From Kent Morrs: Much of my earlier career in intelligence was based on a simple assumption. It was the kind of approach the “craft” shares with a number of other pursuits.
One expects that the usual usually happens.
You look for outliers, patterns that don’t fit the normal profile, or events emerging from unexpected quarters. Everything else is largely ignored, filed away, or filtered out.
Which makes the primary approach energy pundits have to geopolitical elements curious.
Perhaps it’s because some of them are so young they have no genuine personal experience to fall back on.
Or maybe it’s a reflection of this crowd’s pervasive lack of any historical understanding that requires something further back than a 200-day moving average.
Many of these commenters paint the rise of a global flashpoint as an exception to some “rule.”
The textbook (and largely fictitious) portrayal of a normal market in which supply and demand intersect to create price without any other factors intervening is still regarded as what markets do most of the time.
In other words, the thought is that the usual usually happens, with an event now and then upsetting the “natural” order of things. Maybe that was the case a century ago.
But it’s certainly not today, with immediate worldwide news, followed (unfortunately) by half-baked immediate analysis.
The difference here is striking. Crisis is not the exception.
Crisis drives the energy markets because it has been the main ingredient producing swings in prices for some time.
Actually, the connection between international crises and the price of crude oil has been rather direct. The reason is straightforward.
Four Hotspots are Driving Uncertainty
Uncertainty drives the movement of prices.
Price ranges are jarred by any increase in global uncertainty, whether or not there is an immediate translation into a pressure either on the supply or demand side.
Ask any trader.
Without exception, they’ll tell you that markets prefer predictability to any other factor.
As a result, current tensions around the world serve to provide a firming price floor. And remember, it’s the floor, not the ceiling, that really determines the pricing range.
Aside from the localized situations that have a direct bearing on energy flows (for example, the ongoing civil war in Libya or the simmering Saudi-Qatari spat), four stand out as driving the energy “uncertainty factor.”
First, the additional U.S. sanctions imposed on Russia. You can read more about them here.
Second, an acceleration of unrest in Venezuela (with additional American sanctions about to be imposed there as well – click here for more details).
Third, the war of words between the U.S. and North Korea.
And fourth, the conflict over the resources in the South China Sea.
We’ve discussed the first two on several occasions here in Oil & Energy Investor. The new Russian sanctions have a rather direct connection to both the finance and flow of Russian natural gas into Western Europe, along with the prospect of making the import of liquefied natural gas (LNG) a more attractive alternative.
Of course, that dovetails nicely into American plans to export LNG to the continent.
The strong pushback from the Kremlin merely articulates what is already well known. The Russian central budget cannot survive without strong revenue flows from the export of oil and natural gas.
But the Venezuelan crisis has an even more obvious and dramatic impact.
Pundits are Forgetting About This Hotspot’s Effect on Energy
As a major member of OPEC (as well as possessing the largest crude reserves in the world), the domestic collapse there is prompting a rising concern over OPEC production and export levels.
That Washington, D.C., now has the Venezuelan state oil company PDVSA in its sights merely accentuates the situation.
But the dueling tweets between Washington and Pyongyang has filled the TV airways without the connection being made to energy flows.
Now the broader stock market ups and downs over the past several days certainly illustrate the pressure that can be applied when the prospects of military confrontation arise.
But the prospect of a nuclear-armed “hermit state” (North Korea) on energy flows is largely neglected.
Even though it already is affecting oil prices. Not because North Korea is a major producer or customer, but because of the broader uncertainty it generates.
Any military exchange between the U.S. and North Korea will immediately result in massive damage and loss of life in the South Korean capital of Seoul and the area surrounding it.
That will upset the energy trade in the larger region – the one that will drive global energy demand for at least the next three decades.
In turn, the weight any hostilities have on neighboring China would profoundly influence prospects for the super power’s clout in energy trade. Any perception of a decline in Chinese energy consumption or, more likely, a rise resulting from the hoarding of energy and minerals occasioned by war on its borders, will have a quick knock-on effect on prices.
And then there’s the pressure a conflict on the Korean peninsula would have on some of the most important oil tanker routes in the world…
Investments that Bridge Energy and Defense are the Key to Profits
Each of these factors provide a spike in uncertainty.
Remember, it’s the level commanded by futures contracts (“paper barrels”) rather than the actual cost of consignments in transit (“wet barrels”) that sets the price of oil. Those forward-looking “paper” barrels are very much the creature of what oil looks like months into the future.
And that is driven by traders’ perceptions.
The Korean crisis also runs the risk of heating up the fourth situation – the South China Sea. This one is another we have discussed at length in previous editions of Oil & Energy Investor.
Here’s the short of it: China has laid claim to huge swaths of the waters and resources that several other countries also claim.
In addition, Beijing has been energetically building artificial islands in the disputed South China Sea to extend its territorial zones and to serve as bases for military action.
What is done by or to North Korea will accelerate Chinese actions in the South China Sea, moves that have already placed it in direct collision with American interests.
Meteorologists will tell you that perfect storms result when insular disturbances combine. Geopolitical “storms” expand the same way.
It’s for all of these reasons that I’ve been bringing subscribers of all my services into cross-over investment plays that bridge energy hot spots and military/defense stocks.
The new normal of what’s happening worldwide dictates such a strategy.
The Energy Select Sector SPDR ETF (NYSE:XLE) closed at $63.94 on Friday, down $-0.42 (-0.65%). Year-to-date, XLE has declined -14.01%, versus a 10.22% rise in the benchmark S&P 500 index during the same period.
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