Citi analysts caution that the long list of global geopolitical issues poses significant threats to major portions of the world's oil supply, and the risk of an oil price spike may be significant in 2012.

Despite the risks, Citi analysts expect Brent (light crude) prices to be range from USD100/bbl to USD120/bbl, and average USD110/bbl in 2012 and USD120/bbl in 2013. Put simply, oil supplies could be constrained for the next two to three years as there doesn't appear to be enough supply coming to market to allow for unconstrained demand growth. Citi analysts estimate the world is operating with about 2.5 million barrels per day (mb/d) of spare production capacity, virtually all of which is in Saudi Arabia, with the rest scattered around other core Gulf Organisation of Petroleum Exporting Countries (OPEC) members.

Excluding supply disruptions, they expect to see a marginal increase in spare capacity, but the margin remains slim and the potential for disruptions is significant. These include oil-disrupting violence in Iraq; tensions between Israel and Iran; US sanctions and a European Union embargo on Iranian oil; sanctions on Syria; succession and the possibility of strife in Saudi Arabia; elections in Venezuela and Angola; and ongoing violence in Nigeria, Sudan and Yemen.

Citi analysts think oil supplies may be constraining global GDP growth, and this could remain the case until there is a paradigm shift - either oil demand falls due to a transition to more of a natural gas based transportation system in some key markets, or, more likely, shale, tight oil and deepwater production reach a scale that raises global supplies. However none of these are likely to happen over the next two years.

It appears we are now living in a crude oil-constrained world and oil prices may have to stay close to the 'pain point' to constrain demand growth. This pain point is estimated to be around USD120/bbl. At that price total expenditure on energy would consume about 9% of global GDP, a level that has historically been enough to cause the world economy to slow. Citi analysts recognise however that the pain point is a moving target as it is a function of the prices of other energy sources and of the general robustness of the global economy.

Possible spikes but likely unsustainable

The low level of spare capacity and the numerous risks to oil supplies make the odds of an oil price spike high in the view of Citi analysts. If it is a major disruption that drives prices higher, for example Iran attempting to block the Straits of Hormuz, then prices could potentially move north of USD150/bbl very quickly. Citi analysts do not expect them to stay there for very long as they believe that level is simply too much of a burden for the global economy and this could lead to a global recession which in turn would push oil demand and prices much lower.

Historically, oil price spikes resulting from supply disruptions have typically been followed by recessions - the 1973 OPEC embargo on the US resulted in a 300% price spike, which saw global GDP growth drop from 6.4% in 1973 to 1.5% in 1974 and 0.9% in 1975. Similarly, the Iranian revolution and Iran-Iraq war from 1978 to 1981 saw oil prices double and global GDP growth drop to an average of 1.3% from 1980 to 1982, versus a 4.2% average for the previous three years.

Given the already fragile state of the global economy (and the equally fragile state of investor sentiment), signs point to the possibility of strong negative feedback loops coming into play - and a similar outcome (global recession) cannot be written off even if the percentage increase in oil prices is lower. Given that oil prices are already close to the pain threshold for the global economy, Citi analysts think a reasonable estimate of a sustainable ceiling may be around USD120/bbl with some margin for currency movements cloud this target somewhat.

All in all, Citi analysts' base case is constructive for oil prices. Their bull case, to which they assign a 25% probability, is that one of the many possible geopolitical risks to supply comes to fruition - oil prices would spike higher and take a toll on the global economy. Their bear case comes from a disintegration of the Euro (an event assigned a 5% probability), or a hard landing in China. Either of these could cause oil to test long-term replacement cost support levels which they estimate at USD70-USD90/bbl.