Geopolitics and the price of oil

An extract from my book, “Crude Forecasts: Predictions, Pundits & Profits In The Commodity Casino” on how even perfect geopolitical foresight doesn’t necessarily translate into knowing what it will mean for oil prices.

Ruptures in the price trend for many commodities are often the result of geopolitical developments. Political scientists Ian Bremmer and Preston Keat defined geopolitics as: “The study of how geography, politics, strategy, and history combine to generate the rise and fall of great powers and wars among states.” Given its importance to the running of the modern global economy, nowhere is this more vividly observed than in the battle for energy resources and, in particular, oil.

A cursory look at a simple oil price chart dating back to the 1970s reveals a series of bumps. Each of these bumps can be pinpointed to wars and conflicts, whether it was the Iranian revolution, the Iraqi invasion of Kuwait or the US-led invasion of Iraq. More recently, the Arab Spring-related uprisings in Libya or Egypt, civil war in Syria and violence in Iraq and the Ukraine have resulted in escalating geopolitical tensions across many important energy production and transit countries. There is a strong correlation between war casualties in energy producing countries and disruptions to oil output. As many historical episodes suggest, oil producing and distribution systems are hard to keep running when countries are immersed in civil wars or wars with neighbouring countries.

Other commodity markets also face their own geopolitical risk factors; the cocoa market, for example. Supply is concentrated in West Africa and in one country in particular, the Ivory Coast (supplier of approximately 40% of the world’s crop). Frequent political instability in the area has resulted in unrest and outright civil war, disrupting the production and export of cocoa from its ports.

If geopolitics plays such a big role in seismic moves in the oil market and many other commodities, then if geopolitical shifts can be forecasted with any accuracy this must give forecasters an edge, right? The Good Judgment Project, set up by Phillip Tetlock, set out to answer the first part of this question. They explored the profile of the best out of hundreds of forecasters who made over 150,000 predictions on roughly 200 events during a two year period. Forecasters were asked a multitude of questions, such as: Will the United Nations General Assembly recognise a Palestinian state by September 30th 2011? Will Bashar al-Assad remain president of Syria through to January 31st 2012? The researchers found that forecasters can be good at spotting changes, but only over long timescales.

The problem with geopolitical events is that they tend to be binary outcomes (although clearly not always). They either happen in the future or they don’t. This contrasts with what we might term “market” or “economic” risks which are more dynamic. There are three main problems with binary outcomes: first, they offer little information advantage for investors to play with; second, they are hard to predict and, third, they offer few easily identifiable markets that might benefit from a particular outcome.

Even if you have fantastic foresight about how a geopolitical event is likely to develop, the next problem is decoding what the impact is likely to be on a range of different commodity markets. All too often pundits focus on the immediate effect; for example, based on whichever candidate wins an election. However, they forget to draw the dots as to how the “narrative” could change once the geopolitical uncertainty of the political event falls away. Even if you could correctly forecast that the regime of a particular oil producing nation would be toppled within a given year, you wouldn’t be able to know the exact path that oil prices would go as a result.

Just as its very difficult to determine cause and effect in the past, it’s even harder to do it in the near future, even when you have a good grasp of all the information that could affect prices. In the first two months after Iraq invaded Kuwait in 1992, the oil price doubled from around $20 per barrel to almost $40 per barrel. If you asked any intelligent “analyst” or journalist he would have predicted a rise in the price of oil in the event of war. Their reasoning would have been simple – war in the most important oil producing region in the world creates the risk of disruption to oil distribution and supply.

In 1992, oil prices rose relentlessly as the war drums were beating louder and louder in Kuwait, until the cacophony became unbearable. As soon as it became likely that the US and its allies would invade Kuwait to push back the invading Iraqi forces, oil prices gradually fell back. Indeed, once the US-led coalition began its bombing campaign, in a matter of days prices fell from $30 per barrel to below $20 per barrel. As Nassim Taleb’s fictional character, Tony, describes in the book “Fooled by Randomness”, “War could cause a rise in oil prices, but not scheduled war – since prices adjust to expectations. It has to be in the price.”

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