Oil Prices and Geopolitics

By Published On: December 7, 2015

The influence of geopolitical events on oil prices tends to receive a great deal of play in the financial media.

For example, on the morning of Nov. 24, reports surfaced that Turkey had shot down a Russian fighter jet that ostensibly had violated its airspace and failed to respond to warnings. Russia continues to launch air strikes near the Turkish border and has asserted that the warplane was in Syrian territory when it was downed.

The incident received widespread media attention, with many outlets citing the downed plane as the reason that the price of front-month West Texas Intermediate (WTI) oil futures spiked to an intraday high of $43.46 per barrel—up roughly 4 percent from a close of $41.75 per barrel on Nov. 23.

In an ideal world where market participants operate in an emotional vacuum and have perfect clarity regarding the factors that move oil prices, the downing of the Russian plane and subsequent controversy wouldn’t have produced such a move in WTI prices.

In 2014, Syria produced 33,000 barrels of oil per day and Turkey flowed less than 50,000 barrels per day—drops in the bucket in a global market of more than 90 million barrels per day.

Oil pipelines with a combined capacity of about 3.3 million barrels per day pass through Turkey. But the 1.2-million-barrel-per-day Baku-Tbilisi-Ceyhan pipeline is located far from the Syrian conflict, and the 1.5-million-barrel-per-day Kirkuk-Ceyhan pipeline has operated at a fraction of its nameplate capacity for years because of sabotage to the Iraqi portion. Further damage to the Kirkuk-Ceyhan pipeline wouldn’t affect global oil supply meaningfully.

Iraqi oil shipments recently climbed to 4.3 million barrels per day from about 3.1 million barrels per day at the end of 2013, making the nation the second-largest oil exporter in OPEC.

Oil fields in southern Iraq—for example, Rumaila, West Qurna and Zubair—account for roughly 95 percent of the nation’s oil exports and have driven the vast majority of the country’s oil production growth in recent years. These volumes exit the country through ports in southeastern Iraq on the Persian Gulf, far from the Syrian conflict and regions controlled by ISIS.

The downing of a warplane also won’t affect Russia’s ability, or willingness, to supply oil and gas to the global market. Energy commodities account for about 70 percent of Russia’s total exports; the country can’t afford to curb this trade in response to an international incident.

Meanwhile, Russia supplies 30 percent of Turkey’s oil and 55 percent of its gas; the country likewise can’t afford to allow its relations with Moscow to deteriorate too badly.

By the end of the week, the knee-jerk rally in oil prices triggered by news of the downed fighter had dissipated.

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Although geopolitical incidents often move oil prices in the near term, far too many pundits overestimate the longer-term importance of geopolitics on oil prices—especially in a well-supplied market.

Consider Iraq’s invasion of Kuwait in August 1990 and the US-led coalition’s subsequent military action to expel these forces in early 1991.

Iraq began massing troops along the Kuwaiti border in early July 1990, though many intelligence analysts regarded this as a bluff to persuade Kuwait and other OPEC members to reduce surplus production and bolster oil prices.

Iraq invaded Kuwait in the early morning of Aug. 2, 1990, quickly overwhelming its much smaller neighbor’s security forces and prompting government officials and some of the Kuwaiti military to retreat into Saudi Arabia. Iraq eventually grew the occupation force to about 300,000 soldiers.

The US-led coalition’s defense of Saudi Arabia, or Operation Desert Shield, officially began Aug. 9. After a series of diplomatic efforts to force Saddam Hussein to withdraw his troops from Kuwait, the coalition launched Operation Desert Storm on Jan. 16, 1991, with a massive air offensive. The ground offensive began on Feb. 24, effectively defeating Iraq’s army by the end of the day. Four days later, Kuwait had been liberated and US President George Bush declared a cease-fire.

This conflict had significant implications for global oil supply. After Iraq invaded Kuwait, Saddam Hussein controlled about 20 percent of the world’s total estimated reserves.

Iraqi forces also set fire to Kuwaiti oil fields and damaged critical infrastructure as they withdrew from the country.

In the year prior to the Gulf War, Iraq produced about 2.8 million barrels of oil per day, Kuwait flowed 1.41 million barrels per day and Saudi Arabia lifted 5.64 million barrels per day; in 1991, Kuwait produced 185,000 barrels per day and Iraqi output plummeted to 285,000 barrels per day.

Kuwaiti production didn’t recover to its prewar peak until 1993, and Iraqi output didn’t top 2.8 million barrels per day until 2011.

WTI crude-oil hovered between $20 and $25 per barrel at the beginning of 1990, before slumping to a low of about $15.30 per barrel in June. After Iraq’s invasion of Kuwait and the start of Operation Desert Shield, oil prices surged, peaking at $41.02 per barrel on Oct. 11.

These gains were short-lived. By the end of December 1990, oil prices had tumbled to $25 per barrel—the level where they began the year. And by the time US and coalition forces launched airstrikes against Iraq in January 1991, oil prices had slipped to less than $20 per barrel.

Bottom Line: At the height of the Gulf War, oil prices actually declined.

The 1990-91 experience resembles the current environment in many ways, at least from a supply and demand standpoint. At the time, Saudi Arabia, Kuwait and other OPEC members continued to flood the market with oil in an attempt to squeeze out high-cost production and regain market share lost between 1973 and 1985, when the organization scaled back output in an ill-fated effort to support prices. (See Lessons from the Past.)

And back then, some OPEC members argued that the organization should reduce output to bolster prices—one of the motivations behind Iraq’s invasion of Kuwait and threats against Saudi Arabia.

In short, the global oil market faced a significant oversupply in 1990 that limited the effect of production disruptions caused by the Iraq war. Similar conditions exist today.

Although oil prices may still react to geopolitical events in the near term, supply and demand will drive prices in the long term. Debating (or shouting about) geopolitical risk premiums may be a big deal to the financial infotainment complex—these developments attract a lot of eyeballs—but they remain a secondary consideration.



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