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Oil's Perfect Storm

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AP

A perfect storm may be blowing towards the global oil markets—with disastrous economic and political consequences to follow in the wake.

Ambrose Evans-Pritchard, the International Business Editor of the British newspaper the Telegraph, has written a disturbing analysis of the challenges that lurk just below the surface of the oil producing nations of the Middle East and North Africa.

Here are the three major challenges you need to know about: overstated supply and production

Those reassuring reports of OPEC oil ministers meetings to nail down the details of how best to increase oil output may be just a fantasy.

Evans-Pritchard writes that Goldman Sachs now believes that OPEC has already been pumping above its quota since November of 2010—"and therefore cannot easily raise output much without cutting deep into global spare capacity."

He quotes Jeff Currie, a Goldman energy analyst: "We believe that OPEC spare capacity has already dropped below 2m bpd [barrels per day]. The question therefore arises how much spare capacity is left to absorb potential supply disruptions in other countries."

Chris Skrebowski, the editor of Petroleum Review who is also quoted in the article, takes a similar line: "We cling to the comfort blanket that spare capacity exists, but it is mostly fictional, or inoperable. If you take 2m bpd off the figure, the whole dynamic of global oil supply changes."

The two million barrels per day number is especially troubling—since it represents 50 percent of the 1 million barrels per day that have dried up in Libya since the crisis there began.

And that number may drop even further if the Libyan civil war continues to intesify.

Non-Linear Pricing

Before the crisis, Libya produced 1.6 million barrels of oil per day.

That's less than 2 percent of the 88 million barrels per day produced globally.

So why should we worry?

Evans-Pritchard explains that, despite the appearance of only a small percentage of the global oil supply being at stake "…oil prices are determined by levels of spare capacity once supply tightens."

Furthermore: "Beyond a certain point, the price spiral can kick in with explosive force until the economic damage crushes demand."

In other words, oil prices may remain relatively stable—as long as the perception of excess capacity remains.

But if future capacity is in doubt, prices can absolutely explode.

As evidence, Evan-Pritchard cites the following example:

"Some investors see trouble. They are buying oil options contracts for $150 and $200 a barrel with expiry dates late this year, either as a bet or as an insurance against Mid-East mayhem. Barclays Capital said the options 'call skew' is more stretched now that it was during the 2008 spike."

Major Internal Rifts in Oil Producing Nations

Many oil producing countries in the region are plagued by long standing tribal rivalries that threaten their stability—and their future oil producing capacity.

Evans-Pritchard writes, "Mass protest by Bahrain's Shi'ite majority against the ruling Sunni dynasty has been a rude awakening for investors who thought oil wealth would shield the Gulf against turmoil."

And on a similar note— but with broader implications: "Bahrain sits at the epicentre of the world's energy system. It is a hop to Saudi Arabia's Eastern Province, home to an equally aggrieved Shi'ite population and the kingdom's giant oil fields."

Finally, the most chilling bit of analysis: "The world's economic fate now hangs on the success of Wahabi repression. Any sign that the Saudis are losing their grip risks an oil shock large enough to derail the global recovery."

Our cursory understanding of the region—wedded with our great economic dependence—is a dangerous liability for the West.

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