Calm before the storm
This year’s summer is hot, not only in literal terms, but also geopolitically. US President Donald Trump has had a hand in that. He claims to be trying to recoup what he thinks the United States has lost due to bad trade deals, theft of US technologies, illegal currency manipulation and interest rate squeeze.
Crude oil is extremely sensitive to geopolitical developments. However, when we look at its prices in the first three weeks of August, there are no apparent reasons for concern. The price of Brent crude averaged USD 71 per barrel, three dollars less compared with July. Daily oil prices in August oscillated between USD 69 and USD 73, within a range three dollars narrower than in July. It looks as if the oil market suddenly calmed down after the turbulent second quarter. An intriguing situation, indeed.
What could be the reason behind it? I believe the reason is in the uncertainty about upcoming weeks, perhaps months. The tense geopolitical situation is spawning risks on both sides of the oil market. Over the next two quarters, both crude oil supplies (as the effects of sanctions imposed on Iran will start to show) and demand for oil (with customs wars compounding the risk of a slowdown in emerging economies and globally) are uncertain. At the time of uncertainty, ‘wait and see’ is a good strategy. In my opinion, the oil market is waiting for an impulse that would indicate the direction for oil price movements in the short term (over one to two quarters). No trend in oil prices (sounds better than a sideways trend) is not a sign of tranquillity, but – quite the opposite – of tension.
Those who read my blog may have noticed that I prefer to write about a long period of time, because the effects of already known short-term disturbances will wear off, and as for unknown ones – we are unable to predict them. This time, though, I will focus on the short-term perspective, for a simple reason: the long term prospects of the oil market remain unchanged. Crude oil being abundant, it is the prospect of flattering demand that remains a concern. In the long term, its price is equal to the cost of production of the most expensive oil for which there is still demand, currently estimated at approximately USD 70 per barrel (excluding inflation). The uncertainty lies in what path oil price will take to reach that level. It certainly will not be a smooth path.
Let’s first look at the demand side. Today, demand for oil and liquid fuels is growing at a decent rate, estimated at 1.6m barrels a day in 2018, i.e. 300 thousand barrels fewer than in the record-breaking 2017. At that time however, the global economy was already growing at 3.3% and Brent prices were still low, hovering around USD 54 per barrel. In base scenarios, assuming no escalation of existing conflicts and their gradual abatement, the average price of Brent crude in 2018 is expected to reach USD 73 per barrel (up 35% on last year’s level).
However, the customs war between the US and China alone, if continued, may have a strong impact on the prospects for global growth, on which demand for oil depends. And, surely, this is just one of many risk factors. Penalty duties imposed by the US on Chinese exports have already reached USD 50bn. China has struck back by imposing retaliatory tariffs on US exports of similar value. And there is more to come. According to Continuum Economics, the uncertainty created by the customs war being waged between the US and China may do more harm than the war itself. Uncertainty is what significantly delays investment and consumption, reducing manufacturing output and pumping up inflation. The extent of impact depends on the magnitude and duration of the uncertainty shock. International organisations also concur in believing that a continuation of this destructive trade policy between the world’s two economic powers could slow down global growth.
We are already in the ninth year of the current economic cycle, which will end sooner or later. A prolonged economic upturn increases risk appetite, but excessive risk taking is what leads to financial and economic crises. Also the risk of emerging economies has increased significantly due to financial problems faced by Argentina and Brazil and, more recently, the tense political and economic situation in Turkey.
There is also enough oil ‘for now’, as evidenced by a decline in oil prices from USD 80 after mid-May (in response to the US withdrawal from the Iran deal) to around USD 70 in the third week of August. Oil prices in futures contracts have moved into a shallow contango. Spot prices have been lower than prices in futures for delivery in 6 months and similar to those for delivery in 12 months, which is attributable to higher oil production in Saudi Arabia, Kuwait and the United Arab Emirates. According to IHSM, following OPEC’s decision to increase production, Saudi Arabia increased it by almost 500,000 barrels per day, to 10.5m barrels per day in June, but cut it back to 10.2m barrels per day in July for fear of flooding the market with oil before an expected reduction in Iranian exports. In July, Russia increased its oil production to almost 11.2m barrels per day (the October 2016 level, from before the output reduction) and has capacities to increase it further. IHSM estimates that production in the US may exceed 12m barrels per day in the second half of 2019, and US oil exports in June and July amounted to 2m barrels per day, a considerable increase on the previous year.
However, within a few months’ time, situation on the supply side may be tense. It is unclear how far the Trump administration will go in imposing sanctions against Iran and whether, and to what extent, China, India and Turkey – all of them significant importers of Iranian oil – will submit to the sanctions regime. It is therefore far from clear whether, and to what extent, the undersupply of Iranian oil may be offset by increased production in the US, Russia and Saudi Arabia. The first phase of imposing sanctions began on August 7th 2018 and included a ban on raising US dollars by the Iranian government, a ban on purchase of Iranian gold and precious metals, a ban on purchase and sale of the Iranian currency (rials) and on maintaining reserves in that currency, a ban on financing Iranian debt and a ban on exports and re-exports of civil aircraft. Countries entering into transactions covered by the bans may be given 90 days to comply. Judging by the way the prices responded, the implementation of the sanctions has not greatly impressed the oil market, probably due to their nature (the first phase will not affect the oil market) and the expectations that even though they will be imposed, they will be less severe than those in 2012. The second phase will begin on November 5th, when all sanctions imposed back in 2012 will be reinstated. The bans will cover financial transactions with the Central Bank of Iran, investments in Iran’s energy sector, purchases of crude oil and products of its processing, including petrochemicals, financial and insurance transactions, transactions involving trade in crude oil and its products, transactions with Iran’s maritime transport and shipbuilding sectors, as well as provision of insurance and guarantee services.
The Trump administration wants to make these sanctions more painful for Iran than those of 2012. Therefore, a short adaptive period (six months only) is proposed instead of spreading the sanctions over time, as in 2012. Unlike previously, the sanctions will also cover exports of condensate (natural gasoline) and refining products. The total impact of the sanctions is expected to curb Iranian oil exports by 1.0–1.3m barrels per day, with current output of 3.8m barrels per day. Importers of Iranian oil that will suffer the hardest blow include Europe, South Korea and Japan, where imports should fall to zero within six months. China does not intend to give in to the US-imposed sanctions and wants to maintain its imports of Iranian oil, while declaring that the imported volumes will not increase. India, on the other hand, might even purchase more Iranian oil. Turkey is also unlikely to surrender to the US sanctions and will probably increase its purchases of Iranian oil.
President Trump is beginning to understand the negative impact of high oil prices on US economy. It is therefore possible that, to restrain price increases, he will decide to offer more than 11m barrels of crude for sale from the US Strategic Petroleum Reserve. Analysts believe, however, that large and sustained interventions on the US oil market, by lowering oil prices, will have an unintended and undesirable impact on shale oil production, which is the key source of growth in global supply. Lower production vs expectations will in turn push up oil prices.
The risk of a reaction from Iran should also be reckoned with. Almost a third of the world’s oil exports by sea pass through the Strait of Hormuz (also via pipelines). Saudi Arabia’s recent attempt to export oil through the Bab-el-Mandeb strait, connecting the Red Sea with the Gulf of Aden, was unsuccessful due to an attack by Yemeni Houthis on two Saudi tankers.
Another source of significant uncertainty is Venezuela, where production is on the decline may collapse even beyond current expectations.
What will be the impact of these developments on the oil market in the near future? It is difficult to predict the direction of changes, as it has been a long time since so many factors driving the global economic situation and the market depended on such highly unpredictable political decisions. In addition, a part of the relationship between crude oil demand, supply and prices are self-regulating links, described in econometric jargon as a feedback loop. After some time, rising oil prices depress demand and stimulate a growth in supply. On the other hand, lower demand and higher supply put a downward pressure on prices.
In my opinion, oil prices will most likely go up for a while in Q4 2018 once it is clear how restrictive the sanctions imposed on Iran have been. Meanwhile, the increased uncertainty will lead to higher price volatility. If they are introduced in full, half a year (being the derogation period) will not be enough to launch additional shale oil production in the US to offset the slump in production of Iranian oil. The OPEC countries with spare capacity (Saudi Arabia, Kuwait, United Arab Emirates) will be interested in keeping the price in the region of USD 80 per barrel and will not increase production unless the price stays at this level for a longer time. Oil price exceeding USD 80 per barrel is not attractive as it triggers the risk of declining demand (in the long run, a growth of oil market is hampered by demand, rather than supply). After about two quarters following the introduction of the sanctions, the price of oil should fall, in line with rising production in the US and other countries. However, the price drops will not be significant, given price pressures created from Q2 2019 onwards by additional demand for oil, resulting from the IMO regulations. However, this topic will be discussed in another post.