Could The Oil Market Be A War Predictor?

If the oil market is a predictor of anything besides prices in the future, things are about to get a lot hotter in Libya or in Saudi Arabia, or maybe both.  I see the oil market trying to price in an escalation of further war.

Oil is priced using futures markets, where contracts are deliverable every month.  Therefore each month has a separate contract and a uniquely traded price.  When you look at these prices placed in a time line, like a calendar, you get a mapping of prices that can either increase or decrease the further into the future you go.  If prices generally increase, you have a “curve” of prices called a contango, if they tend to decrease, you have what is known as backwardation.

I’m simplifying for clarity, but a contango curve is normally more demand sensitive, among other things – the bets in the oil market are engaged to protect against an increasing industrial need for oil in the future, perhaps even protecting against future hoarding.  We’ve seen a constant contango curve in oil since 2006 and saw the most intense contango in the oil market on a percentage basis during 2009, when oil was reaching the nadir of its deleveraged move from the collapse of all the markets in late 2008.  What the oil market was saying during this time was “Oil demand may be slack now, but I’m still betting strongly on increased demand in the future”.

This is the curve we associate with emerging economy growth and peak oil arguments as the drivers of oil price.

But in the last six weeks, we’ve had a change:  A rapid move of the curve to become much flatter and in some places to reverse and become backwardated. 

Backwardated curves tend to be more supply sensitive – the bets in this market are more often engaged to protect against a rapid destruction of supply choices in the near term.  It will therefore make sense to you that the most intense backwardated oil market will emerge as the Middle East becomes disrupted and as Western forces threaten to intervene militarily. One of the most intense backwardation moments reached in the oil market was in 1991, as the United States prepared to take on Saddam Hussein in Kuwait in Gulf War I. 

This backwardation has increased since NATO intervention in Libya, implying that the military action we’ve already taken may not be the end of it, according to the oil market.  Protecting against a “Gulf War”-like escalation seems to be what the market is predicting today. 

Two specific disruptions could fit the bill for this kind of event:  Real “boots on the ground” action in Libya by US or NATO forces, or even a further contagion of Yemen and Bahrain disruptions into Saudi Arabia, where the United States would be practically forced to protect the Kingdom in a way they have not been obligated elsewhere in the region.

The question becomes:  How good is the oil market at predicting the future?  Its history has been spotty, but if you believe in “the Wisdom of Crowds” and James Surowiecki’s work, it’s certainly something to take seriously – the participants engaged in trading oil are necessarily much more attuned to the geopolitical possibilities than the rest of us.

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