The Middle East has a dramatic impact on the global price of oil...and today we've got visual proof!

I call it the 'Middle East Effect' - and over the past few years it's responsible for the majority of oil's major moves, including a recent pullback in prices.

So what's next for the Middle East Effect and oil prices?

Before we get our boots muddy in the Middle East, let's back up and take a look at how the oil market works. Consider it a crash course on crude!

As you know, oil makes the world go round. It keeps cargo ships moving, airliners flying, cars driving, electric turbines spinning and heaters, well, heating. Thinking in terms of your daily activities, it wakes you up, heats your coffee, starts your car, powers your computer, transports your dinner and heats your home so you can sleep sound at night.

With such a high impact on daily life, the oil market is a little more complex than just standard supply and demand. You see, most of the world-spinning factors listed above are planned well in advance.

After a visit to a Chevron refinery a few years ago, it's clear that refining is much more than just turning black goo into usable products. Instead it requires loads of planning and logistics. The same goes for power plants which, order their crude weeks or months in advance.

Crude is complex. So complex, in fact, that physical crude trades in what are called 'future' contracts. These future contracts add a whole new angle to the physical market - indeed, if a refiner needs to guarantee having oil six months from now at a known price, future contracts are the ticket.

But to figure out that price for future crude, there's a lot of speculation at play.

Speculation is a fancy word for guessing what the price of oil (or any commodity for that matter) will be at a specific point in the future. These educated guesses take everything into account, future supply and future demand - plus, for today's discussion, the likelihood of a disruption in supply.

For example, if Iran threatens to close the Strait of Hormuz the price of oil would spike. But this spike doesn't just affect the current price of crude, it also affect the price of futures contracts that refiners buy.

So you see, even though there may not be a real supply disruption in the crude market, the expectation of one can have a drastic effect on current and future prices. This is an important concept to keep in mind. But there's more to the story...

The Middle East Effect Revealed!

It should come as no surprise that Middle East supply has a lot of control over the price of oil. In that same sense, speculation about the stability of the region will also have a direct impact on prices.

But don't take my word for it, take a look at this:

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Over the past 24 months there have been four clear oil price trends that can be traced back to action in the Middle East. Starting in the spring of 2011 with the first rising of the Arab Spring and continuing through to more recent OPEC supply cuts, you can see that when the Middle East heats up crude prices follow.

But as you can also see from the chart above, when there's no real threat from the Middle East or North Africa, prices tend to fall back to their natural level - what appears to be a price baseline around $85.

Indeed, right now there's nothing fuelling the Middle East Effect. The latest news out of the region is rather stale - sanctions against Iran and OPEC oil cuts. That's yesterday's news. It's also a big reason we're seeing a substantial pull-back in oil prices lately. With no extreme turmoil or supply disruption in site, the Middle East fear premium is leaving the market.

So where do we go from here?

A Cycle of Violence

This all gets back to a concept that Byron King revealed last year. In short, many Middle East oil producers need a high price of oil to keep stability in their country.

'Without this oil price,' Byron says, 'there's not enough money to import food and other consumer goods, let alone to pay for the army and secret police - or the palaces and fancy jets.'

Naturally, that leads to a cycle of violence. High oil prices lead to stability, while low oil prices lead to future violence.

Take news out of Egypt, for example. Egypt is replacing its wheat buyer. And although this may not seem like big news, it's a drastically important position for Egypt's stability.

You see, Egypt imports over five million metric tons of wheat each year. The wheat is part of Egypt's mega subsidies for bread.

Without this government-paid-for bread, the public would riot - just look at what happened in Mexico when tortilla prices tripled in 2007. In Egypt, though, it could be much worse - with a subsidy cut, bread prices could rise by a factor of 20 or 50.

In particular, the government's wheat program delivers 80 billion loaves at less than a penny each. The program costs the Egyptian government $2.5 billion a year - that's a lot of dough. So in a very finite way, if Egypt doesn't spend $2.5B on bread subsidies the government can kiss stability goodbye. Uproars, riots, panic and violence would fill the streets.

It's the same across the Middle East. Sure, Saudi Arabia may not be giving bread to the public at a penny a pop but there are plenty of government-sponsored programs that keep the masses happy.

Truly, if you can't keep the people happy or pay the military, as a country you're in trouble.

This brings us back to the price of oil. Without a consistently high price of oil many countries in the Middle East wouldn't be able to pay their ever-growing list of subsidies.

What's the sweet spot for oil prices? Here's a look:

As you can see, the price that Saudi Arabia needs to keep the government coffers filled is right in the US$80-90 range. Anything below that level and turmoil will start to bubble up. Same goes for most countries in the Middle East.

A Short Term Outlook for Oil

So here's our short-term outlook for oil. The baseline price appears to be US$85, but with added Middle East volatility prices have been trading at a premium, anywhere from $10 to $30, to that baseline.

Today, with no direct threat of volatility in the region prices should continue to fall. But don't expect prices to drop too far below the $80-85 range.

That's because once prices drop to the low $80s, support mechanisms kick in.

First, supply tends to dry up - marginal producers like oil sand production (with breakeven costs around $60) won't have much incentive to produce oil.

Second, demand will kick in. With lower prices, buyers world-over will come to the market - Americans will drive more and the Chinese government will buy more, for example.

The last reason to rest-assured that prices won't go far below $80 gets back to what we talked about above. If oil prices drop too low, governments in the Middle East have trouble paying the bills. When the bills and subsidies don't get paid, people revolt. And just the hint of a Middle East revolution can bid the price of oil higher.

Plan on seeing oil in this range for a while. Prices won't get too high, but they won't go too low either. That's a great long-term price environment for efficient oil producers that are out of the Middle East danger zone.

Regards,

Matt Insley
for The Daily Reckoning Australia