(Geo)Political Risk and the Price of Oil: End of an Iconic Duo?
For decades, the bond between the level of (geo)political risk and the price of crude oil seemed unbreakable. Whenever the specter of instability in the Middle East increased, so did the price of oil. When political tensions receded, the price fell. The two always seemed to be moving in perfect harmony, making it a safe bet for traders, and a tenet of conventional wisdom for analysts. Suddenly, however, we find ourselves in a situation where the Middle East is rife with political risk, and yet the price of oil hit a seven month low this week. Why doesn’t the relationship hold? Why has the iconic duo broken up?
To understand the break up, we must first understand how the level of political risk and the price of oil came together in the first place. For decades, oil and gas production was concentrated in a relatively small number of generally unstable countries and transported through a few vital transit points in the Middle East. As the main supplier of oil and gas, the Middle East became a strategic priority for oil-consuming countries dependent on steady supplies. Whenever stability in the Middle East was threatened, so too was it expected that the supply of oil and gas would be disrupted. Basic economics tells us that instability, and consequent fear of lower supply, means a higher price- especially in light of growing demand.
The formula held for decades, giving countries like the US the need to focus on maintaining peace, or at least stability of supply, in the Middle East. The 1973 oil crisis and embargo, long gas lines, and high prices left a lasting mark. Yet, as we know, countries are wary of being dependent on others for something that is so central to national security and productivity. Amid fears of peak oil and other hysteria, as well as a growing emphasis on more environmentally sustainable energy sources, many countries began investing in ways to wean themselves off their dependence on the Middle East. Meanwhile, the countries of the Middle East got better at securing their oil infrastructure in an effort to insulate it from periods of political upheaval or isolated security crises. The stability of the formula (if high political risk, then high prices) turned into an impetus to change the status quo.
Fast forward several decades, and the US is now an oil exporter, largely thanks to the shale revolution. Many other countries outside the Middle East (and OPEC) continue to produce oil output at record levels. Non-OPEC countries are supplying more crude to China than OPEC countries. Given diversification in global energy sources, the growing popularity of solar and wind power, and other advances in technology, as well as discoveries of substantial oil reserves in areas outside the Middle East, the world now has a global oil glut. Since the end of 2014, the price of oil has remained below $65 per barrel, largely due to increasing supplies from a number of producers outside the Middle East, and lower than expected growth in demand among traditionally oil-hungry consumers in Asia, like China and India. It remains low despite the rise of the Islamic State terrorist group, ongoing military conflicts to defeat it, and insurgencies in Syria, Iraq, Libya, Yemen, and Nigeria. It continues to stay low even given the ongoing diplomatic crisis between Saudi Arabia and her allies against Qatar, and even while Venezuela, another major oil producer, teeters on the brink. Just one of these events would normally constitute a major political risk and cause the price of oil to spike, but the price hovers around $43 per barrel of crude. The two members of the iconic duo are heading in opposite directions: even as each new crisis increases the level of political risk, the price of oil hits progressively newer lows.
On the one hand, this is good- the US and other countries have diversified their energy sources and are no longer dependent on the Middle East. On the other hand, it means the US and other countries do not have the same interest in keeping the Middle East stable at any cost. We are likely to see the Middle East grow more chaotic as the traditional providers of stability and guarantors of security turn their attention elsewhere. It seems paradoxical now, but so long as the global supply of oil remains stable, the Middle East is likely to grow ever more unstable, as the rest of the world has less of an interest in sacrificing blood and treasure there.
What can we learn from this? The calculus that made the price of oil dependent on the level of political risk has changed. The prevailing conventional wisdom no longer holds. In geopolitics, change is the only constant, and therefore in geopolitical calculus, new variables can cause longstanding relationships to change. Although we continue to see small one-day spikes in oil prices, crises in the Middle East- even several simultaneously- are no longer enough to really disrupt the overall global supply and demand relationship, and therefore not enough to drive up prices for any sustained period. Therefore, we all need to update our thinking; the best way to do so is via interactive simulations that open our eyes to new realities and allow us to experience the consequences of different paths.
Given the extent to which the global economy is interconnected, growing instability in the Middle East will have second and third order effects throughout the world. As risks grow, so will opportunities for those countries that can contribute to further diversification of energy resources, and for others that can take advantage of instability in the Middle East to benefit their own positions. For example, oil-producing nations can increase output to force the price to drop further, thereby placing further pressure on countries that rely on oil revenues to fund their budgets. Even as the level of political risk in the Middle East breaks up its relationship with the price of oil, it is not likely to stay single for long.
Milena Rodban is a geopolitical risk consultant and simulation designer, advising private firms, including tech companies, media organizations, non-profits, and universities, to help them successfully navigate complex business and security environments. She can be reached via email at email@example.com or on Twitter, @MilenaRodban.