A “political risk” approach to oil pricing and “failures” to produce

A “political risk” approach to oil pricing and “failures” to produce

Mar 3rd, 2011

Based on data to be found in the CIA world factbook  it is easy to find how oil production is shared world-wide among single oil-producing countries. Those are for example members of OPEC. At the end of this post we have added a short summary table with a selection of North African and Middle East producing countries. We present a “political risk” approach to oil pricing and “failures” to produce in this blogpost.

Numerous articles have recently shown up in the media talking about risks, “political” risk, production failure, oil shortage, etc. The trigger was the crude production variability, due to political, social turmoil and crisis in the Arab World. The region of interest spans from North Africa to the Middle East, Iran. The volatility  has stirred a sudden increase of oil price, bringing back concerns and fear of recession in the West,

Remarkably few articles use proper technical glossary and, as a result, many are confusing and actually misleading.

Allow us to clarify. The risk, in case of oil production “failures”, can be evaluated as the combination of the chances a specific country would stop/reduce supplying (for a number of reasons from internal turmoil, to perfectly legitimate political reasons…we will expand later on this) and the consequences of that “failure”.

Just looking at the daily production does not bring any value to the discussion

Like for any “accident”, the cost of consequences would be made of various components. Let’s say in the case of oil:

a) “factual impact” because of shortage

b) “perception impact”, or let’s call it “fear factor”

c) “speculative impact” or “greed factor”.

In the case of Libya, which produces a very small percentage of worldwide supply, we would tend to say that “fear factor”and “greed factor” constitute the largest portion of the price hike we have seen occurring in the markets. For other countries we would probably come to different conclusions. However, at the end of the day we would probably recognize that the global impact could be estimated as a non-linear function of countries’ production.

We can build that function and it does not need to be a “precise function”. An optimistic and pessimistic curve will operate for the sake of proper risk analysis.

What about the probabilities

Here again, no serious professional would dare to come out with a single number. However, a sensible application of available tools and methodologies can lead to define relative likelihoods among the producing countries.

The beauty of looking at relative values is that, as shown many times, we humans are better in defining relative estimates, rather than absolute estimates. For example: we can easily tell if a person is heavier than another, but we are at loss to tell the weight of a single individual out of the blue.

Now, once we have probabilities estimates (min-max, for example) and “impact estimates” (pessimistic-optimistic) on the price of crude, we can plot them on a likelihood-consequence (risk) diagram to deliver a clear representation of the risk situation (numerous posts in this blog deal with this type of plot).

You would be amazed. The results may be very different from what you’d expect. That is because we, humans, are not good at thinking at two metrics simultaneously! Risk is not an intuitive matter.

Methods exist, they have been applied to other industries, they DO work.

How come we do not use them when we need to have a better vision of our global risk environment?

World ranking by oil production Country/Region Oil — production(bbl/day)
2 Saudi Arabia 9,764,000
4 Iran 4,172,000
7 United Arab Emirates 2,798,000
9 Kuwait 2,494,000
10 Iraq 2,420,000
12 Algeria 2,180,000
18 Libya 1,550,000
20 Qatar 1,208,000
24 Oman 806,000
28 Egypt 630,600

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Category: Hazard, Risk analysis, Risk management

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