oil supplies would most likely be lost to world markets for at least a short period of time. Even a short interruption of Iran's oil supplies would create an instant shortage on world markets because Iran is the world's 4th largest oil producer, producing about 5% of the world's oil production supply according to the CIA. (LINK). Iran is the second largest oil producer in OPEC, after Saudi Arabia.

For that reason, perhaps you can realize why the talk of $200 to $250 per barrel might become a reality. We're already double the price from "normal" and the reality is that this price abnormality is based to some extent already on fears by oil traders who are putting their money where their fears are.

Does this mean that oil traders are expecting a war? The answer, in a way, is both a yes and a no, but the better answer is that the traders are "hedging their bets" on the possibility in ever greater numbers. Traders are being quoted by the news media as indicating reasons for recent price rises are linked to fears and concerns about the potential for war in the Middle East.

In other words, oil traders are becoming increasingly convinced that the possiblity for war-disruptions of oil is a very real threat. It is not something that oil traders simply jump to conclusions. It is not merely based upon rhetorical headlines.

A Short Primer on Oil Trading

Aside from some private speculators, the trading of oil is primarily done by the oil industry itself Oil industry traders seek to reduce risk of price fluctuations by trading contracts for future deliveries to help keep prices stabilized and avoid the possibility of greater losses from unforeseen circumstances. Oil prices, like any commodity traded on an auction basis, constantly fluctuates then on a variety of factors. An oil company is constantly re-assessing its production positions and selling or buying other contracts to keep up or keep down with the price fluctuations.

As a trades sees the risk that their oil contract for a June 2008 delivery date might not be available due to war action, the trader might take out a similar contract for an earlier date to buy oil so he can later meet his obligation to supply someone else with the oil that he agreed to deliver in June. He might then decide that if war is going to break out in January of 2008, he might want to buy oil for delivery in December of 2007, or even buy it for delivery in November of 2008. He knows, that he's obligated to supply oil for delivery in June of 2008 so if he's concerned that his oil, sitting in Saudi Arabia might not make it out of the Gulf in time to meet the contractual requirement, he is in deep legal and financial trouble that could bankrupt him or his company, particularly if there are thousands of such contracts that are in trouble.

Companies with oil contracts for delivery in a month when they cannot make delivery are in serious risk of bankruptcy or perhaps even criminal, legal charges of fraud. Therefore, under such risks, they will buy another contract from someone else with the oil supply amount needed, at any price to meet that sales obligation they originally contracted for June of 2008.

Oil At $250?

It is entirely conceivable that oil prices during a military action or war with Iran could reach $200 or $250 or who knows, prices might climb far beyond even those price levels. It all depends. The other day, the head of the Council on Foreign Relations noted that should military action develop between the US and Iran he expected oil to reach $200.00 per barrel. LINK. Other notables such as tycoon, Warren Buffet predicted earlier this year that if a war broke out with Iran, oil could reach $250.00 per barrel.

For such reasons as those cited above, traders are already preparing for such possibilities of war and buying oil contracts now. This is part of the reason why oil prices are going up.

Traders are so skittish about war disrupting oil supplies, that even talk of military action between Turkey and Iraq's Kurds has the oil market jittery.Why? Here again, there are concerns that Iraq's oil flow might be interrupted, but also too are fears that a Turkish attack might lead to wider military action, perhaps between the US and Iran on a sooner or later basis.

No one is more keenly sensitive to the pressures of war than are oil tradres. Their financial survival can be at stake. For that reason oil tradres have a certain expertiese and knack for knowing which way the wind is blowing and the likelihood for or against war. More so, teh big international oil company traders are privvy to what the Persian Gulf Arabs think. They're usually privledged to smoe insider knowledge from Arabian leaders.

It is utlimately for all these cited reasons, why oil traders seem to think a war is coming to the Middle East in the near future.

Because of what we are seeing in the price of oil, we should realize that the oil industry is often times a true barometer of the pressures for war. On that basis, the oil market is telling us that the pressures for a future conflict have grown to the point that oil traders are beginning to take action to protect themselves against potentially negative ramifications.