Why Energy Investors Need to Know about Geopolitical Volatility

As an energy investor, if you want to find one wild card in the oil industry that can swing crude prices, geopolitical volatility is by far the most unnerving, unpredictable force out there. Some reports have suggested that conflict in the Middle East adds a $20 to $30 premium to crude oil prices.

To understand why, remember that disruptions in areas like the Strait of Hormuz can have a major impact on the petroleum trade. The strait is a natural choke point between the major oil-producing members of OPEC (Saudi Arabia, Iraq, and Kuwait) and open water. In 2009, about one-third of the world's oil-borne sea trade was shipped through the strait. Overall, that accounts for almost one-fifth of the world's oil supply.

When supply disruptions do occur, you must take other factors into consideration. When Libya's oil production was curtailed in 2011 during its six-month civil war, countries like Saudi Arabia decided to make up the shortfall.

An immediate problem that surfaced was the quality of Saudi Arabia's spare capacity. Unlike Libya's light, sweet crude, the Saudis' spare capacity was of poorer quality. The European refineries that it went to, however, weren't set up to process the heavy, sour grade of crude.

The point here is that OPEC's inability to add high-quality oil indicates a potential problem during future supply disruptions. Failure to deal with these events can lead to short-term price shocks.

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