This Middle East Meltdown Will Send Oil to $300 a Barrel – and Pump Prices to $9.57 a Gallon

[Editor's Note: U.S. oil prices yesterday (Tuesday) hit their highest levels since September 2008 as investors reacted to fears that Middle East tumult would spread from Libya to such key Organization of Petroleum Exporting Countries (OPEC) as Iran and Saudi Arabia. But never fear: Even if the Middle East melts down and oil prices soar, there are moves you can make to hedge away your risk. We have two suggestions for you here.]

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The unrest in the Middle East oil patch is roiling the global oil markets on an almost daily basis.

The events in Egypt, Libya, Saudi Arabia, Oman and other countries are also forcing us to ask that long-dreaded question: What happens if the countries throughout the Middle East region fall to radical governments?

The answer is both stunning and surprising.

In an absolute worst-case scenario – if the entire Middle East falls under radical control – we could be looking at $300-a-barrel oil and pump prices of $9.57 a gallon. Definitely a stunner.

Here's the surprise: Even such a worst-case outcome would not result in the end of Western civilization as we know it. In fact, you can hedge against such a meltdown – just follow the recommendations that we detail below.


A "Model" of Chaos

The Middle Eastern and North African (MENA) countries produced 22.7 million barrels per day in 2010, rather more than U.S. consumption.

However, two of those countries can be left out of the equation. Iran already is run by radicals – any change there would be an upgrade. And Iraq is a democracy that's host to 50,000 U.S. troops; one must hope that a regional collapse would pass it by.

Realistically speaking, even if run by radicals, Middle Eastern countries will not stop exporting oil; they need the money. And it won't even matter if these countries refuse to export to the West: If their oil goes to China, India or elsewhere, it will simply be a substitute for – and therefore free up – oil that had been coming from other regions.

Now I will concede that a wholesale change to economically inept regimes in the Middle East will lead to reduced output. For instance, when the Shah Mohammad Reza Pahlavi was ousted in the Iranian Revolution of 1979, output fell from 6 million barrels a day to 3 million – a 50% decline.

A decline of a similar magnitude seems a reasonable assumption for Middle East countries that succumb to radicalism. If all of them except Iran and Iraq went radical, that would reduce global energy output by 9.9 million barrels per day – or 11.4% of last year's total world output.

It used to be very difficult to figure out how much price effect a supply shortfall might have, but fortunately we now have a "control experiment" to use as a model. I'm talking, of course, about the record-oil-price spike of 2007-08.

A Calculated Impact

Between the summer of 2007 and its successor in 2008, oil prices rose by 70% while U.S. consumption fell by 4% (when the year's modest economic growth is corrected for).

That means the "price elasticity of demand" – an economic term that measures the responsiveness of buyers to a change in price – is about 4/70. Plug that figure back into the supply shortage of 11.4% and you get a price increase of about 200% (Output Reduction of 11.4% x Price Elasticity of 70/4 = Price Change of 200%).

In other words, were we to have a "worst-case scenario" revolution in the Middle East, we would be looking at the current price of oil (about $100 per barrel) increasing by 200% – to about $300 a barrel (Current Price of $100/Barrel + 200% Increase = New Price of $300/Barrel).

You can quibble with the exact number: Europe has higher gas taxes than the United States, so would see less of a drop in demand than we would; emerging-market economies, on the other hand, are much poorer, and might well see an even-bigger drop-off in demand, perhaps even returning to bicycle transportation.

Even so, our $300-a-barrel estimate feels like a good round number that's backed by logic and a certain economic soundness.

Under such a scenario, we'd be looking at U.S. gas prices of about $9.57 a gallon – up from the current $3.19. The cost to the typical motorist – who uses about 500 gallons of gas – would be an additional $2,700 (assuming that his usage declined by 11.4%).

That's not enough to afford the payments on a $41,000 Chevy Volt, suggesting that government-backed schemes to shunt the citizenry out of their gas-guzzlers still remain uneconomic – even with crude oil at $300 a barrel.

The more-damaging economic impact would be on the U.S. balance of payments. The $265 billion that it cost to import oil in 2010 would balloon to about $800 billion. And that's including the decline in oil-related consumption that would result from the big surge in oil and gasoline prices.

Were this scenario to become real, we'd watch as the U.S. balance-of-payments deficit soared to more than $1 trillion. We might even see a collapse of the U.S. dollar – at the very least, an implosion of the greenback would be a very real possibility.

Pulling 4% of gross domestic product (GDP) out of the U.S. economy would absolutely tip us into a recession. And this second downturn would be somewhat deeper than its 2008-09 predecessor.

Inflation would also be a problem, probably rising into double digits as it did in the 1970s – essentially "stagflation," given the already-high unemployment rate the nation currently faces.

At this point, it would matter a lot what government and the U.S. Federal Reserve opted to do.

If the administration then in office followed the fiscal "stimulus" and ultra-loose money policies of 2008-10, the result would be economic collapse. The budget deficit would soar toward $3 trillion, and the shortfall would be impossible to finance: Nobody would want to buy that amount of U.S. Treasuries from a country with such a massive balance-of-payments deficit.

Meanwhile, with short-term interest rates 10% below the inflation rate, inflation itself would spiral into hyperinflation.

The result would be a total economic collapse.

Such a collapse would be avoidable with different policies. If interest rates were raised a few points above inflation, that would reward savers, and provide a brake on inflation. It would also produce a Reagan-era rate of job creation, as high interest rates would make it cheaper for employers to hire labor than to invest in expensive equipment.

Finally, reducing public spending and thereby reducing the deficit would also free up the capital markets and banking system for small business, normally the chief creator of jobs. Thus, in this scenario, the nasty recession would be brief, and would quickly give way to healthy, vigorous recovery with inflation declining.

Two Moves to Make Now

A broad revolution in the Middle East does not necessarily translate into a total economic collapse here. But how our country fares – and whether we avoid such a meltdown – completely depends on how our elected leaders and central bankers react.

No matter what happens, you don't have to suffer. In fact, as an investor, hedging against the possibility of a Middle East revolution is surprisingly easy. Just buy the Canadian tar sands oil companies Suncor Energy Inc. (NYSE: SU) and Cenovus Energy Inc. (NYSE ADR: CVE).

Energy analysts talk a lot about the "economics" of tar sands – industry jargon for "what level of oil prices allows tar-sands players to turn a profit?"

We could go through that math here, too. But we don't have to – for the answer is clear.

With oil at $100 a barrel, these stocks are somewhat expensive. But at $300, they're a steal!

Actions to Take: The unrest in the Middle East is on every investor's radar – especially now that oil is over the $100-a-barrel mark. But what happens if things really fall apart in a region that's home to two-thirds of the world's known crude oil reserves?

Well, under a worst-case (but not Doomsday) scenario, we could be looking at $300-a-barrel oil and $9.57-a-gallon gasoline.

Economic disaster, right?

Not necessarily.

Here in the United States, a lot will depend on what Washington does. But U.S. investors have choices. In fact, hedging against the possibility of a Middle East revolution is surprisingly easy. Just buy tar-sands stocks.

Everyone always talks about the "economics" of tar sands. Experts identify particular price levels of oil that turn tar-sands companies into viable – and profitable – businesses.

Under our worst-case scenario, this is irrelevant. With oil at $300 a barrel, make no mistake: These companies are profitable. Indeed, they're a steal.

We're recommending two in particular, to buy as hedges against a Middle East meltdown: And they are Canadian tar sands oil companies Suncor Energy Inc. (NYSE: SU) and Cenovus Energy Inc. (NYSE ADR: CVE).

[Editor's Note: Money Morning Contributing Editor Martin Hutchinson is a numbers man. His wealth of mathematical knowledge - paired with his financial expertise - has successfully guided him through 37 years as an international merchant banker. It also helped him calculate the global economic impact of Middle East political turmoil, and warn investors like you how to prepare.

Now you can benefit even more from Hutchinson's knack for numbers.

Hutchinson is using those same skills to help investors multiply their wealth by uncovering outstanding quality stocks with consistent high cash payouts. Just click here to read a report that details how you, too, can pull enormous amounts of money out of the global financial markets, or subscribe to his advisory service, The Permanent Wealth Investor.]

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Join the conversation. Click here to jump to comments…

  1. John Paul Masbaum | March 2, 2011

    I wish I knew how to play this, through mutual funds, not etf's, as my 401 brokerage acct. allows me to buy funds.

    Can this kind of information be covered by you insightfull folks?

    JPM

  2. Smeg | March 2, 2011

    MIDDLE EAST MELTDOWN?

    WESTERN PLIGHT?

  3. Steve comer | March 2, 2011

    good to see you not falling into the shale gas trap ,a fatal dinasaur response to energy , which
    will , absolutely spell our end , by destroying our eco -systems,,,,,,esp Water!!
    best solution is as you have identified it , and don't forget Albertas reserves( oil)
    imperative to this scenario is the accelerated development of alternatives
    ( see Gasland) for a peek at the devil itself,,,,, Steve

  4. Raymond Kordonowy MD | March 2, 2011

    I haven't been keeping up with the newsletters this past week so forgive me if this was addressed. I have a question regarding the Middle East crisis. As the system seizes the various leaders assets, what happens to the shares held in the sovereign wealth funds? How does this affect short and long term share prices?

    Thanks

  5. Richard Melucci | March 2, 2011

    Excellent article. But, did I miss the second move we should make? Or are you counting the two Canadian tar sands oil companies as two moves? Or is the second move obviously to buy gold?

    Thanks

  6. JohnS | March 2, 2011

    $10 gas??????? NOT going to happen in my lifetime in the USA!

  7. jr ewing | March 2, 2011

    hi folks!
    I also wonder should that be a hedging, to buy these two oiltar things? I don´t worry over middle east-I can´t long for ever-you also have kuwait and irak-they do not seem to have these trobles-this time?

  8. DD | March 2, 2011

    Gas is the one thing I would like to see on par with Europe. I would like to see a decent public transportation system be put in place in some of the major towns and cities within the US and I think a higher gas prices might force people to find alternative means of getting around. Sure there will be some losers in this, but if you drive for a living, a discount gas card of sorts might work so they can buy gas cheaper than someone who uses a vehicle just for personal reasons and convenience. Only in the US would someone sit in traffic for two hours + each way just to go to work!

  9. ken | March 2, 2011

    oil from the tar sands cost of production now ranges around $ 20 to $ 40 per barrel so $100 oil is making our country very rich its about time considering you took all our cheap oil years ago with your oil companies being here so now you can call us the blue eyed arabs of the north we also already pay near or over $ 5.00 for our gas thats how we pay for our roards and health care wake up america the party is over if oil stays high but i dont think it will its happened before many times and goes right back again

  10. Mike Dunn | March 3, 2011

    Martin: Give us a break. Before oil gets to $150/barrel the US economy will go into a double dip recession. Our economy is far more fragile than it was in 2007-2008 period. This downturn will be even more brutal than the one started in 2008. This time the Fed will have less weapons in their arsenal to fight this double dip. Congress does not have the necessary real desire to make the draconian budget cuts in order to revive this floundering economy. I agree it would probably would not hurt to buy Canadian oil sand stocks and Gold stocks such as my favorite GG-Goldcorp. I expect the regular stock market averages to be down 40%-50% by late summer-MED

  11. Mathew | March 3, 2011

    JohnS said, "$10 gas??????? NOT going to happen in my lifetime in the USA!"

    John, just because you don't want/think it will happen does mean it wont. Now put down your American flag.

  12. Alix Berenzy | March 3, 2011

    Please don't say turn to gas drilling. I live at ground zero in the Marcellus Shale. The government may be willing to sacrifice the water in our little region- but they would have to be truly crazy to contaminate NYC's water supply. Already there are law firms devoting themselves to suing on behalf of those whose well water has been ruined.

  13. Philip Beck | March 3, 2011

    We have all the proven oil and gas we need in the U.S. Why doesn't our government start openning up the drilling, since we do it more planet friendly than the Middle East does, and create jobs? More people working and paying taxes, less money funding countries who hate us!

  14. Steve | March 5, 2011

    The car manufacturers created our addiction to oil and the oil companies are the drug dealers supplying our antiquated method of transportation. Remember, GM and Ford destroyed the Tucker Car Company who was revolutionizing their industry. The oil companies, car manufacturers and bribed politicians are making sure that we stay addicted to their profitable crap. We all know that the technology is available to build a car that can be filled with water and run on clean burning and quite powerful hydrogen fuel. They try to scare us by saying that you would not be able to find a hydrogen filling station, but its a matter of simple electrolysis to separate the oxygen from the hydrogen in water. But the oil companies are surely suppressing this basic technology to keep us addicted and to keep their record profits in place. Furthermore, the bribed politicians haven't figured out a way to tax something that falls free from the sky during every rainstorm.

  15. Bob Pinkus | March 6, 2011

    There are very large reserves in the U.S. which were not mentioned in this article. Check Kent Moors' articles. Moors is much more experienced in this field than Hutchinson, who is unable to separate his extreme political beliefs from economic analysis.

    Why would any U.S. administration continue current monetary if we were experiencing inflation. They wouldn't. But in Martin Hutchinson's mind this fear seems reasonable.

    Drilling technology improvements which increase domestic production, increasing use of alternative energy sources and improved efficiency of autos will transform our energy infrastructure.

    In addition, there are multiple experimental energy production efforts happening. One such project is the multinational experimental nuclear fusion reactor (ITER) which will be operation in the near future and may be ready for commercial application within 25 years. Technological breakthroughs are very possible, even likely. They will completely change the equation.

    Beware of Martin Hutchinson's fear mongering.

    Beware of Money Morning! They consistently overstate how profitable their advice is for customers. Do research, don't assume their statistics are factual.

  16. Bob Pinkus | March 6, 2011

    Beware fear mongering.

  17. Bob Pinkus | March 6, 2011

    If oil goes over $150 we will see an avalanche of alternative technologies arise.

    Mr. Hutchinson consistently underestimates the creativity and entrepreneurial capacity of Americans and others around the world. Unfortunately, he is unable to separate his extreme political views from unbiased economic and social analysis.

    This type of oil spike could be a blessing in disguise.

  18. Alan Barringer | March 6, 2011

    Why is no one in goverment looking at Natural gas for transportaion? I have heard that we have enough for 100 years, we don't have to refine it, we can fill up at home in most cases. I just cant't belive this country""s energy plan???

  19. Curtis Cerenzie | March 6, 2011

    I agree with Beck. The focus should be on development in our country. We are number one in coal, uranium, nat gas, and oil. We have somewhere around a trillion barrels of oil shale, over 200 billion barrels of oil sands, and vast reservoirs of light oil in Alaska, North Dakota, and Texas.
    Everytime I hear an analyst say there's no point in opening new drilling because it will take too long, I want to throw my television! Tell the government to get off its behind and streamline the processes and rules!

  20. JOHN HILL | March 6, 2011

    As a partner in a medium size Venture Capital firm, we are always "sampling the waters" for thoughts from industry insiders. As of this time, NO ONE inside the oil/gas industry sees even $200.00 per barrell oil as the remotest option. All see Saudi Arabia as the leading moderating factor.
    Regarding the upstream processes for oil exploration, be on the lookout for TR Solutions and their analytical sytems. Their non-compete/non-disclosure agreement is about to expire with BP.

  21. Robert in Canada | March 6, 2011

    For a guy who claims to know so much about the oil industry, why does Martin Hutchinson keep describing the Canadian oil sands as 'tar sands'?

    There isn't any tar involved up there, it's just heavy oil mixed with clay and sand. That's why people who know anything at all about it call it 'oil sands' (oil + sand = oil sands).

    The term 'tar sands' was invented by the environut movement like Al Gore, David Suzuki, Green Peace, etc. to make the oil sands business appear like an evil monster that must be eliminated. This helps them raise more money from un-informed and mis-informed people.

  22. cherry | March 7, 2011

    response to Steve;- Long ago during the second world war a research centre in England developed a method of running cars and trucks on WATER … just as you said… lot of great research done out of neccessity ..including RADAR in those days BUT as usual commercial interests shut down competing technology. There was a top secret unit that verified viability of this. It may seem odd but as a child in 1938 I watched the "Lord Mayors Parade" in London England from the RCA Victor head office ON TELEVISION (in black and white) I could look out of the window and see the same thing on the T.V. but it was years before the commercial developement of this came to everyones home. PULL YOUR SOCKS UP AMERICA AND USE THE CREATIVE IMAGINATION YOUR COUNTRY HAS BEEN FAMOUS FOR!! To hell with the big buisiness Poo Bahs If you can go to the moon and make Nuclear bombs YOU CAN ALSO PUT YOUR BRAINS AND GUTS INTO SOLVING THIS PROBLEM…we should all have realised that being slaves to OIL has restricted our financial ,economic and diplomatic freedom for too many years…and I speak for ALL the countries dependant on oil…ENOUGH IS ENOUGH!! CANUCK CC

  23. jr ewing | March 8, 2011

    hi folks!

    this mid east thing – cynically – there are maybe some weeks with less production – so what?
    people behave like hens running for a fox!
    the economy should be more far looking, planning – the leftish are of course right – the borgouise are silly, as usual -that´s it…..
    currency, gold, silver must be the thing now?

  24. Jaap Schwarz | March 11, 2011

    The negative environmental effects of tar-sand oil extraction are enormous. The north american continent is abudant with shale gas. new techniques (gas-fracking) could bring this into exploitation, without the negative effects of fracking based on water injection. The subsequent liquefaction of(natural) gas will produce the perfect fuel for cars etc. The problem for the north american countries is not the lack of basic materials, but merely the power of the big oil companies. they want first returns on their oil contracts and prospects before they want to invest in new types of fuel. The US could be an exporting country. What a difference with the EU. We are chained to Russia, because we do'nt have a culture of exploration!

  25. Vito Buonomano III | March 13, 2011

    I read some of the garbage above from the expert oil know everything comments and I have to laugh.
    Very simple the US is not addicted to oil etc. and demand will continue to decrease if oil stays at its current price level or goes any higher.
    I do home and business energy audits in the North East and there is a strong willingness for people to reduce or totally eliminate their heating oil consumption because it is damaging their wallets. The amount of buildings in the North East with no pipe insulation is insane and the oil savings by adding pipe insulation to your average home or business is significant.
    If oil becomes cheap again like it was in this Country for decades consumption will increase. So watch out OPEC and Alberta Canada because in ten years your USA oil market will slowly fade away and hopefully the people and companies causing the environmental disaster in Canada will be held liable for mess they created in the name of greed.

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