Seven months ago, I warned Fools to carefully watch relations between Iran and Saudi Arabia as both vie for power as the U.S. leaves Iraq. Three months ago, the situation heated up after the foiled Iranian government plot to kill the Saudi ambassador to the U.S. This month, Iran and Saudi Arabia have been publicly sparring over the West's plan to embargo Iranian oil. This continuing situation has me, my fellow writers, and Goldman Sachs convinced that a portion of your portfolio should be in oil stocks, as sky-high oil prices are not as far off as you may think.
Goldman Sachs' top commodity picks
Last week, Goldman Sachs' head of commodities research, Jeff Curie, revealed to investors the company's top commodity picks for the year. Goldman expects Brent crude to average $120 in 2012 but end the year high at $127 per barrel, a 14% increase over Brent crude's current price of $111 per barrel (WTI crude oil is just below $100 a barrel). While its expectation is only 13% higher, Goldman believes oil has "massive upside price risk relative to our target." In other words, Goldman believes oil prices could spike.
Oil price spike
Goldman's reasons for a possible spike are "the current environment, tight fundamentals, [and] the current geo-political situation in Iran." The big factor is the geopolitical situation in Iran. The U.S. has been pushing a plan among Iran's major oil customers to embargo Iranian oil over the country's nuclear program. As this chart from the Carnegie Endowment shows, these customers include the EU, as well as the large Asia-Pacific nations:
In retaliation, the Iranians have threatened to close the Strait of Hormuz, the gateway for 20% of the world's oil. The U.S. has said it will ensure the strait stays open. U.S. Defense Secretary Leon Panetta said, "We cannot tolerate Iran blocking the Strait of Hormuz, and that's a red line."
With all of this going on earlier this week, Saudi Arabia stepped forward and announced it would boost production by as much as 2.7 million barrels a day -- slightly above Iran's exports -- if there were a large drop in supply. On Wednesday, Iran warned Saudi Arabia against delivering more oil to compensate for a drop in Iranian exports if they are hit by sanctions. Iran's foreign minister said Saudi Arabia's promises "will create all possible problems later" between Saudi Arabia and Iran and said the promises are "not friendly signals."
While Europe has said that an embargo is not on the table for at least six months, as the Arab Spring has shown, conflict can arise very quickly. Iran's leaders are not the most rational, and as Mark Helprin stated in The Wall Street Journal: "To assume that Iran will not close the Strait of Hormuz is to assume that primitive religious fanatics will perform cost-benefit analyses the way they are done at Wharton. They won't, especially if the oil that is their life's blood is threatened."
Why this matters
Chaos and unrest have a much larger effect than most people realize. When large oil powers go through chaotic times, a significant amount of their oil-producing capabilities is lost for years. Often, these countries never return to the production levels they had before chaos started.
As the events in Libya last year showed, moderate drops in production can lead to large spikes in oil prices. The loss of Libya's 1.5 million barrels per day (total world supply was roughly 82 million barrels per day at the time) added an estimated $10 to $15 premium to Brent crude oil prices.
It is a big "if," in terms of if Iran and Saudi Arabia fall into chaos, but it's still worth pondering what could happen given that Iran and Saudi Arabia produce 4.2 million barrels a day and 11.5 million barrels a day.
While we can't know the future for sure, it's good to follow the Boy Scouts' motto of "be prepared." If the Strait of Hormuz was closed and a conflict erupted between Iran and its neighbors or the U.S., oil prices would spike.
Who's it bad for?
As fellow Fool Travis Hoium has noted, if the Strait of Hormuz were closed, oil shippers would be hit hard. There is already an oversupply of ships, and if 20% of the world's oil was stopped, Frontline
Who's it good for?
In a crazy year where the Dow Jones Industrial Average
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Dan Dzombak holds no position in any company mentioned. Click here and like my Facebook page to follow my coverage of the oil and gas sector. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.