Is the Oil Market About to Endure a Rough Ride?

Published May 21st, 2018 - 07:52 GMT
Geopolitical shocks have been a recurrent theme in the international oil market. (Shutterstock)
Geopolitical shocks have been a recurrent theme in the international oil market. (Shutterstock)

President Donald Trump's decision to withdraw from the Iran nuclear deal and reimpose financial sanctions on Tehran will have a profound impact on the global oil market.

Since Brent rose to $77 once Trump ignored the pleas of France's president and Germany's chancellor and unilaterally broke an international agreement, the geopolitical risk premium in crude oil can only rise. Iran's exports to Europe and even Japan/South Korea will collapse. This could mean the loss of 500,000 barrels of crude in the wet-barrel market. Iran will also resume its nuclear programme, setting off a new arms race in the region. It is no surprise that hedge funds are long 1 billion barrels in oil futures, options and swaps. The oil market is already tight since Venezuela's financial meltdown has meant the loss of 500,000 barrels. Libya, Nigeria and Angola are also producing below targets.

Saudi Arabia now faces a strategic dilemma. Even though it brokered the oil output cut deal with Russia that removed 1.8 million barrels a day of crude oil from the global market, it does not want an oil spiral that could trigger an economic recession in the West. As America's key ally in the Middle East, it could be forced to increase output (the kingdom's spare capacity is almost 3MBD, especially since Trump tweeted that the Opec 'artificially' raised the oil price, a situation 'unacceptable' to Washington. The geopolitics of black gold will determine the price of Brent.

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Geopolitical shocks have been a recurrent theme in the international oil market. President Nixon's resupply in the October 1973 war in the Sinai/Golan Heights led to Saudi King Faisal's 'oil embargo' and a fourfold increase in oil prices. When the Shah of Iran lost his Peacock Throne in 1979, crude oil prices rose from $18 to $45 even though the Iranian oilfields were a mere 4 per cent of global supply. In August 1990, Saddam Hussein's invasion of Kuwait triggered an oil panic, global stock market crashes and recession in the US and Europe. I lived in New York in the early 1990s and remember Trump's hotel/casino junk bonds in default. Yet time changes. The world moves on. The unthinkable becomes the inevitable, as Trotsky once put it. Even in 2018, oil prices reflect complex global financial realities.

Crude oil markets become more sensitive to geopolitical risk when global inventories are tight, not when they are in a glut. In June 2014, militants vanquished two Iraqi army divisions, seized Mosul and established a renegade 'caliphate' in a third of Iraq, the Opec's second largest producer after the kingdom. Still, Brent crude plunged from $115 in June 2014 to $28 in early 2016. Geopolitics did not matter during a global oil glut.

The Saudi-Russian output cut deal in Vienna in 2016 were a game changer in the oil market. Saudi Arabia reverted to its role of the Opec's swing producer, a role it had abandoned in November 2014. Riyadh ignored its political differences with the Kremlin on Syria and Iran to remove 1.8 million barrels a day from the oil market. Sometime last summer, when Brent was $45, I began to realise that global inventories had begun to fall, thanks to supply outages in Libya, Venezuela, Iraqi Kurdistan and Nigeria at a time when petroleum demand in Asia surged, led by China, India, Japan and South Korea. The West's commercial inventories have now shrunk to 2.85 billion barrels. Saudi oil exports have fallen to 7 million barrels a day. Yet global oil demand has risen by almost 1.8 million barrels, thanks to the first synchronised global economic recovery since 2010. Greek sovereign debt crisis.

The oil storage surplus has shrank from 400 to a mere 40 million barrels in the past two years. In the language of oil diplomacy, the market has 'rebalanced' now with a vengeance. Saudi Crown Prince Mohammed bin Salman and the Russian president have seized back their dominant position in the world oil market.

Supply shocks have the potential to trigger panic buying in a tight wet-barrel market. Venezuela is becoming ungovernable under President Maduro, Hugo Chavez's handpicked successor.

Libya's rival governments in Tripoli and Tobruk - rival militias - have devastated its post-Gaddafi oil export infrastructure on the Mediterranean. President Buhari's botched naira devaluation has been a disaster for the Nigerian oil industry (the ultimate 'Shellfare state'). Brent crude is in a strong bull uptrend for now and the Permian Basin in Texas is printing petrodollars! Drill, baby, drill! Watch the shale kings yell, howdy!

By Matein Khalid

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