politics, geopolitics and financial flows in a ‘low’ oil price environment

8/14/2019 Politics, Geopolitics and Financial Flows in a Low Oil Price Environment

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A more feckless oil weaponTHE L AST FIVE YE ARS SAW T HE RE B IRT H OF T HE USE OF OIL AS A

CRIT ICAL INST RUME NT of foreign policy by key resource countries Iran, Russia

and Venezuela in particular. The underlying geopolitics of the oil market is defined by the

worlds dependence on oil as an energy source, particularly but not only in the transportation

sector, and by the concentration of oil resources both assets and flowsin a handful of

countries. As energy prices were rising, these countries rapidly earned increased respect

from other governments and investors, which propelled them to rely increasingly on oil and

natural gas as instruments of foreign policy. The degree to which the Chavez example

reverberated in Latin America is one reflection of this, just as Moscows assertive attitude

has brought more heavy-handed Russian diplomacy to neighboring states, from Ukraine

through Transcaucasia to Central Asia, than at any time since the collapse of the USSR.

With oil and natural gas prices having collapsed, the power of their weapons has beenwaning rapidly, turning creditor into debtor nations and depriving them of the revenues

required to fulfill their international goals. This too is problematical internationally for this

reduction in their power has been swift and the governments involved find it difficult to

believe that the authority they earned in a period of high oil prices has withered. Two

dangers loom on the horizon, each with global consequences. First, lower revenues are

creating domestic political problems, as the populations of key energy-producing countries

have grown accustomed to much higher per capita incomes as energy prices soared.

Financial problems are likely to emerge as companies and some governments inevitably

default on their international obligations. Second, with their power weakened, other countries

may be tempted to try to weaken the resource players further, unleashing unpredictable

forces.

In thinking about how the oil instrument or weapon might evolve within this environment

during the coming years, it is useful to reexamine the context of oils use as an instrument of

foreign policy, especially if the oil market is about to undergo a sustained period of weak

demand and low prices. This context is related to the division of the world as a whole into

three broadly different sets of countries.

FIRST , THE US, CANADA , T HE COUNT RIE S OF WE ST E RN EUROPE

AND OECD AS IA have basically relinquished the use of oil as an instrument of policy intheir relationships with one another. Although aspects of their own xenophobic pasts come to

light from time to time, by and large these countries have given up impeding flows of energy

or flows of capital into energy in the relations with one another. They have dismantled the

state at least so far when it comes to energy regulations, and both the flow of goods and

the flow of capital among them is guaranteed and unimpeded. When it comes to relations

with the outside world with OPEC countries, Russia or other emerging markets their

positions are more nuanced and frequently embody the direct and unabashed use of oil as an

instrument of policy, as had been the case of US and European relations with Libya until

recently and with Iran over most of the past decade and a half.

For a second group of countries, for whom earnings from oil and gas are critical sources of

government revenues and critical factors in their economies, the sector traditionally remains

a core instrument of foreign policy. What differentiates how oil or gas may be used as a

weapon is the state of hydrocarbon markets and of oil and gas prices. In a relatively benign

With lower prices, the powerof the oil weapon is waning

rapidly

For some oil producers theoil weapon is ever present

Within the OECD oil hasbeen relinquished as an

instrument of policy


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environment, resource rich countries are as dependent on their markets as their markets are

on them, and from time to time even more so. This means that they do not have freedom totake advantage of their customers in a zero-sum manner, in which ones gain comes at

anothers loss. Rather the world is more ambiguous and at best a seller or a buyer must think

in terms of relative gains or losses both gain together but one more than the other; or both

lose together, but one more than the other. In tight markets, however, the naked,

unadulterated oil weapon comes into its own. It can take on the brutal face of Russian gas

diplomacy withholding supply to blackmail others, either for money or for political

reasons. Or it can take on the more subtle face of Iranian and Venezuelan diplomacy, where

oil revenue is critical because of the geopolitical uses to which that revenue is put.

The third group of countries includes much of the emerging market world. Among the so-

called BRICs, the darlings of emerging market investments in the middle part of this decade,

Russia clearly falls in the second category of countries, but Brazil, India and China, like most

emerging market governments, are in a position of ambiguous status. India and China are oil

importers and while state firms play a large role in the energy sector, so do market

mechanisms. Indeed in their relations with other countries, especially with the OECD

countries, Brazil, India and China have clearly opted far more for market solutions that limit

the role of energy as an instrument of policy. It is likely the case that if low oil prices persist

for several years, these emerging market countries will find that subsidizing energy

objectives will become increasingly too expensive and will move increasingly into the first

world camp. The implication is that Chinese policy will increasingly look like Indias the

state will decreasingly favor national flag companies and nationally-owned companies will

focus on their commercial objectives and shun circumstances in which governments use

them for larger non-energy foreign policy purposes. And Brazil, as a major emerging long-

term exporter will likely evolve to look far more like the UK or even Norway, with its

national champion company forced to confront competition in its home market to keep it

honest and competitive.

Figure 1. Real per capita net oil export revenue ofselected OPEC countries (2000$)

Figure 2. Nominal OPEC oil export revenues

$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

$14,000

$16,000

$18,000

$20,000

1994 1996 1998 2000 2002 2004 2006 2008

OPEC

UAE

Saudi Arabia

Venezuela

Iran

Nigeria

0

200

400

600

800

1,000

1,200

1996 1998 2000 2002 2004 2006 2008

billion usd Libya

Venezuela

Nigeria

Kuwait

Iran

UAE

Saudi Arabia

Other OPEC

Source: EIA. Source: EIA.

For the BRICs the oilweapon is a frequent

temptation


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or even rise toward $70 the government will be unable to support the array of international

activities that it has engaged in recent years. In particular, it will be strained to continue tosupport various groups throughout the Middle East in pursuit of the governments

international policies.

The flip side of the erosion of the use of oil or natural gas as an instrument of foreign policy

is the potentially wider attraction to its use by oil importing countries. From a global

perspective, the most widespread use of oil as an instrument of policy by an oil importer has

been the United States, through its perennial political attraction for sanctions against oil

producers to deprive them of revenue. Newly-elected President Obama is himself on the

record as favoring a more entrenched gasoline embargo of Iran, for example. It remains to be

seen how his Administrations attitude toward what might be perceived as renegade oil

producers will evolve. But the history of US administrations using oil sanctions, especially in

periods of low oil prices, suggests that regardless of arguments that might be made that these

sanctions are in the long run likely to be ineffective and counterproductive, the new

Administration is likely to be tempted to follow the path of its predecessors.

The taming of resource nationalismHUGO CHAVE Z CAME T O POWE R IN VE NE Z UE L A IN AN E L E CT ORAL

L ANDSL IDE at the lowest point that oil prices reached in 1998, ushering in a decade of

increased resource nationalism, with its many faces. The Venezuelan case was particularly

poignant insofar as this phenomenon is normally associated with the increased role of the

state in the management of national resources and of the energy sector as part of the

enhancement of state power. In Venezuela, rather ironically, Chavez found in the state

company PDVSA less a source of power than an impediment to government control.

Dismantling the state firm turned out to be a pre-requisite to the new resource nationalism.

Thats because in many ways the independent state firm had latched onto the logic ofglobalization and became the supporter not only of the pursuit of commercial rather than

political objectives, but in the process the main supporter of two trends that epitomized

globalization: investment abroad, especially in the main markets to which PDVSA sold crude

oil and mostly in the form of refining assets, and foreign investment at home, bringing in

additional capital to exploit marginal fields on the one hand and fields where their local firm

had lacked technical expertise.

But another aspect of the Chavez revolution resonated internationally, a fundamental change

that manifested as oil markets tightened after 2003. One of the conditions of tightening

markets is that they facilitate a process whereby governments the main holders of acreage

being made available to investors to exploit resources increase the cost of acreage

acquisition and resource exploitation as the balance of power weighs more heavily on their

side than on that of companies. In short, those with capital, technology and human capacitiesto exploit resources must cater in tight markets to those (the governments) with acreage and

seeking capital technology and management skills. Taxes go up as the market for exploration

rights tightens and the price and fiscal take associated with exploration rights also increases.

During the past five years as the world underwent an exploration boom, the costs of

exploration and production finding and development costs have increased at a

phenomenal rate, by 350% or more between 2004 and 2008. Part of the increase was in the

In todays softer marketsimporting countries mayagain find oil sanctions

attractive

Resource nationalism willhowever, be a sticky

phenomenon

Resource nationalism isbasically a reflection of

tightening marketconditions


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form of taxes or rents from exploration and production imposed by governments. One of the

most interesting features of this element of costs is that they are sticky even as competitiveconditions emerge, For example, during the past nine months, the costs of tubular steel, day

rights for shallow water rigs and vertical land rigs, the price of engineering services and an

array of other costs have fallen. The cost deflation partly reflects overcapacities that have

recently emerged, as in steel costs or in shallow water exploration, where rig availability has

increased due to recent capital expenditure programs. Yet measures of exploration and

development costs have not experienced the same 30-50% reduction seen in these core costs.

Thats because critical contracts are longer term in nature; deepwater rig day rates are set in

term contracts lasting 5 or 10 years and rig owners holding of these contracts are reluctant to

renegotiate their terms.

One of the features in the landscape of the upstream sector today is a bargaining ritual

unfolding between companies with capital to expend and contractors whose services are

required for exploration and development programs. The same ritual dance is unfolding in

the relationship between governments and their issuance of exploration licenses and firms in

their quest. Undoubtedly, in the short run all of the costs are sticky. Just as drilling

contractors are reluctant reduce rates, so too are governments reluctant to start competing

with one another to attract capital to invest in exploration and production activities.

Some analysts have argued that the government tax regimes in place are so sticky that there

is little hope that governments will change policy rapidly or any time soon to attract capital

for investment in natural resources. One major international oil consultancy has recently

concluded after conducting a rapidly put together survey that a reversal in resource

nationalism is unlikely to take place in the near term, concluding that government policy in

this area takes a long time to reverse. This conclusion might well be overly hasty. It is based

on conditions of the 1970s which are far different from those of today in critical respects.

The new turn toward resource nationalism, for example, follows a period in which it was

neither fashionable nor cost effective, as opposed to what unfolded in the 1970s when mostof the energy resources of the world were nationalized. The superficial survey also ignores

the rather rapidly responsive fiscal changes that took place in the UK, Norway and Canada,

where governments, having tightened terms for foreign investors, loosened them rapidly and

considerably when confronted with highly competitive conditions for attracting capital. It

just might be the case that the rapid collapse in oil prices over the past nine months might

also be accelerated by reversal of resource nationalism.

In some resource rich countries, the need for capital to boost production in order to boost

revenue is becoming critical. Over the past few weeks one of the governments leading the

movement to attract capital is the same one that led the resource nationalism charge in a

rising price environment, namely Caracas. Hugo Chavezs new attempt to attract capital for

the Orinoco belt this summer may well not attract the capital required because of low prices

and because of the recent history in dealing with foreign ownership and the well-knowcounter actions of Exxon especially and also of ConocoPhillips to those moves. But other

companies have remained in Venezuela and are bullish on their ability to exploit heavy oil

resources. Penetrating their bargaining postures at this stage is a bit premature. A prolonged

period of low prices brings with it the potential for significantly lower costs, both for

development and for operations.

In todays softer marketcompanies with capital to

spend are gainingbargaining clout

The sharp fall in pricesappears to be accelerating

the decline of resourcenationalism


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Venezuela is not alone in confronting the dilemma that without external capital, technology

and project management skills, its resource base might erode too rapidly. Among major oilproducing countries, Russia, Iran and Iraq are in a similar position and even Brazil might

find that spreading the risks of exploration and development with foreign capital might be

highly attractive in a lower price environment. In Russia, production in 2008 was already

lower than in 2007 and the consensus is for a slide of 5% in the production base this year.

Both Gazprom in the natural gas sector and the companies seeking to exploit resource-rich

offshore waters increasingly recognize that it cannot develop the resource potential on their

own. It seems far more likely to expect a more rapid relaxation of terms in these major

resource countries than the skeptics now expect. And if Caracas and Moscow move in this

direction, it is likely to Baghdad, Brasilia, La Paz, Quito and Tehran will not be far behind.

Saudi Arabia and surplus capacities

As in all tight markets, governments in consumer or importing countries have been obsessedby fear of supply disruptions in the oil sector during the past five years. In recent years,

similar fears have entered the West European political landscape when it comes to disruption

of natural gas supplies from Russia. Fear has also, as always, been twinned with greed

on the part of exporters, creating an interplay between the two in a dance that become quite

complex.

There is little doubt that the decline in surplus oil production capacity to virtually zero in the

middle of this decade jolted markets. The lost cushion of surplus capacity, which had once

seemed a permanent fixture of oil markets before the price collapse of 1985, surprised all

market participants, not the least of which was Saudi Arabia, whose ability to supply markets

Figure 3. OPEC crude production and spare capacity (1973-2009)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

Jan-73 Jan-77 Jan-81 Jan-85 Jan-89 Jan-93 Jan-97 Jan-01 Jan-05 Jan-09

kb/d OPEC production Spare capacity

Source: EIG, LCMC estimates

The return of surpluscapacities appears likely to

last several years cappingprices

as a mirror reflection ofhow lower capacities

accelerated the price rise


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lies at the heart of its political clout both globally and within OPEC. That Saudi Arabia and

other key OPEC countries were caught off guard by the evaporation of surplus capacityexposed the complacency about their upstream investments. Energy Intelligence Group

pegged surplus production capacity at around 12 mb/d at its peak in 1985 and was eliminated

when Iraq invaded Kuwait and the UN embargoed their oil, yet was still over 5 mb/d as

recently as mid 2002 (Fig. 3). It then virtually disappeared, not as a result of oil capacity

peaking but rather as a result of above-ground politics: the Venezuelan strike in 2002-03,

growing upheaval in Nigeria, Irans failure to put in place an acceptable regime for attracting

capital, and the US ousting of Saddam. And it was only then that resource nationalism in

Russia and elsewhere reduced the pace of non-OPEC oil production growth.

By 2003-04, Riyadh became concerned about this lost capacity. To be sure the kingdom

responded by raising production (including from the Neutral Zone), which PIW pegs at 7.5

mb/d in mid 2002, growing to 9.2 mb/d (2003), and after falling in 2004, reaching close to

11.0 mb/d in 2008. But by boosting production, Saudi Arabia ate up is spare capacity and

that cushion for the global market dwindled further. In the meantime, Saudi Arabia engaged

in an urgent and massive campaign to increase its production capacity after 2008, and there is

little doubt that campaign is succeeding despite the doubts of peak oilers. PIW estimates that

Saudi capacity rose from 9.5 mb/d in 2002 to 11.8 mb/d today and will climb another 1 mb/d

by 2010, not including rapidly growing gas liquids potential. OPECs total production

capacity appears to be heading to well above 37 mb/d by 2010, 5 mb/d above 2002 levels

(before the Venezuelan strike) and a record historical level.

In retrospect the disappearance of OPEC/Saudi spare capacity was the most critical element

in propelling prices from 2003-08, and the reemergence of that capacity should be the most

critical element for at least the next three years, longer if global demand fails to rebound to

its earlier 1.5- 1.8% annual growth level. Here is a short list of the reasons:

Saudi Arabia will likely wield surplus capacity for its own political ends keepingprices moderate to spur economic growth and curry influence internationally as well

as to withhold export earnings from countries whose use of oil revenue is deemed

inimical to the kingdoms international objectives (e.g. Iran, Venezuela and Russia).

High spare capacity also carries the threat of higher production to ensure discipline

within OPECs membership.

The very existence of surplus capacity overhanging the market will reduce

speculative flows designed to take advantage of a price spike.

To the degree that the kingdom again defines a price band within which it hopes to

maintain prices, speculative flows will be reluctant to test those limits. At the

moment, Saudi policy appears directed to maintaining a price band of $40-$75.

Tamer financial flowsIt now appears that the enormous financial flows that began entering commodities markets in

2003-04, propelling prices upward after that and downward after mid-2008, are going to play

a much more neutral and benign role going forward than they had in recent years. There are

several ways in which financial flows impacted markets over the past five years, mostly

through growing investor activity in financial instruments which provided direct exposure to

Lost capacity especially inOPEC countries, caught

governments and industry

by surprise

And incentivized Riyadh toaccelerate upstream growth

Financial outflows fromcommodities is now

pressuring price


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energy (and other commodities) prices, but also through equities and other investments that

provided indirect exposure to the underlying values of commodities.Evidence of this abounds. Open interest in futures and options on crude oil on the two major

exchanges on which the two are traded NYMEX and ICE grew phenomenally from 2004

into 2008, providing the most objective measure of these flows. As 2004 opened there were

some 628,000 futures contracts in open interest on the NYMEX, representing 628 million

barrels of oil. By September the total open interest grew to 1.54 million contracts,

representing over 1.5 billion barrels of oil and the number hovered in a range of 1.35-1.5

million contracts from then until late June/early July 2008, after which open interest entered

a period of time of steady decline well into December of last year, falling back to just over

1.1 million contracts. Adding in open interest in ICE crude oil contracts emphasizes these

trends, as combined NYMEX and ICE open interest grew from 950,000 contracts

(representing nearly 1 billion barrels of crude) in early 2004 to 2.7 million contracts (2.7

billion barrels). As deleveraging took place from mid-2008 to the end of the year about 1

billion barrels (more than one third of total open interest in crude oil) had been liquidated.

The flows into and out of oil, like those into and out of other commodities, were actually

much greater. Adding the flow into and out of options to outstanding flows into crude oil

contracts brings total exposure closer to 7 billion barrels at its peak in 2008. But more

interesting and less easy to track are flows into and out of crude oil via over the counter

contracts, which by our judgment grew from being a fraction of exchange traded crude in

2004 (perhaps some 80% of exchange-traded open interest) to a multiple of exchange-traded

crude by 2008 (probably more than 120%). And the deleveraging that has taken place during

the selloff in the commodities world and other asset classes since mid-2008) was paralleled

in OTC interest, which we estimate to again be a fraction of exchange-traded volumes.

Part of the rise and fall of exchange-traded and OTC crude oil tracks closely total investment

flows into passive investments (index funds, like the S&P/GSCI or the DJ/AIG). Theseinvestments were undertaken largely by pension funds, endowments and some sovereign

wealth funds. While the initial motivation for these investments was asset diversification,

these investments became increasingly attractive in the context of 2004-08, with tightening

markets due largely to higher demand growth in the US, China and elsewhere; surplus

capacity dwindled, further increasing financial flows and pushing prices upward, which only

attracted more investments. It is our judgment that assets under management in these passive

index funds rose phenomenally, especially from 2006 to midsummer 2008, growing from

around $75 billion to $280 billion before falling back by year end to the same level as early

2006. While some of

this outflow is

associated with reduced

asset values, a great deal

of it is the result ofmassive liquidation of

positions in passive

investments, as seen in

the figures below.

What was true of

passive investments has

Both exchange traded andoff-market open interest is

now falling

The liquidation of passiveinvestments helped lead themarket down in Q3


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also in my judgment been true of speculative flows affecting the back end of the market, or

deferred prices, as well as investments in commodity funds that, unlike index funds, are not

simply long-only but trade long-short largely on the basis of technical factors. It seems to be

the case that somewhere between 15 and 20% of capital flows into commodities came from

passive investors, while another 10-15% came from technical commodity traders. The rise

and decline of commodities prices reflects and is partially caused by the demand for paper

commodities. A regression analysis applied to these flows shows strong causality between

inflow of new capital into these funds and higher prices, as well as outflow and lower prices.

As is clear in the figure above, it now appears that the liquidations which drove marketsthrough the latter part of 2008 have now been curtailed and that investor flows are likely to

have a far less dramatic impact on prices than was the case during the period 2004-8. Indeed,

the view that prices are likely to fluctuate within a narrower band of $40-75 per barrel

reinforces the conclusion that financial flows into commodity index funds going forward for

much of the next two to three years will be benign.

A similar conclusion relates to speculative flows. The deleveraging that has taken place over

the past six to nine months affected not only passive investors, but also speculators. Among

the many factors at work, two in particular loom large and also reinforce that view that

financial flows will have a significantly reduced impact on prices.

First, there is simply less capital available in hedge funds and from individual investors to

impact the market in a way similar to what happened over the past few years and in

particular over the period September 2007 through June 2008. During this period a sort ofinvestor frenzy took place, close to a mass hysteria among investors, in which high oil

prices were considered to have no impact on the global economy and to be the inevitable

result of higher demand in emerging markets and peak oil. Only much higher prices, it was

thought, could play the dual role of killing demand and encouraging new investments in

supply. Attention was focused on buying deferred oil, which rose from $70 per barrel in

September 2007 to $135 in May 2008. In the four weeks after April 1 alone, it rose from $95

to $130. That money exited rapidly after July, as prices started to fall.

But the market liquidationappears now to be over

Speculative flows havediminished as well


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Second, there were other, even more speculative short term investments, which came in

spurts, including September-October 2007 and late spring 2008. These speculativeinvestments saw little risk in putting money into deferred oil and significant upside potential

in case of a disruption to supplies. The disruption scenario was fueled by the view that spare

capacities were a factor of the past and that Saudi Arabias upstream expenditures could do

little more than keep pace with alleged accelerating depletion of its giant fields, especially

the supergiant Ghawar field. Without spare capacities to replace lost disrupted oil, whenever

perceptions increased of a potential major disruption from a political event especially one

focused on Iran and its quest for nuclear potential speculative flows increased. As spare

capacities now are large and growing and expected to remain a major feature of the market

for the next two years, speculative flows designed to generate super earnings with a

disruption will look increasingly like poor bets.

A final financial factor that grew to have an important impact on both passive investor flows

into commodities and on speculative flows relates to the dollar, a currency under increasing

duress as the credit crisis erupted and spread, fueling expectations beginning in September

2007 in particular of rate cuts by the US Federal Reserve Bank prompting higher commodity

prices and precipitating a de-linking of the currencies of Saudi Arabia and other Middle East

producers from the dollar. There was a direct causal link between rising commodity prices

and speculative flows going long the Euro, short the dollar, and long commodities. Here too

there are reasons to believe that over the next few years the impact of the dollar and of

speculative flows will be significantly less pronounced.

History bears this out before 2007, when it became fashionable in financial circles to

believe there was an inverse relationship between the US Dollar/Euro rate and the dollar

price of commodities, there was in fact no discernible correlation between the two. And now,

even if there were, the likelihood is that the US Federal Reserves cut to virtually zero is

being matched by similar cuts by other central banks, and that loose fiscal policy in the US

will be matched by loose fiscal policies elsewhere. In short, the factors that for the past fiveyears exacerbated price volatility and helped push prices up will no longer be as effectively

at work.

The result: a more benign oil market?It is tempting to conclude that for the next three years or even longer the oil market will be

less tumultuous than it was for most of this decade. That is both a possibility but also in the

end a false hope. Certainly it is likely that the oil market will see far more limited financial

flows exacerbating price trends than it has in the past half decade and longer. Certainly it is

likely that a tamer market for exploration and production could increase global production

capacity, mirroring the past half decade when resource nationalism constrained the growth in

supply. And certainly it is possible that there will be more opportunities for OECD-typegovernance freeing up markets for trade and capital flows will again diminish the temptation

by oil producers to use oil as an instrument of policy.

Even so, darker clouds remain on the horizon. One of these clouds has to do with the

unintended consequences of some of what now see unfolding. Right after the Iran-Iraq war

concluded, in the winter of 1988-89, Saudi Arabia (and Kuwait) started to increase

production to erode prices and deprive both Baghdad and Tehran of oil revenues because of

In softer markets the

risk/reward fromspeculation is shifted

The decline of the dollar

also spurred speculativeflows into oil

and this too is a feature ofthe past

The oil market lookssuperficially more benign

But darker clouds are on thehorizon


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suspicions about how each country might use the increased revenue associated with higher

production after the war. One consequence of that was Iraqs taking of Kuwait in the summerof 1990 and its physical threats to the Arab Gulf oil producers. That should serve as a cogent

reminder that resource wars have not been waged in a high price environment, but they

certainly have in a low price environment. Similarly, lower prices in the late 1990s, again

engineered by Riyadh, aimed to punish Venezuela for eroding Saudi Arabias position in the

US market. The result was the election of Hugo Chavez as President of Venezuela. These

historical examples should remind us that the impacts of unintended consequences can be

rather severe.

Additionally, softer markets do not necessarily mean that the chances of political disruption

are more limited. The threat of terrorist attacks in Saudi Arabia might actually increase as

factions in other countries conclude that the kingdom is responsible for lower prices by not

curtailing production enough to push prices back over $100 per barrel. Nor can one rule out

an Israeli attack on Irans nuclear facilities, leading to a shutting in of Iranian output in

retaliation, or an Iranian effort to block passage of tankers through the Strait of Hormuz in

the Arabian Gulf. And it remains possible enough for civil strife in Nigeria, Venezuela and

perhaps one other large producer to result in a simultaneous disruption from those three

countries.

Whats more, even though the probability of a price spike remains more remote than it did a

year ago, there is no reason to expect that oil price volatility has come to an end. There are

many factors that have impacted the growing volatility of oil prices. Among these are current

global economic conditions, which have seen the volatility of exchange rates increasing and

impacting the volatility of all oil prices; and even within oil, physical market conditions

themselves, including bottlenecks around the Cushing, Oklahoma pricing hub for WTI have

had a role in enhancing volatility.

Any list of geopolitical risks lurking over oil markets must include a set of factors related tothe Middle East, and its hard to prioritize them. Even so, the inevitable departure of the US

from Iraq could unleash political forces that impact oil flows in multiple unexpected ways,

especially if one result is open civil war within the country and its division into successor

states, aping what happened in the Balkans with the breakup of Yugoslavia, with perhaps an

even more bloody result. Nor can one keep from the list a multiplicity of factors related to

Iran the elections this year, the countrys nuclear ambitions and the reactions of neighbors

and international powers (including the US) to them.

The financial crises confronting a range of resource rich countries provide another long list

of potential nightmares. The list includes Russia and Ukraine, with a question of who

defaults first and with what consequence; it includes Venezuela, Ecuador and Bolivia in

Latin America, the heartland of resource nationalism. Indonesia, Nigeria, Egypt and the other

North African countries are not far behind.

While the future remains uncertain, one trend remains clear: the way the interaction of

politics, geopolitics, and financial flows impacted oil prices between 2003 and 2008, is

unlikely to persist during the next two years and beyond. But even in an atmosphere of lower

prices, these dynamics are well worth watching; the fabric of the last five years may have

Softer markets dontnecessarily limit chances of

political disruptions

Price spikes are moreunlikely, but price volatility

has not necessarily ended

The financial crisis createsan additional layer of risk

The Middle East stillpresents a host of

eopolitical risks


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unraveled, but the threads are just now beginning to form a fresh pattern. A new world of

geopolitics is emerging and it is still too early to determine when circumstances will warranta revaluation of this new world.

CertificationThe views expressed in this report accurately reflect the personal views of Edward Kott and Edward Morse, the primary indivi duals responsible for this report,

about the subject referred to herein, and no part of such compensation was, i s or will be directly or indirectly related to the specific recommendations or views expressed herein..

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NEW YORKPierre Houri

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Pierre Lacaze+1 212 398 1230

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LONDONBen Kelly

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HONG KONGAlex Colin Jones+852 3793 1101

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politics, geopolitics and financial flows in a ‘low’ oil price environment

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