Back to the Future: New Middle East Looking Less “New”

For much of 2012, turmoil in the Middle East has provided a major support to international oil prices. But the inclination to diplomacy that gripped the center stage of several conflicts in the last week or two may be signs that oil market supply and demand fundamentals might reassert themselves, potentially bringing lower prices in their wake.

Markets have been gradually moving in supply surplus mode with non-OPEC supplies recovering and the intermediate term outlook for China’s economy still in question. If diplomacy continues to be the chosen path in the Middle East, traders may increasingly focus themselves on the long term potential of oil production from shale and LNG’s potential to take market share away from oil in the U.S. transportation sector. That would mean a gradual price decline to match changing fundamentals could assert itself. Several oil majors, in addition to Shell and Clean Energy, are making investments to get into the game of fuel for LNG trucks and the possibility to move LNG into other transport markets such as rail or marine is said to be equally, if not more, promising.

The most interesting thing about Israel’s skirmish with Hamas earlier this month is that the kind of dangerous escalation that might have been expected in light of political change sweeping across in the Middle East did not materialize. Instead, major players reverted back to traditional, historical roles, with Egypt and the United States leading conflict resolution diplomacy. The ceasefire between Israel and Hamas also came against the backdrop of other diplomatic efforts to convene a major multinational conference on denuclearizing the Middle East, a gathering aimed at resolving the Iranian nuclear standoff with the West peacefully.

All that shuttle diplomacy was then followed by an even more surprising announcement, in the post Israel-Hamas ceasefire euphoria, that President Mohamed Morsi of Egypt was exempting his Presidential decrees from judicial review until the ratification of a constitution. Morsi’s declaration was interpreted by many, including the Egyptian street, as a roll back on the principles of the Arab Spring and a return to the normalcy of authoritarianism.

Taken alone, these events might seem to be pointing to an eventually easing off of the war premium in oil prices. Indeed, financial players have been liquidating perhaps worrying that negative economic news will now outweigh Middle East developments. Even today’s rumors about the failing health of King Abdullah of Saudi Arabia did not give oil markets an upward lift.

But the path to a diplomatic solution with Iran might prove illusory, since it was Iranian television in the first place that has been promoting false rumors of deaths of senior Saudi officials over the past several months. Regional instability works in Iran’s favor by decreasing the chances of a major loss of proxies in Syria, Lebanon and elsewhere. The West will have to assess how to distinguish the difference in appearance between what “crying uncle” in Tehran would look like vs the usual game of buying time by calling for negotiations. In the meantime, oil traders might be tempted to look at rising U.S. oil production and throw in the long position towel.