HEDGING THE UNTHINKABLE

2016-04-18 5pm EDT  |  #oil #Iraq #Mosul Dam

Although most crude oil traders are focused on this weekend’s failure of the Doha talks, I thought I would take a moment to write about another potentially devastating catalyst for the oil market.

Before I start, I would like to point out at these levels, I am fairly agnostic about the future price of crude oil. But I believe there is a small chance for an out of the blue disaster that most market participants are not giving enough attention.

In 1981 Saddam Hussein began construction of Iraq’s largest dam. The Mosul Dam (also known as the Saddam Dam) was built in the northern part of Iraq on the Tigris river. It was not exactly a crowning piece of engineering (from wikipedia):

Because the dam was constructed on a foundation of soluble gypsum, the engineers recommended thorough grouting within the foundation before the superstructure was built. Instead, to speed construction of the dam, engineers blanket-grouted 25 m (82 ft) deep around the foundation and a curtain 150 m (490 ft) directly below the dam. A grouting gallery that would allow continuous grouting of the dam’s foundation in order to promote stability was also installed. Construction was complete in 1984 and in the spring of 1985, the Mosul Dam began to inundate the Tigris River, filling the reservoir which submerged many archaeological sites in the region. The power station began generating power on 7 July 1986. Because of significant structural stability issues associated with the Mosul Dam, ongoing grouting and additional construction and repairs are necessary.

Even in the best of times, this dam is a powder keg. Its poor construction means it requires boat loads of ongoing maintenance:

The earthen embankment dam is located on top of gypsum, a soft mineral which dissolves in contact with water. Continuous maintenance is required to plug, or “grout”, new leaks with a liquefied slurry of cement and other additives. More than 50,000 tonnes (49,000 long tons; 55,000 short tons) of material have been injected into the dam since leaks began forming shortly after the reservoir was filled in 1986, and 24 machines currently continuously pump grout into the dam base. Between 1992 and 1998 four sinkholes formed downstream of the dam and a fifth sinkhole developed east of the dam in February 2003 which was filled several times. In August 2005 another sinkhole developed to the east.

There is zero doubt that if this dam was in a modern Western nation, it would have been dealt with years ago:

In January 2016, U.S. General Sean MacFarland warned that the dam might undergo a “catastrophic” collapse. He added, “What we do know is thisif this dam were in the United States, we would have drained the lake behind it.”

Yet it’s not in the United States, but Iraq. To make matters worse, it’s in territory controlled by ISIS. Although the Iraqi government now controls the dam, over the past year it has slipped back and forth between ISIS and the government. But more importantly, it is extremely difficult for the Iraqi government to make the necessary repairs with fighting raging so close.

The consequences of a dam collapse are unimaginable.

Not only will the loss of life be catastrophic, but there is a real damage to a fair bit of Iraq’s oil:

There is a great Seeking Alpha article “The Mosul Damn - OPEC’s Unavoidable Supply Cut” by Middle East Medium that is a must read. The author goes through much more detail about the consequences of the dam failing.

Although I am not predicting the collapse of the dam, if the worse happens, oil will not go up by a couple of bucks. No, in the worse case scenario oil will be gapping $5 to $10 higher easily. It wouldn’t surprise me if it caused an even greater short term spike that almost seems ludicrous writing down.

There was a time Middle East instability caused oil to rise in price because of potential supply disruptions. Nowadays many oil analysts believe ongoing tensions cause the price to decrease as nations increasingly pump more oil in an attempt to cause damage to their neighbours (or steal more share for themselves).

The ensuing disaster from a Mosul dam collapse would unequivocally send crude oil prices soaring. This sort of Middle East tension is not the kind that sends prices lower. Too many traders have forgotten about the dangers of a supply disruption.

I sure hope I am worried about nothing, but that’s the best time to buy insurance. I am picking up some way out of the money calls on crude oil. I will be content if they end up being dust, but I don’t want to end up saying to myself “all the signs were there…”

Thanks for reading,
Kevin Muir
the MacroTourist