Are markets usually so sanguine about the potential for military conflict?
In 1810, Nathan Rothschild is said to have coined the phrase "buy on the sound of cannons, sell on the sound of trumpets". The Rothschild family made their fortune during the Napoleonic wars and the suggestion that markets sell on the fear of war and rise once it begins has often proved correct since then, a topic which has been covered in a recent blog. This may partially explain why markets have not responded more to Trump's bellicose tweets. It may also be because they feel that the conflict can be confined to Syria and will have little global impact. It is hard to say what will happen and between writing and reading, these comments there may be a shift in the situation. On Wednesday, Trump Tweeted that the missiles "will be coming" the next day he said it "could be very soon or not so soon at all" we just do not know. Past missile attacks have had little impact but Russia warning against attacks and their presence on the ground in Syria has the potential to escalate the threat. If the Russians retaliated by attacking the source of any US attack, such as a US aircraft carrier then situation is changed completely. However, the expectation is that this is unlikely and any action can be contained in which case the market is right to be sanguine.
Is it worth looking at oil with the potential for armed confrontation in Syria?
In isolation, the conflict in Syria has little direct impact on the oil price. However, the combination of wider conflicts in the Middle East and Russian involvement in Syria may have a broader impact. Five years ago, the oil price was riding high at over $100 per barrel. The high price stimulated increased exploration and the development of new methods of extraction such as shale oil deposits in the US. A shift in policy by Saudi Arabia (a misguided attempt to defend their market share) had resulted in excess supply and inventories increased as Iranian oil came back to the market following the lifting of sanctions by President Obama in 2015. As a result, the market fell and by early 2016, the oil price was below $30 per barrel. As a result, investment in new production fell rapidly. The Organization of Petroleum Exporting Countries (OPEC) and Russia also reacted to the fall by agreeing to cut production. There were initial concerns that OPEC members would cheat on their quotas, but compliance has been good, inventories have fallen, and the price of Brent Crude is now up to around $70 per barrel.
The price of oil is always a balance of supply and demand and the rise in the oil price has seen an increase in drilling activity, but this is still well below the level of five years ago. Shale oil production can come on stream fairly quickly but the wells have a limited life. Therefore, if prices fall, supply tails off faster than with conventional oil wells. The market has been looking for a new equilibrium in supply and demand; Saudi Arabia is the largest oil producer in the world and the war with rebels based in the Yemen has seen missiles aimed at Riyadh. So far these have been shot down by the US made missile defence system, but clearly there is scope for one of the many attacks to disrupt production or shipping. The possible bigger threat to supply would come from the US breaking with the Iran nuclear deal. President Trump has been highly critical of this deal and the appointment of two hardliners to his cabinet suggest that the US could be on the verge of re-imposing sanctions. This would reduce oil supply further, and there may be good reasons to see oil higher but many investors will still question whether this will be offset by subsequent increases in US domestic production. For perspective, the loss of 350-500 thousand barrels of crude from Iran would curtail world production by about 4%. US onshore shale production accounts for just under 10% of global supply, so output would have to increase by 40% in a short space of time for the Iranian loss to be fully offset.
For a time investors shied away from the volatile sector and with difficulties around predicting the path of oil, prices have been slow to return. There were concerns that the high dividend yield on UK major oil companies could not be sustained but cost cutting and recovery in the oil price makes this look safer than it has been. The oil price may continue to fluctuate but the sector looks better value than it has for some time.
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