Risk Of An Oil Price Spike

The biggest risk of higher oil prices looks to be the latest storm brewing in the Middle East. Our contention has been that oil prices are destined to slip back to their pre-stock-bounce range once economic reality sets in and demand remains persistently low. To that end, we own a hedge against falling oil prices.

However, the likelihood of military action against Iran by either the US, Israel, or both is growing, and such action would cause oil prices to spike. Let’s look at the situation and chance of an attack, and why it would put upward pressure on oil prices.

In April, the Obama administration granted Iran until Sept. 24 to open talks with the five members of the UN Security Council plus Germany, a group referred to as P-5+1. The consequence of not doing so was to be harsh sanctions. Since then, Obama extended a fig leaf to the Islamic world with his friendly speech in Cairo, the appointments of special envoys George Mitchell for Israel/Palestine and Richard Holbrooke for Afghanistan/Pakistan, and soft-edged diplomacy intended to reverse harsh feelings left over from the Bush years.

The result of the fig leaf has been impressive when judged by the content of warm speeches all around, but not so great when judged by the list of concrete steps to improve upon America’s interests in the region. Terrorist activity has not declined, Mitchell was unable to change the situation between Israel and the Palestinians on the settlement issue, Holbrooke hasn’t improved the Afghanistan War situation at all, and, most vital to our discussion, Iran hasn’t budged in its nuclear ambitions or even attitude toward the US and the P-5+1. It’s now past the Sept. 24 deadline, and the situation technically calls for sanctions to be applied. Will they be?

Apparently not right away, because the talks have been rescheduled to start this Thursday, October 1. Few are holding their breath for the talks to mean anything, anyway, so attention is already turning to what will happen when Iran changes nothing.

If the sanctions are applied, they need the cooperation of China and Russia in order to work. Either country could supply Iran with all the fuel it needs, and both countries have expressed their disapproval of the sanctions. So, the sanctions are looking like a joke.

That leaves an attack as the most probable way of thwarting Iran’s nuclear plans. It would likely involve both the US and Israel, because either country’s initial entry into a fight with Iran would draw the other in. Israel can’t go it alone against Iran and the US won’t let Israel come out of a conflict worse off.

Besides, the first thing Iran would do in case of being attacked is close the Strait of Hormuz, which would bring the US immediately into the fight. In July, Iran’s oil minister issued the threat and received the US response, as reported by Fox:

The US Navy and its Gulf allies will not allow Iran to seal off the strategic Strait of Hormuz if the country is attacked, the commander of US naval forces in the Gulf said Wednesday.

The warning comes as Iran’s oil minister vows that any attack on his country by the United States or Israel would provoke an unimaginably fierce response.

The announcement by Vice Adm. Kevin Cosgriff, commander of the 5th Fleet, came as he was holding talks with naval commanders of Gulf countries at a conference in the United Arab Emirates capital of Abu Dhabi. The one-day meeting was to focus on the region’s maritime and trade-route security and the threat of terrorism.

The 5th Fleet is based in Bahrain, across the Gulf from Iran. Cosgriff said that if Iran choked off the Strait of Hormuz, it would be “saying to the world that 40% of oil is now held hostage by a single country.”

“We will not allow Iran to close it,” he told reporters.

Cosgriff’s comments follow Iranian threats that it could seal off the key passageway in case of a Western attack on Tehran. But Cosgriff said that if Iran moved to choke off Hormuz, the “international community would find its voice rapidly” against Iran.

Here, we run up against the risk of an oil price spike. Whenever 40% of the world’s oil supply is perceived to be held hostage, prices will spike.

That’s where we may be heading. Yesterday, Iran test-fired missiles that it claims can hit any regional target. That came on the heels of the US and its allies expressing concern that not only has Iran not slowed down its nuclear ambitions, but has in fact grown them by building a second uranium enrichment facility.

There is always the option of doing nothing, but that would make the US look unbelievably weak to sit by idly while Iran makes nuclear weapons. It would also force Israel to go it alone, which would cause Iran to close the Strait of Hormuz, which would draw the US into the fight anyway. Doing nothing would be about the worst option because the US would look weak and still end up in another military action.

Thus, as Iran moves ahead, the options before the US are sanctions that won’t work, a military strike that will result in the Strait of Hormuz closing for a brief period, or doing nothing until forced into joining an Israeli military strike that causes the closing of the Strait of Hormuz for a while.

As you can see, the odds are pretty good that we’ll see the Strait of Hormuz close in the near future, which will send oil prices higher. That’s why we’re watching this issue carefully, and may need to sell our oil hedge soon.

Disclosure: Long PowerShares DB Crude Oil Double Short (DTO)

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