While the commodity cycle is currently on a downward trend, oil is volatile due to political and global conflicts. (As it always has been.)
The 1973 Arab-Israeli War only lasted 19 days, from October 6 through October 25, but the effects of this short conflict are still with us 40 years later.
One of the biggest outcomes was the acknowledged power of OPEC, the Organization of Petroleum Exporting Countries; or more specifically, the power of the Arab countries in that cartel.
Shortly after the war began, these countries imposed a ban on selling oil to several nations, including the U.S., in retaliation for supporting Israel in the war. The embargo didn’t end with the fighting. It lasted until March 1974. In that time, the price of a barrel of oil shot from $3 to almost $12, resulting in shocks throughout the economy.
Given that U.S. oil production had peaked in 1970 while consumption continued to rise, the Arab OPEC nations realized they had the power to force us and other nations to pay a higher price for oil, thereby starting the greatest wealth transfer in the history of the world.
The oil embargo caused near-panic in U.S. political circles, where the government reacted with a mixture of policy initiatives and price controls. This resulted in gas rationing, long lines at filling stations, and the Department of Energy. A ban on exporting raw oil was put in place.
A lot has changed in four decades.
The U.S. has made great strides in cutting oil consumption per person, and even saw the total use of oil in the U.S. decline recently.
At the same time, domestic producers made great strides in recovering massive amounts of fossil fuels from rock formations through hydraulic fracturing, or fracking.
These trends mean that the U.S. can meet more of its oil demand from internal sources… sort of.
The problem is that most U.S. oil is of the light, sweet variety (West Texas Intermediate, or WTI), while much of what we import is heavy sulfur (Brent).
Since U.S. oil production began dropping in 1970, the refining capacity added since then has been for Brent crude oil. Unfortunately, refineries can’t simply switch between the two. This means that our refining capacity for WTI has been swamped by local supply.
Since we still have an embargo on exporting raw oil — except to nations with a free trade agreement — there isn’t much that oil producers can do… until now.
Earlier this year, two oil companies received private rulings allowing them to export condensate, which is a very light form of oil. This will allow the companies to sell very limited quantities of raw oil to the international market. The sales themselves won’t move the oil price needle, but the concept of lifting the embargo will have a dramatic effect.
Expect our prices to go higher.
When U.S. producers are allowed to sell their raw oil to the rest of the world, then the price of WTI and Brent should reconnect.
The current difference in price came about when U.S. oil production increased and we were flooded with supply.
It only stands to reason that when we can sell our excess supply on the world markets, there will no longer be an overhang of oil in the U.S., so the cost of locally sourced oil will move higher. We can expect our price at the pump to follow suit.
This isn’t a judgment on whether we should, or should not, lift the embargo. It’s simply an assessment of what will happen as the embargo is dismantled.
I expect the same thing to happen when natural gas liquefaction and export finally gets underway in 2015, as supply is siphoned off by the world market, and sold at a higher price.
All of this means we should be prepared for equalization with world prices as the sudden bulge in supply gets drained away.
If prices for oil and natural gas remain high in the years to come, we will face higher costs for gasoline, heating oil, and electricity generated from natural gas. All of this will take more money out of consumers’ pockets at a time when wages are falling behind inflation, leading to another drag on consumption, and therefore a drag on the economy.
While this would be negative for the economy as a whole, it would lead to big profits in the energy sector, providing investors with a potential pocket of profit from what is otherwise a costly turn of events.
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