Anxiety Drives Oil Prices

How does political instability affect oil prices? Consider these recent headlines:

"British Sailors Seized in Persian Gulf -- Oil Jumps $4/Barrel"
"Israel Rumored to Offer Cease-Fire in Lebanon Campaign -- Oil Retreats $1/Barrel"
"Nigerian Rebels Attack Offshore Rig -- Oil Up $1.50/Barrel."

The logic seems simple enough: Political instability threatens to disrupt supply, which raises prices. While certainly true, this misses the bigger picture: Chronic political instability leads to underinvestment in production and undersupply.

Over the past few years, two sources of instability -- nationalization of oil assets and violence in producer countries -- have caused a deficit of upstream infrastructure investment abroad. As a result, capacity is flattening while demand grows unabated. This combination points to a growing risk of tighter markets and higher prices in coming years. But that will create investment opportunities.

Two Types of Suppliers

To understand the impact of instability on supply, you first have to understand the suppliers. There are essentially two types: (1) international oil companies (IOCs) and (2) national oil companies (NOCs).

IOCs are multinational publicly traded companies, like Exxon Mobil(XOM - Cramer's Take - Stockpickr), British Petroleum(BP - Cramer's Take - Stockpickr) and Royal Dutch Shell(RDS.B - Cramer's Take - Stockpickr).

IOCs possess advanced exploration, production, management and commercial expertise honed over decades of competition. They are usually integrated producers, meaning that they control and add value through the entire oil lifecycle, from ground to retail pump. What they do not have is very much oil. Today, IOCs possess less than 10% of the world proven reserves.

To see Keith Lieberthal's take on political instability and oil production, click here.