“The Smouldering Political Risks are not Fully Priced into the Oil Price”

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In an exclusive interview related to his new report on crude oil, „Force Majeure – Middle East,“ commodities analyst Ronald Stoeferle from the Erste Group in Vienna, Austria talks about the highlights of the report that was published yesterday. He says: “In our opinion the large scale geopolitical fire and its effects are clearly underestimated.”

By Lars Schall

Ronald Stoeferle, who is a Chartered Market Technician (CMT) and a Certified Financial Technician (CFTe), was born October 27, 1980 in Vienna. During his studies in business administration and finance at the Vienna University of Economics and the University of Illinois at Urbana-Champaign, he worked for Raiffeisen Zentralbank (RZB) in the field of Fixed Income / Credit Investments. After graduating, Stoeferle joined Vienna based Erste Group Bank (http://www.erstegroup.com), covering International Equities, especially Asia. In  2006 he began writing reports on gold. His four benchmark reports on gold such as „A Shiny Outlook“ and „In Gold We Trust“ drew international coverage on CNBC, Bloomberg, the Wall Street Journal and the Financial Times. Since 2009 he also writes reports on crude oil. The latest oil report by Stoeferle, titled „Force Majeure – Middle East,“ was published yesterday.  The press release and the report can be found respectively downloaded under this link:

http://www.erstegroup.com/en/Press/Press-Releases/Archive/2011/10032011

Highlights of the report are:

– Political tsunami not to be stopped soon.
– Commodity rally largely liquidity-driven.
– Will the rising oil price trigger the next recession?
– Shale Gas on the Rise.
– Peak oil already reached?
– Development from the point of view of the Austrian School of Economics: moderate upward potential in the short run, trend reversal afterwards.
– A Chinese „Black Swan“?
– Forecast 2011: continued upward trend to USD 150, Trend reversal expected for the second half.
– Average Brent price 2011: USD 124/barrel.

Mr. Stöferle, in your new oil report you assume that the geopolitical tensions, that prevail at present in the Middle East, are too little incorporated in the current oil price. Why?

Well first of all, Lars, many thanks for inviting and interviewing me, it’s a pleasure! Yes, my new oil report is called “Force Majeure” which is the common clause in contracts for war, strike, riots, earthquakes and so on.

I generally believe that the smouldering political risks are not fully priced into the oil price. The Iran conflict is growing more acute on a daily basis, as is the situation in Libya, Iraq, Iran and the Middle East in general. Although the political status quo in Saudi Arabia, Oman, Bahrain, and the UAE is more stable than in Egypt, we still believe that a domino effect is possible. The latent social tensions due to high unemployment, political repression, the drastic increase in food prices, and growing gaps in income should not be underestimated. The rallying oil price only adds to the dissatisfaction and at the same time fuels inflation. The same is true for many other nations (e.g. China and India), which have also seen their first protests.

You also assume that the conflagration in the Middle East will expand. Even to Saudi Arabia? And if so, what are the consequences for oil production?

It is difficult to predict the dynamics of such developments, but we do not expect the unrest to subside as quickly as it has come up. This is why we can imagine the “wind of change” to blow through Saudi Arabia as well. King Abdullah is very sick, and his crown prince is unpopular. Therefore a changing of the guards would come as a welcome reason to take to the streets. The unemployment rate of the 20 to 24 year old is 42%. The social dynamite that such a desperate situation contains is enormous. There’s this wonderful saying “The deeper you push a ball under water, the higher it jumps once it has slipped out of your hands.”

The most recent “social action” worth almost USD 40bn should calm the situation only temporarily; it will not solve the structural problems. Should production in Libya and Algeria be disrupted for a longer time, this would practically exhaust the spare capacity of Saudi Arabia. On top of that Libyan oil contains less sulphur and is lighter than Saudi oil and is thus not that easily replaced. Therefore it’s clear for me that oil will be traded with a substantially higher political premium in the future. In our opinion the large scale geopolitical fire and its effects are clearly underestimated.

Do you look at the the promise of the Saudis with skepticism, that they can increase their oil production, currently about 9 million barrels per day, to compensate for any loss of production elsewhere?

Good point! I do not believe that Saudi Arabia is able to step up production by a massive degree without any problems. The country has never produced more than 11mn barrels/day, which is why we think it is unlikely to expect it to expand production to 12mn barrels/day within a short period of time. In the recent past the country has fallen short of practically all production targets, so the problem seems to be of a structural nature.

What are your thoughts on Iran and Iraq?

The latently smouldering Iran crisis seems to be gradually deteriorating. The recent manoeuvre of two Iranian ships has added fuel to the situation. On top of that the status quo in Iran is extremely tense – and should only get tenser – due to the cancelled subsidies for petrol and gas (i.e. the resulting price hike). Last December Iran cancelled the governmental subsidies (a total of USD 70bn, i.e. almost a third of the public budget) for fuel and food, and the petrol rationings were cut by 10%. The consequences for the population were dire. Petrol prices more than quadrupled. Food prices have so far doubled, and inflation should soar to almost 70%. In the first days after the taking-effect of these measures, fuel demand dropped by almost 15%, and power consumption decreased by 6%. The reason for the measures seems bizarre: “Oil and gas belongs to the twelfth Imam”, i.e. the Shiite messiah.

The nuclear programme constitutes another central point of contention. Teheran has continued to enrich its uranium, and the IAEA now believes that Iran has the material for two nuclear bombs at its disposal. The additional sanctions imposed by the other countries are not exactly helping to de-escalate the situation, and diplomacy is at a dead end. Not willing to accept nuclear arms, Israel destroyed an Iraqi nuclear reactor already back in 1981, and it did the same thing to a Syrian reactor in 2007. Possible scenarios of a military strike on Iran can be accessed on the homepage of the Saban Center for Middle East Policy.

The impact on the important transport route in the Strait of Hormuz can hardly be imagined and quantified. Some 17mn barrels/day pass through this bottleneck, i.e. 33% of the entire volume of oil that is transported by sea. The Strait of Malacca is a similar chokepoint of global trade. About 15mn barrels are daily transported through this strait that links the Indian with the Pacific Ocean. In case of a supply blockage on one of the two routes the oil price would definitely set new all-time-highs, which would presumably be located on the other side of USD 200/barrel. Therefore we can see an upside risk for the oil price and increase the political premium.

The crucial question with regard to oil: What’s your relation to Peak Oil? And has Peak Oil in your opinion already occurred in conventional oil?

I think that “Peak Oil” is rather reality, than scaremongering. As already pointed out in the previous two special reports, we think that the maximum global production of conventional oil could soon be reached. The production profile of specific fields, regions, and countries has the same structure, i.e. that of a bell-shaped curve. According to Robert Hirsch 64 countries have already reached their maximum production levels. Nevertheless peak oil seems to remain a contrarian topic. According to a Credit Suisse poll, only 5% of investors currently regard peak oil as a threat. The remaining 95% expect peak oil in 20 years or not at all.

More and more official institutions are dealing with this issue, which underlines the fact that Peak Oil is not just a chimaera of doomsday prophets, scaremongers, and congenital pessimists, but rather imminent reality. For example, the British Department of Energy and Climate Change is collaborating with the Ministry of Defence and the Bank of England on a study about the consequences of Peak Oil. The US Department of Defense also published a study, which called for the US military to be made independent of oil by the year 2030. The growing influence of oil nations such as Iran and Venezuela and the resulting dependence are regarded as a threat. The only countries with a reserve/production ratio of more than 75 years are currently Iraq, Iran, Saudi Arabia, Venezuela, Kuwait, and the United Arab Emirates. The rising demand for oil in China is also regarded as detrimental to the interests of the USA.

The study “Peak Oil – Sicherheitspolitische Implikationen knapper Ressourcen” (Peak Oil – implications of scarce resources on the safety policy) by the German Department for Future Analysis, a think tank of the German Bundeswehr, is particularly interesting and delicate. The study, which is well worth a read, describes how as a result of the declining oil production a tipping point could be reached, from which point onwards the economic system would tip over and the following consequences are possible:

– The Western industrialised powers lose their influence
– Dramatic shifts of political and economic balances of power
– Massive reduction of mobility
– Further erosion of trust in governmental institutions and politics
– Negative impact on democracy, since a systemic crisis would create “space for ideological and  extremist alternatives to existing forms of government”
– Possible partial or full failure of the markets, which could result in a regression to barter trade
– Shortages in the supply of essentially important goods, such as food, and famine as a result
– Price shocks in practically all areas of the industry and in almost all stages of the value chain
– Banks would lose their basis of business, since companies with low creditworthiness would not survive
– Loss of confidence in currencies, as a result hyperinflation, and return to barter trade on local level
– Mass unemployment and state bankruptcies

This is really serious stuff and to me it seems that official institutions are finally realizing that Peak Oil is a huge threat. I think this wonderful saying by Jean Monnet describes the mindset best: „People only accept change when they are faced with necessity, and only recognize necessity when a crisis is upon them”

What are the consequences of these developments for the future growth potential of the real economy, which depends on cheap energy resources?

An increase in the oil price tends to affect the economy with a time lag of several months. According to a rule of thumb, an increase in the oil price of 10% causes the GDP to fall by about 25bps. Since the announcement of QE2, the petrol price has risen by 22%. Petrol has increased above the important mark of USD 3 per gallon for the first time since October 2008 again in the USA. The high price feels like an additional tax to the US consumers. An increase in the price of 10 cents per gallon translates into a burden of USD 14bn per year for the US households. This means that an increase to USD 4 per gallon would put a burden of almost USD 70bn on US consumption. Many indicators – among them the relatively obvious weakness of the retail index in comparison with the S&P 500 index as well as the still extremely negative ABC consumer confidence – suggest that “Joe on the street” can already feel the consequences of the price rise.

Is a much higher oilprice poison for China? Why are you stating in the report: „China can and will not be the single driving force of worldwide recovery, the sheet anchor and messiah of the global economy“?

I am bearish on China for quite a while now. I think that the extrapolation of historical growth rates is always dangerous, as a look through history books shows. Sometimes this boundless optimism reminds us of Japan at the end of the 1980s. 20 years ago the Japanese GDP accounted for 18% of global GDP – today the share has fallen to 8%. The daily news reports about billions worth of takeovers and investments by the Chinese underpin this picture. An interesting detail: Hong Kong has passed Tokyo as most expensive office location.

I do no expect the Chinese economy to collapse, but a profound market consolidation seems overdue. To an economy that has been growing at double-digit rates for years, a GDP growth rate of only 5% feels like a severe recession. The sooner China allows the necessary cuts to be made, the less deep they will go. However, the Chinese government is confronted with a difficult task. Due to the extremely high capital intensity of the Chinese economy (gross fixed capital formation > 40% of GDP) future growth will hinge on a higher propensity to consume of the Chinese population. But in order to boost China’s domestic consumption real wages would have to rise first. And currently it is precisely the low wages that represent China’s most important competitive advantage, which have facilitated the high growth rates in the past decade. It is therefore clear to see that the Chinese leaders are caught between a rock and a hard place. History has often shown that what had been planned as “soft landing” ended up as abrupt crash. Following the teachings of Ludwig von Mises, a laissez-faire policy would be the only right answer to the recession. The massive interventions in the market delay the cleansing of the market and only make the following consolidation worse.

We are therefore sceptical about the – meanwhile generally accepted – belief in the Chinese economic miracle. However, the overcapacities – considerable as they were even before – have further increased. The public share in the overall economic output has been gradually growing, with public infrastructure projects responsible for the majority of growth. Dubai seems to have granted the world a sneak preview into a classic boom-and-bust cycle, although the Chinese dimensions are disproportionately bigger. Since China is a centrally planned economy, it may remain on the growth path for longer. But in the long term, China, too, will not escape the basic principles of economics.

Does the oil price perspective has any impact on the gold price?

Oil and gold have a strong positive correlation with each other. Both commodities are traded in US dollars and tend to increase when the dollar depreciates against the most important currencies. Also, oil is one of the most important indicators for inflation and thus also for the gold market. On top of that, the argument that oil production is about to see its peak (“peak oil”) can also be applied to gold along similar lines. The constant purchasing power of gold can also be measured in terms of this ratio. For example, one ounce of gold today buys the same amount of oil as in 1945, 1982, and 2000.

Crude oil showed in 2008 that it was normal for a commodity to set new all-time highs on an inflation-adjusted basis during a bull market. The oil price exceeded the inflation-adjusted high at the end of the cycle in its parabolic phase by more than 50%. By analogy, gold would have to rise to an inflation-adjusted USD 3,450.

What are your expectations related to the precious metals market in general?

As you know I’m since my first gold report in 2006 very bullish on Gold. The risk/return profile of gold investments remains excellent. I still believe that we’ll hit a target price of at least USD 2,300. That may sound extremely optimistic or illusory. But who would have thought at the beginning of the 1990s, when the S&P 500 index was at 300 points that it would increase to 1,500 within a decade? Who, at the beginning of 2002 and at an oil price of USD 20/barrel, would have thought that the oil price would rise to USD 150/barrel? That is the essence of a bull market. Every trend ends in euphoria and excess.

Unfortunately many market participants find it apparently difficult to distinguish between a bull market and a bubble. A few historical examples show that gold is definitely no bubble. At the moment, the US gold reserves account for close to 1.85% of the US GDP. In 1940 the value was 20%, by 1980 it had fallen to slightly below 7%. Comparing gold with the historical money supply, we find that the current price level seems attractive as well. In 1980, 45% of the money supply (M1) was covered by gold, today close to 5%. This means that it would have to increase by a factor of 8.5. If one were to cover the MZM supply, the gold price would have to increase to about USD 10,000. If the central bank wanted to cover the money supply M2 with gold, the gold price would have to increase to almost USD 30,000/ounce.

Thank you very much for taking your time, Mr. Stoeferle!

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