Since last week when Israel decided that Hezbollah’s ongoing guerilla war against the Jewish state would no longer be tolerated, oil prices have dominated the financial news.  Stories of crude oil making new all-time highs are certainly capturing the attention of investors and speculators around the world today.

 

While this latest in a long history of flare-ups in the Middle East is certainly relevant geopolitically, unfortunately its importance for oil prices is being vastly overrated.  Neither Israel nor Lebanon produce or export any material amounts of oil.  No major oilfields, major pipelines, or supertanker routes on the seas are anywhere close to the current theater of operations on the Israeli-Lebanese border.

 

And, believe it or not, the oil markets reflect this irrelevance.  On July 5th, a week before the Israelis started their latest anti-guerilla campaign, oil closed above $75 to a new all-time nominal high.  Oil was still near $75 a week later when the Israelis decided to disarm Hezbollah once and for all.  In the subsequent two days as the operation intensified, oil climbed to just above $77, a modest 2.7% gain.  And that was it, oil has been weak since.

 

So while oil prices are definitely high today, only the last 2.7% or so, which has already bled off, can be directly tied to Israel’s anti-Hezbollah operations.  Oil has been climbing on balance all year, and it consolidated high between $70 to $72 in May and June during a very quiet time geopolitically.  $70+ oil is not a conflict-driven anomaly, but a valid fundamental reflection of tight global supplies and perpetually rising demand.

Gaining the proper perspective on market developments is absolutely crucial for traders.  The financial media is claiming Israel’s anti-guerilla campaign is driving the high oil prices, but oil had climbed above $75 on no news over a week before this latest crisis erupted.  And the media is also making a big deal of new all-time highs, a point that is technically true in nominal terms but misleading since inflation is not properly accounted for.

 

In order to better understand the oil market, which will vastly increase our odds of making successful trades related to it, we need to understand today’s oil prices within their historical context.  But this cannot be accomplished with standard price charts.  Over decades prices get distorted by the Fed’s relentless inflation of the fiat US dollar supplies.  In 1980 $20 was worth something but today it can’t even buy a decent lunch.

 

So this week I built real oil charts denominated in constant 2006 dollars.  They show the oil price since 1970 through the same purchasing-power lens through which we view the world today.  The US Consumer Price Index, which understates inflation for political reasons, was used to reflect the perpetually declining value of each US dollar.  This makes these real oil charts conservative to the low side compared to where they would be if true monetary growth was used as our inflation proxy as it ought to be.

 

I used daily oil data back to 1983, as far back as we have it, and then spliced in monthly oil prices before that.  And of course the CPI is only released once a month, so the inflation calibration of nominal oil prices is done monthly.  The resulting charts are pretty interesting though and really helped put oil into its proper perspective for me.

 

Today’s high oil prices, which are nowhere close to all-time inflation-adjusted records yet, are not anomalies driven by geopolitical unrest.  The real oil history shows what true geopolitically-driven spikes look like and that the modest 2.7% gain we saw in oil last week when Israel started looking for its kidnapped soldiers was trivial.  Traders need to understand oil in strategic perspective, to not be swayed by prevailing media biases utterly dominated by a chronic short-term worldview.

 

These four charts detail this crucial-to-grasp real history of oil.  Inflation-adjusted oil is rendered in blue and joined by the usual accompanying key moving averages and Bollinger Bands.  And the normal nominal oil price, not adjusted for inflation, is charted in red.  If you internalize and understand these real oil charts, you will help immunize yourself against media distortions and have a higher probability of trading oil profitably.

 

 

Relative to the last 35 years or so, oil prices are absolutely high today.  But when adjusted for inflation, they remain far short of the $99 per barrel all-time real high of April 1980.  In fact, oil traded above today’s levels in 2006 dollars from September 1979 to December 1981, over two years.  Thus it is extremely misleading for the financial media to report on “all-time highs” today but ignore the tremendous inflationary distortions of the past quarter century.  Yes oil is expensive, but it has certainly been worse.

 

The other key point from this overview chart is that oil’s current bull market is not a spike.  It is driven by global supply and demand fundamentals, not geopolitically-driven crises.  These fundamentals include dwindling production in the best oilfields of past decades, few major new oilfields being found, global production shifting towards harder-to-refine heavier and higher-sulfur oil as the preferred light-sweet crude is exhausted, and the enormous demand created by the unprecedented industrialization of Asia.

 

The handful of true geopolitical spikes above, in 1973, 1979, and 1990, highlight what a true geopolitical crisis can do to the oil price.  The modest gains in oil last week on the Israeli campaign were trivial and immaterial compared to a real geopolitical spike.  And the new oil bull is rising in an orderly manner typical of fundamentally-driven prices, not the instant stratospheric push that extreme geopolitical unrest can spawn.

 

Since the next three charts zoom in on the 1980s, 1990s, and our current oil bull, I’d like to use this first oil overview chart to remember the 1970s, a time of truly geopolitically-driven oil supply disruptions that had massive price impacts.  Pondering the 1970s can offer a lot of perspective today on just how crazy geopolitical crises really have to get in order to drive oil prices sharply higher.  We aren’t even close yet!

 

Some historical background is necessary to understand geopolitical crises and their impact on oil prices.  The following developments continue to shape oil prices worldwide to this very day.

 

The modern state of Israel was founded on May 14th, 1948.  Since the Prophet Muhammed didn’t like the Jews and attacked this “People of the Book” 14 centuries earlier in his Qur’an, the Muslim governments weren’t thrilled about the Jewish state despite 78% of the original territory allocated to a Jewish homeland already going to Palestinians in the form of Transjordan.  So the very next day on May 15th Lebanon, Syria, Iraq, Egypt, and Transjordan simultaneously invaded Israel with the express goal of wiping it off the map.

 

Amazingly Israel miraculously fought off its hostile neighbors and won.  The invading Muslim governments were furious and embarrassed that a tiny upstart country without a real army was able to beat them, so their hate for Israel simmered.  Tensions erupted again in 1956.  Egypt nationalized the crucial Suez Canal and banned Israeli shipping through it.  So Israel invaded Egypt to take the canal in a highly successful, at least in pure military terms, operation.

 

Since Egypt couldn’t fight Israel militarily, it went through diplomatic channels to force Israel to withdraw from the Sinai Peninsula after the 1956 crisis.  By the early 1960s Syria was launching guerilla raids into Israel and a low-intensity conflict on Israel’s northern border was brewing.  In late May 1967, Egypt closed the Straits of Tiran to all Israeli-flagged ships.  The US and UK had guaranteed the straits would remain open to Israel as part of the 1957 settlement that led to its withdrawal from Sinai.

 

By late May, Jordan joined the anti-Israel military alliance between Syria and Egypt.  A few days later, Iraq joined.  Hostile armies amassed on Israel’s borders once again.  Israel saw the writing on the wall and launched a pre-emptive strike on the Egyptian Air Force in early June 1967.  This strike took out over 2/3rds of the Egyptians’ combat aircraft and ensured Israeli air superiority.  Israel launched operations over the next few days and seized the Gaza Strip, the Sinai Peninsula, the West Bank, and the Golan Heights.  These new territories gave Israel more strategic depth against the inevitable Muslim invasions.

 

This Six-Day War in 1967 had a profound impact on oil prices in the following decades.  The defeated Muslim governments were once again embarrassed and bitter.  They started working to turn the Organization of Petroleum Exporting Countries, which was founded in 1960, from a cartel into a major political force.  OPEC was hijacked by its Arab members with the express purpose of exerting pressure on the West over its support of Israel.  The Muslim nations decided to use oil as a weapon against Israel’s allies.

 

In October 1973, on the holiest day in the Jewish calendar Yom Kippur, Syria and Egypt launched another simultaneous surprise invasion of Israel.  The Syrians and Egyptians made good progress into Israel in the first day or two, but then Israel rallied and fought back.  Within a week, the Syrian invaders were driven out and the Egyptian invaders had been flanked and encircled.  Emergency US airlifts into Israel helped it replace its munitions and equipment used to repel this surprise 1973 invasion.

 

US resupply efforts began on October 13th, a week after Syria and Egypt invaded Israel.  A few days later on October 16th, the Arab countries of OPEC cut production of oil and embargoed oil shipments to the West, particularly the United States.  Saudi Arabia, Iran, Iraq, Abu Dhabi, Kuwait, and Qatar raised their oil prices by 17% and slashed their production.  This oil-as-a-weapon campaign soon deepened in early November as Arab producers announced another 25% output cut and threatened 5% more.

 

This Arab Oil Embargo, a consequence of Syria’s and Egypt’s failed 1973 surprise invasion of Israel, led to the first major geopolitically-driven spike in oil.  From July 1973 to January 1974, the Arab production cuts designed to punish the United States for supporting Israel drove oil prices up 170% in real terms!  Where oil had been trading near $16 per barrel in 2006 dollars in the summer of 1973, by early 1974 it broke $44 real.

 

These events, while largely forgotten today, are very important to consider.  The oil crisis of the 1970s began because two Muslim nations invaded Israel to make another go at wiping out the Jewish people.  The Israelis fought back, won, and repelled the Muslim aggressors.  So Muslim oil-exporting countries, furious at yet another crushing defeat by the Jews, slashed their oil production to punish Americans for supporting our ally Israel.  OPEC directly attacked the American people economically in the 1970s for a war we did not fight that happened to be started by Muslim nations.

 

Oil prices then stabilized around $40 to $50 real for the next five years or so.  These prices were vastly higher than the high-teens real prices of the early 1970s and they spurred more oil production worldwide.  But in early 1979 the Shah of Iran fled his country and the hardcore Islamist Ayatollah Khomeini seized control.  Protests that drove out the Shah spilled over into oil infrastructure and decimated Iranian production capability.  When the Khomeini regime resumed oil exports, Iran’s volume was much lower and inconsistent.

 

This Iranian Oil Crisis really shouldn’t have been so bad, as other nations like the Saudis expanded their production to offset much of lost Iranian production.  Overall about 4% of global production was lost.  But in the US the Carter Administration implemented disastrous price controls that exacerbated the supply shock.  Oil soared from $44 in today’s dollars in January 1979 to $99 real by April 1980, a massive 124% real gain!

 

These 1973 and 1979 oil crises really help put the past week’s oil developments into perspective.  Last week oil climbed less than 3% on Israel’s anti-Hezbollah campaign.  This is trivial, literally nothing, compared to the 1973 real 170% spike driven by a full-blown Middle East war and the 1979 real 124% spike driven by the fall of the government of a major oil exporter.  And Israel is not an oil exporter, so if OPEC decides to use oil as a weapon once again it should be considered as an unjustified Muslim economic attack against the West.

 

There is one final point I would like to make on this long-view strategic chart.  Between 1986 or so to 2003 or so, oil largely traded in a loose, multi-decade consolidation between $20 to $40 real.  This huge base is the technical foundation under our current secular bull market in oil.  Because this base was so low though, it did not provide high-enough profit margins to drive extensive oil exploration.

 

If oil prices had been higher in the late 1980s and 1990s, global supplies would be higher today, OPEC’s production would be proportionally smaller relative to global production, and oil prices would not be this high.  Due to pure supply and demand, we all need to realize that high oil prices are necessary to ensure companies take the immense risks to find future supplies.  High oil prices today ensure adequate oil tomorrow, they are essential.  But we are now paying the piper for low oil prices in the late 1980s and 1990s.

 

 

The oil action of the early 1980s is extremely interesting.  After the Iranian crisis drove oil to nearly $100 a barrel in today’s dollars, oil prices gradually started to decline until late 1985.  For the most part they even stuck to a tight real downtrend channel.  This slow retreat, radically asymmetrical compared to the blisteringly fast geopolitical spikes of the 1970s, shows that there were very real supply issues under the high oil prices of the early 1980s.

 

But just like today, high oil prices then were good and necessary in order to spur exploration and increased production to return future prices to more normal levels.  As the early 1980s marched on, global oil production gradually increased which gradually drove down prices as world supply growth outpaced demand growth.  This is exactly the way free markets are supposed to work, higher prices lead to higher supplies which then reduce the higher prices back to more normal levels.

 

I think this early 1980s decline also illustrates a key principle very relevant to investors and speculators today.  Exploring for oil is immensely challenging, expensive, and time consuming.  And once major oil deposits are found, bringing them into production takes vastly more capital and additional time.  The lead time between high prices spurring companies to increase production and actual production increases hitting the markets is usually many years.

 

So odds are we are not going to see a price collapse when our current oil bull ends at some point years in the future, but a gradual decline of the oil price at best kind of like we see above.  And of course the situation today is radically different so our current bull could last many more years or even decades.  Conventional oil is getting harder to find, global peak light-sweet-crude production may be past already, and Asia remains in its early stages of industrialization with still very low per-capita oil demand compared to the West.

 

The most fascinating and important part of the 1980s occurred in early 1986.  Oil prices collapsed, crashed really, plummeting 67% from $59 real in November 1985 to $19 real in March 1986.  When the bottom fell out of the oil prices, it ripped the oil industry to shreds.  Mass layoffs happened, exploration stopped, and oil infrastructure was largely neglected from then until just a few years ago.  This 1986 price collapse, in a very real sense, is the reason why we don’t have adequate global oil supplies today.

 

How did it happen?  Blatant market manipulation.  By the middle of 1985, the oil industry saw clear sailing ahead.  Going forward oil prices were expected to fluctuate between $40 to $60 in 2006 dollars, a healthy level that would ensure continuing oil exploration and new supplies coming online.  But all was not well within the OPEC cartel.  Many OPEC members were violating their OPEC quotas, overproducing oil.  This increased their marginal profits temporarily, but the added supplies were putting pressure on oil prices.

 

Saudi Arabia, of course, is the 800lb gorilla of the oil world.  It wanted to hold the line with OPEC production and not flood the market with oil.  Yet its fellow OPEC members continued to overproduce.  For years Saudi Arabia cut its own production, which helped stabilize oil prices but hurt it.  After cut after cut in the early 1980s, Saudi oil revenues were off 75% and its market share was rapidly shrinking.  If the House of Sa’ud kept reducing production to offset other OPEC members’ quota cheating, it would eventually be out of business.

 

So the Saudis warned the world many times in 1985, if the OPEC nations kept cheating on their quotas and non-OPEC sources continued to flourish, the Saudis would not tolerate it.  Since Saudi Arabia had the lowest cost of production in the world, it could afford to see oil prices go far lower than every other producer.  It threatened to open its taps and flood the markets if OPEC didn’t hold the line.  OPEC blew off the warnings so the Saudis opened their production floodgates.  Within months oil had utterly collapsed.

 

While the Saudis acted rationally in their own self interest, their manipulation sliced the throat of the oil industry.  With real oil prices back down to early-1970s levels, most oil exploration ground to a halt.  Saudi market share increased as fewer other sources could compete with them on price, but this Saudi gambit stunted new supplies coming online for almost 15 years.  Low prices provide no incentive to explore and produce so new supplies were not searched for and brought into production.  The entire industry rusted.

 

So if today’s high oil prices are a response to artificially low oil prices in the 1980s and 1990s that led to capital abandoning the search for oil, then more than anyone else the House of Sa’ud is the responsible party.  I bring this up because the US media is implying today, falsely, that Israel’s operation in southern Lebanon is keeping oil prices high.  Israel’s action of the last week is irrelevant though and oil prices are high today for complex historical reasons, not minor geopolitical crises.

 

 

In the 1990s oil remained weak, slowing meandering between $40 real to $20 real for the most part in subsequent trends.  The one exciting exception was the First Gulf War.  In August 1990 Iraq invaded Kuwait, under the pretense that the Kuwaitis were slant-drilling underneath the Iraqi border to tap Iraqi oil.  At the time oil skyrocketed as fears exploded that Saddam Hussein would continue to roll his armor south into Saudi Arabia and seize the richest oilfields in the world.

 

From June 1990 to October 1990, oil rocketed 157% higher from $24 real to $61 real, a massive increase.  Once again this highlights just what a true geopolitical oil spike looks like.  Much of the world was not thrilled with Iraq annexing Kuwait and the US began to assemble a coalition to repel the Iraqis.  The US liberated Kuwait in early 1991 once enough American forces were in the region.  By January 1991, oil prices had once again returned under $30 in 2006 dollars.

 

This short-lived massive spike offers some important lessons relevant to today’s oil prices.  In 1990, oil rocketed because a Muslim nation annexed another Muslim nation.  Even though Iraq tried to suck in the Israelis by raining missiles on Israeli cities in order to ignite another wider Middle East war, Israel did not respond and stayed out of the conflict due to heavy US pressure.  Israel was not the cause of the 1990 oil spike and is not responsible for high oil prices today, despite media insinuations otherwise.

 

Geopolitical spikes, when they happen, will not last unless there are true fundamental reasons under the spikes.  The First Gulf War spike collapsed so rapidly because Kuwaiti oil production was not damaged as much as feared and Saudi oilfields escaped unscathed.  If the Iraqis had done serious damage to Saudi fields, the oil price would probably have just slowly declined as production was gradually brought back online.  High oil prices driven by geopolitical crises are only temporary unless true underlying supply issues exist.

 

Since oil prices have been climbing relentlessly since late 2001, and not spiking, it should be obvious to all market participants that this is not just a speculative panic.  Global oil supply growth is just not keeping pace with global oil demand growth and prolonged higher prices are the only way this undesirable situation will be rectified.  Sustained higher prices driving increasing production are the only force that can ultimately drive down these higher prices.

 

For the rest of the 1990s oil prices largely remained under $30 in real terms, providing little or no incentive to search for new oil supplies.  In 1997 and 1998, oil prices started falling lower at a faster pace.  This cyclical bear market was brutal enough to drive oil back down below early 1970s levels in inflation-adjusted terms.  With oil languishing at the equivalent of $13 in today’s dollars in December 1998, why even bother producing the stuff?  Gasoline at the time fell under $1 at the pump yet few if any Americans cared about future oil supplies.

 

This time, not surprisingly, proved to be the ultimate secular low of the multi-decade oil bear.  At the time, oil analysts were convinced that vast new oil supplies from Russia and former Soviet territories were going to come online so the oil price would remain low indefinitely.  As always at major turning points though, just when the majority thinks an existing price trend will continue forever is just when it is ready to change.  With oil prices well below the cost of production in most of the world’s oilfields, something had to give.  A new bull market was born.

 

 

If oil hadn’t been driven so low in the late 1990s, we would have more producing oilfields around the world today and hence greater global oil supplies and lower prices.  But largely thanks to the Saudi stunt of 1986 in crashing world oil prices, the oil industry could not find enough capital to explore at a large scale and infrastructure rusted.  The only remedy to restore supply growth was for oil prices to rise for many years.

 

And this is indeed what has happened since.  Oil initially started climbing in 1999 and 2000 but then succumbed to a rather strong cyclical bear in 2001.  But by 2002, the primary ascent phase of our latest secular bull market in oil was underway.  The most important observation to note here is that this bull has been ascending in a conservative and orderly manner.  Oil is gradually moving higher because demand growth is outstripping supply growth.  Middle Eastern tensions probably had little to do with the oil bull of the last five years or so.

 

I hope this brief survey of modern oil-price history helps you put today’s oil prices into perspective.  Oil prices are high today, but they are nowhere near the $100ish per barrel all-time real highs of early 1980.  And back in the early 1980s when global supplies were vastly more favorable than our tapped-out world today, real oil prices remained above today’s levels for over two years straight.  It takes a long time to bring new oilfields into production and this process only begins after companies become convinced high prices are sustainable.

 

And technically the conservative and orderly bull market in oil so far in the 2000s looks absolutely nothing like the sharp crisis-driven oil spikes of the 1970s and 1990.  This shows that our current bull market in oil is a true fundamentally-driven bull.  Global demand growth for oil, especially out of Asia, is dwarfing the world oil industry’s ability to keep pace with supplies.  Oil infrastructure was neglected for about 15 years after the Saudi-engineered crash in 1986 and it will probably take a similar period of high oil prices to rebuild it.

 

And despite media insinuations otherwise, Israel has nothing to do with today’s high oil prices.  In 1973 the Muslims decided to use oil as a weapon to punish Western consumers because our governments supported Israel.  But in 1979 a radical Muslim regime replaced a moderate Muslim regime in Iran and oil skyrocketed.  Israel wasn’t involved.  In 1990 a Muslim nation annexed another Muslim nation.  Israel wasn’t involved.

 

Even if Israel didn’t exist, the Muslim oil-producing countries of the Middle East are generally unstable for a variety of reasons and their internal and external strife, totally independent of Israel, is the biggest geopolitical risk for another massive oil spike.  Blaming Israel, a non-exporter, for high oil prices is absolutely ridiculous.  It is an amazing irony of history that the world’s most accessible oil exists in a region with some of the world’s most corrupt governments lavishly enriching themselves at their peoples’ expense.

 

With high oil prices likely here to stay for pure fundamental reasons even if by some miracle there is never another war or revolution in the Middle East, prudent investors and speculators can earn mighty profits in them in the years ahead.  Investors can buy elite oil stocks today at incredibly low valuations under 10x earnings.  For some reason oil stocks are still priced as if $40 oil will exist forever.  It is silly and this anomaly won’t persist.  Speculators can leverage the coming oil stock gains even more with oil-stock call options.

 

If you are interested in riding this young oil bull, we periodically invest and speculate in promising oil stocks when technical conditions reveal good entry points.  Our acclaimed monthly Zeal Intelligence newsletter details the actual trades, and the logic and timing behind them, when we make them.  Please subscribe today!  And we have been trading extensively, and very profitably, in oil-stock call options in our Zeal Speculator alert service for active speculators.  Vast profits will ultimately be won in this oil bull.

 

The bottom line is the recent media reports on oil are woefully distorting the real situation.  Oil has been in a conservative and orderly bull market for supply and demand fundamental reasons since at least late 2001.  A week before this latest conflict involving Israel it was already above $75.  Today’s oil price environment has nothing to do with Israel.  High oil prices will persist until global supply growth catches up with demand growth.

 

And while oil is definitely high in real terms, it can always go higher.  It was higher for years in the early 1980s in 2006 dollars and it ought to head higher today to drive more exploration and production.  Investors and speculators who keep this fundamental foundation in perspective ought to reap fortunes in this powerful bull.

 

Adam Hamilton, CPA

 

July 21, 2006

 

So how can you profit from this information?  We publish an acclaimed monthly newsletter, Zeal Intelligence, that details exactly what we are doing in terms of actual stock and options trading based on all the lessons we have learned in our market research.  Please consider joining us each month for tactical trading details and more in our premium Zeal Intelligence service at … www.zealllc.com/subscribe.htm

 

Questions for Adam?   I would be more than happy to address them through my private consulting business.  Please visit www.zealllc.com/adam.htm for more information.

 

Thoughts, comments, or flames?  Fire away at zelotes@zealllc.com.  Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally.  I will read all messages though and really appreciate your feedback!

 

Copyright 2000 - 2006 Zeal Research (www.ZealLLC.com)