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One buzzword – "tail risk" – is dominating oil markets and could have big implications for prices for 2012. If this year was marked by relative stability in crude prices, with oil trading in a narrow band between $100 and $120 a barrel in spite of turmoil in the Middle East, next year may be very different.

Oil traders and investors are bracing themselves for a rougher ride. In the trading rooms of London, New York and Geneva the talk is of tail risks, low probability events that have an outsize impact on prices.

The problem, says Daniel Jaeggi, head of trading at Mercuria, the Geneva-based oil trading house, is that these tails are "currently inordinately fat." On the one hand are intensifying fears over the euro zone crisis, a bearish factor. On the other, the continuing political turmoil in the Middle East could be bullish.

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"This means that the [price]outcomes could be substantially altered from the base case if any one of a number of low probability events materializes," he says.

Indeed, Antonie Halff, a veteran oil watcher and energy economist at the U.S. Department of Energy in Washington, says: "I have never seen a time when the expression 'fat tail risk' has been used more."

Free from such risks, the consensus among bankers, physical oil traders and hedge fund managers is for a base case oil prices scenario in 2012 of about $100 a barrel. This base case is founded on relatively healthy oil demand growth of about 1 million to 1.2 million barrels a day, compared with 1.2 million barrels per day this year. It also envisages OPEC, the oil producers' cartel, sustaining its output at the current three-year high of about 30 million barrels per day, and the end of the supply disruptions that have plagued the market this year in places such as the North Sea and Libya.

Yet, Ed Morse, head of commodities research at Citigroup in New York, warns that when it comes to tail risk events affecting oil prices, 2012 could make 2011 look like a "calm, normal" year. "While most of the known and knowable factors at work have a bullish cast, some of them are decisively bearish."

The biggest, and more bullish, tail risk is of heightened turmoil in the Middle East and north Africa and, increasingly, in Russia, the world's second-largest oil producer. An attack by Israel on Iran, for example, could push oil prices briefly towards $250 a barrel, according to some estimates.

Oil traders and investors have over the past month been busy buying "call" options, contracts that give the right to buy oil at a predetermined price and date, after the International Atomic Energy Agency said that the Islamic Republic had sought to design a nuclear warhead.

That buying has accelerated since France, Germany and the UK began pushing the European Union towards an oil embargo against Iran, dealers say.

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"We have seen persistent buying of out-of-the-money call options since October," says Chris Thorpe, executive director of energy derivatives at INTL FCStone in New York. Ray Carbone, president of Paramout Options, says: "The call options from $120 to $180 a barrel have seen sustained interest day after day since October."

The issue of Iran – whether it is the prospect of an EU embargo, an attack by Israel or Tehran moving first and closing the critical gateway of the Strait of Hormuz – is not the only geopolitical risk.

Analysts also point to the threat of a regional war were Syria to collapse, a turn for the worse in Libya, and even the risk that political turmoil in Russia around the presidential elections in early March could disrupt oil production.

But the upside price risks have downside risks pulling in the other direction, analysts say. Investors have bought protection against a bearish surprise through "put" options, contracts that give the right to sell oil at a predetermined price and date. The main "fat tail risk" on the downside is that a break-up of the euro zone triggers a new global recession that cuts oil demand consumption growth sharply. The global financial crisis of 2008-09 saw the first two consecutive years of falling consumption since the 1980s, driving oil prices briefly below $40 and forcing Opec to cut output to stop the price collapse.

Options dealers caution, nonetheless, that put options buying has not been as intense as the purchases of calls. "The upside price risk is still the main fear," says Mr. Carbone.

Besides the euro zone, investors are worried about a surge in oil production from Iraq. Baghdad plans to open a new export terminal in early 2012 that could boost output by at least 500,000 b/d by mid-year. The plan has suffered multiple delays. Yet, any increase, if not offset by lower output from other OPEC countries, could flood the market, particularly if demand slows.

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Another potential downside price risk is booming U.S. oil production from the newly developed shale oil regions of North Dakota and Texas. Some observers are betting on a large supply increase in 2012.

The collection of risks is just that, though. The oil market could weather all these scenarios and prices could stay range-bound.

Light sweet crude oil Monday ended just under $98 (U.S.) a barrel.

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