Furthermore, any major conflict that would see Iranian production reduced to zero would have major spill-over effects. In the unlikely event that Iran did close the Straits of Hormuz, one of the market's "perceived threats," that would not only cut off the bulk of Iran's own oil exports, but it would also cut off the bulk of Saudi Arabia's exports. Around 20% of the world's traded oil, some 17 million barrels, passes through the Straits every day. Most of that oil comes from Saudi Arabia. The only alternative is to ship the oil across the country via the 745 mile East-West pipeline that dumps out into the Red Sea. The pipeline has a nameplate capacity of just 5 million barrels a day, half of the Kingdom's current production. In addition, oil exports from Iraq, Kuwait, and the UAE would be severely disrupted in such a scenario.
The chance Iran would close the Straits is very small as it would be the equivalent of committing economic suicide. But Wall Street seems to think that this scenario or something equivalent is plausible enough to go long the crude markets. This has created an upward spiral in prices.
Now, blaming speculators for high prices is nothing new. What is new is that one of the largest speculators in the oil markets, none other than Goldman Sachs (GS), admitting that heavy speculation does have an impact on oil prices. How much? Well, Goldman's oil analyst wrote in a note last month that every million barrel equivalent of oil futures that was net long the market adds 10 cents to the price of oil. The market is currently net long US benchmark crude, or WTI, by 258,406 contracts which is equivalent to 258 million barrels of oil. At 10 cents per every million barrels, that would mean speculation is currently adding $25.80 to every barrel of oil -- without the excess speculation, oil would trade at around $81.52.
This premium in the oil price is part market-specific and part fear premium. Passive investment funds that have a long bias, ETFs and commodity bulls keep the crude contract in the net long category usually all the time. The fear premium added by the Iranian situation has just exacerbated this distortion in the price. This fear premium will continue for as long as Wall Street is worried. So even if Saudi Arabia could flood the market with oil and plug any perceived supply shortage, it wouldn't make a difference unless this overhang in speculation is addressed.
The next time the President heads to the Middle East to discuss high oil and gasoline prices, he would be wise to make a pit stop on Wall Street.