Thursday, January 10, 2013

Oil and geopolitics

The recent oil price increases  are more likely associated with strengthen of economic growth. Oil prices are moving higher even though there is no obvious geopolitical risk. Nevertheless, geopolitical risks are always hanging over thee oil market.

A significant portion of option demand in the oil market is driven geopolitical risks. Geopolitical risks can be tempered by the current conditions of the oil market. One of these key structural issues is the level of over capacity in the market. If there is limited overcapacity, any disruption will lead to a greater market move because oil will just not be available. If there is more overcapacity around the world, an oil price shock can be dampened.Supply will be forthcoming form new sources if those are located away from the shock. A second structural issue is the amount of inventory held in storage. Low inventory will mean a strong price reaction to any shock. This is consistent with any stock/usage model of commodities.

Right now there has been a decline in capacity to something below 3 mb/d. Estimates suggest that 4.5 mb/d would represent about 5% of global demand. If there is a shock, there will be a strong market reaction. Hence, it makes sense to buy out of the money calls under threat of a geopolitical shock.

Robert McNally from the Rapidan Group presented some informative charts at the Morgan Stanley Miami Commodities Conference.

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