Here’s Why & What Could Make Oil Prices Surge Much Higher

Here's Why  What Could Make Oil Prices Surge Much Higher

Why What Could Make Oil Prices Surge Much Higher

The geopolitical risk premium has taken center stage as one of the key drivers of oil prices in recent months, often trumping fundamentals to send prices soaring on concerns about where the next sudden oil supply disruption would come from.

In recent weeks, a perfect storm of nearly erased global oil glut and simmering—and at times flaring—tensions in the Middle East and the worst production loss without an armed conflict (Venezuela) have supported oil prices and boosted them to levels last seen in November 2014.

In the coming weeks and months, geopolitical risks could further boost oil prices in a market that hasn’t been this tight in years. The main risks to oil supply could come from the Middle East, North Africa, and Venezuela.

SP Global Platts has summed up the key flashpoints around the world that could lead to oil supply disruptions, potentially further boosting oil prices.

Iran

OPEC’s third-largest producer Iran—which pumps 3.8 million bpd as per OPEC’s secondary sources—could be the most immediate threat to supply.

U.S. President Donald Trump has until May 12 to decide whether to waive the sanctions against Tehran as part of the nuclear deal that global powers signed with Iran. Analysts think that the possibility of President Trump not waiving the sanctions is high, but they diverge wildly as to how a no-waiver would impact Iran’s oil exports and global oil prices. Estimates vary from a zero to one million bpd loss of supply out of Iran, and a premium to oil prices of between $2 and $10. Iran’s top oil customers are China, India, and South Korea.

Yemen

The Iran-Saudi proxy war in Yemen risks escalating. The Iran-aligned Yemeni rebels—who have been fighting a Saudi-led Arab coalition in Yemen since 2015—have been targeting Saudi Aramco oil facilities and the Saudi capital Riyadh with missiles and have been trying to attack Saudi oil tankers in the sea. Yemen lies along one of the main global oil chokepoints in the Red Sea. Millions of barrels of crude oil pass Yemeni shores from the Suez Canal en route to Europe every day.

The Red Sea

The conflict in Yemen is also a risk to tanker route disruptions in the Red Sea. While Yemen is not a major oil producer, further escalation of the war could spill over to the oil chokepoints around the Middle East that could disrupt oil tanker routes and flows.

The Bab el-Mandeb Strait is one of the key chokepoints around the Arabian Peninsula. Located between Yemen, Djibouti, and Eritrea, Bab el-Mandeb connects the Red Sea with the Gulf of Aden and the Arabian Sea. According to EIA estimates, a total of 4.8 million bpd of crude oil and refined petroleum products flowed through this waterway in 2016 toward Europe, the United States, and Asia.

The Strait of Hormuz

The Strait of Hormuz is the world’s most important chokepoint, with an oil flow of 18.5 million bpd in 2016, the EIA estimates. The Strait of Hormuz connects the Persian Gulf with the Gulf of Oman and the Arabian Sea and is the key route through which Persian Gulf exporters—Saudi Arabia, Iran, Iraq, Kuwait, Qatar, the UAE, and Bahrain—ship their oil. Only Saudi Arabia and the UAE have pipelines that can ship crude oil outside of the Persian Gulf and have additional pipeline capacity to bypass the Strait of Hormuz, which is a route of more than 30 percent of daily global seaborne-traded crude oil and petroleum products and more than 30 percent of the liquefied natural gas (LNG) flows. Iran has threatened in the past to block the Strait of Hormuz, and although analysts think that it would struggle to do so due to the U.S. naval presence in the area, a further flare-up in the Tehran-U.S. relations could be a risk to the oil flows in this vital global chokepoint.

Syria

The complex proxy conflict in Syria is also a risk to heightened tension in the Middle East, although Syria is not a big oil producer. Further escalation of the conflict, or heightened U.S. vs. Russia/Iran tension, is a risk to which the oil market could react.

Iraq

Iraq—OPEC’s second-largest producer behind Saudi Arabia—is holding parliamentary elections on May 12 amid still unresolved issues with the Kurdish region that have hit Iraq’s oil exports from the north to Turkey’s Mediterranean coast. According to Platts, the election is a short-term risk as it could delay assigning oil contracts as Iraq is pushing for recovery of its oil, refining, and civil infrastructure sectors after it declared victory over ISIS at the end of last year.

Unsurprisingly, the Middle East is home to most of the oil supply risks. But there are other geopolitical risk factors to oil prices, both close to the Middle East and far off in Latin America.

Libya

The North African oil producer has managed to lift its production to around 1 million bpd, but risks still persist with rival factions fighting for control and suddenly disrupting oil facilities’ operations and oil export terminals.

Venezuela  

 Venezuela’s oil production is crumbling, and the only way ahead is further down, all analysts say. The only question is how low the production could drop. According to OPEC’s secondary sources, Venezuela’s oil production averaged 2.154 million bpd in 2016, and 1.916 million bpd in 2017. In March 2018, its production plunged to 1.488 million bpd. Oil production is set to further collapse amid lack of maintenance, staff exodus, and the economy in total disarray. Venezuela holds a presidential election on May 20, which the U.S. and several Latin American nations say they will not recognize. New sanctions on Venezuela could follow, including a possible ban on U.S. light oil exports that Venezuela uses to blend its heavy oil to move it through pipelines.

To be sure, none of the above geopolitical risks could materialize, but even if just one or two were to occur and actually disrupt oil supply, oil prices could surge in this tight market. – Tsvetana Paraskova

Higher Oil Prices Are OPEC’s Only Concern

OPEC could achieve its goal of eliminating the oil inventory surplus this month. But the goal posts will now move to another metric in order to justify keeping the production limits in place in order to drive oil prices higher.

As of February, the OECD commercial stocks stood at 2,841 million barrels, just 30 million barrels above the five-year average. That data came from the IEA’s April Oil Market Report, which publishes the inventory data on a two-month lag. Because we are largely looking through the rearview mirror at the inventory data, the stock surplus could be zeroed out this month, the IEA said, although we won’t know for a few more weeks.

The precise moment when inventories reach the five-year average – OPEC’s stated goal as part of its production cut agreement – is a bit beside the point. Whether it occurs in May or June doesn’t matter all that much. The most important thing is that the surplus is virtually eliminated, well before OPEC’s agreement is set to expire. Refined product stocks are actually already in a deficit relative to the five-year average.

Higher Oil Prices Are OPEC’s Only Concern

The agreement was thought to last until the end of 2018, but that remains in flux. OPEC officials have signaled that they want to keep the cuts in place regardless of what the inventories are actually doing right now and that there is very little chance that the group takes action in June to phase out the agreement early. The coordinated cuts could even be extended into 2019.

But on what basis? Because the inventory metric will soon be obsolete, OPEC is scrambling for another justification. Earlier this year, the group hinted at a few possible alternatives. Perhaps the group could use the seven-year average for inventories instead of the five-year average. Presumably, that would require keeping the current cuts in place because the past seven years incorporates a period of time in which inventories were lower.

More recently, however, Saudi oil minister Khalid al-Falih has pointed to low levels of upstream investment. He argues that since the oil market downturn began in 2014, industry investment has cratered and has yet to bounce back in a major way. That is raising the odds that the oil market faces a supply crunch in a few years, a conclusion repeatedly echoed by the IEA.

Investment is the “most important metric” for evaluating next steps for OPEC, al-Falih recently said.

Still, it is interesting that the most powerful oil minister from within OPEC is pointing to investment levels as some sort of justification for keeping the current production cuts in place. Al-Falih says that by driving oil prices higher, it will stimulate more investment.

But one could be forgiven for questioning the motivation behind that. For one, investment levels, as a gauge of oil market health, is a rather subjective metric. At what level is spending sufficient? And when will we get there?

Second, it isn’t obvious that it is in OPEC’s interest to stimulate a ton of investment in non-OPEC supply. After all, OPEC has been ceding market share to other producers for a while now; it isn’t clear that stoking higher levels of shale drilling is really a good thing as far as OPEC is concerned.

Moreover, some analysts argue that the spending shortfall is overstated. “Over the next 10 years, we see that supply will continue to keep up with demand growth,” said Espen Erlingsen, an analyst at Rystad Energy, according to Bloomberg. “The surge in North American shale activity and start up of new fields are the main drivers for this growth.”

So, why talk about investment levels? Perhaps al-Falih is using oil industry spending as a pretext to keep the current production cuts in place to simply drive oil prices higher. Saudi Arabia has some very strong reasons to pursue higher prices, regardless of inventories or investment levels. The Kingdom wants to close a fiscal deficit and it also needs revenues for the economic diversification plan as part of its Vision 2030.

Most importantly, Saudi officials want higher prices ahead of the IPO of Saudi Aramco, tentatively scheduled for 2019. Exiting the OPEC cuts would pose a serious risk to oil prices, even if inventories are indeed back at average levels.

As such, it is very useful for Saudi Arabia to pivot to oil industry investment levels as a justification for keeping the production cuts in place. Oil prices will drift higher as inventories dip below average levels and the market grows tighter. For other OPEC members, higher oil prices also shower them with more cash, so no harm in going along. Keeping barrels offline does require a sacrifice, but prices have shot up over the past year, more than offsetting the pain of restricting supply. There is a long-term risk – sparking too much rival non-OPEC supply. But for now, OPEC is playing for the short-term gain.

“Talking about the need for more investment is a way of saying: ‘Hey, world, we’re OPEC and we want higher prices, but we’re actually doing you a favor’,” Mike Wittner, head of oil market research at Societe Generale SA, told Bloomberg. “In the end, it’s about revenues.” – Nick Cunningham

Will Higher Oil Prices Destroy Demand?

Oil prices have dipped a bit this week, but still remain at their highest levels in nearly three and a half years. The reasons are by now familiar to most readers who pay attention to the daily whims of the oil market: OPEC cuts, falling inventories, geopolitical unrest and strong demand growth, to name a few.

But at what point do higher prices start to destroy some of that demand, erasing one of the most significant bullish factors influencing the market right now? As John Kemp over at Reuters points out, there isn’t a magical threshold in which demand is humming along swimmingly and then suddenly drops off a cliff. There isn’t a binary response in that way.

Consumers respond in different ways to different prices, and the duration of high prices also matters quite a bit. Auto fleet turnover takes time, and people don’t rush out and buy a more fuel efficient car immediately when prices spike. And as John Kemp rightly argues, demand will likely take a hit before we can detect it in the data.

Nevertheless, demand is sensitive to prices, which is to say it will slow or even decline if prices rise high enough. A brief look at recent history bears that out. Crude oil prices saw a historic run up in prices in the years preceding the 2008 record high spike and subsequent meltdown. That rally essentially ended a century-long upward trend in demand, which hit a high above 21 million barrels per day (mb/d) in the U.S. in 2006-2007. The financial crisis, a terrible economy, more efficient cars and a somewhat saturated auto market led to a temporary peak in oil demand, which was followed by several years at lower levels.

Will Higher Oil Prices Destroy Demand?

When oil prices rose back to $100 per barrel in 2011 following the Arab Spring, demand dipped even further.

Only when prices collapsed in 2014 did the U.S. start to see a revival in demand. U.S. consumers enjoyed more than three years of cheap oil, causing them to fall back in love with SUVs and pickup trucks.

However, we could be on the verge of another shift in the cycle, with WTI at a three-year high, sitting just shy of $70 per barrel. More importantly, the OPEC cuts, the prospect of supply outages in Iran and Venezuela, and the depletion of inventories down to average levels promise to push prices even higher. We haven’t seen any discernable change in demand just yet, but again, these things take time to show up in the data.

The IEA projects oil demand will rise by a robust 1.5 mb/d in 2018. The agency believes total demand will outstrip supply for the rest of this year, with the supply gap growing as time passes. That, of course, is predicated on the assumption that demand does indeed grow at that projected rate of 1.5 mb/d. But, at some point, if demand exceeds supply by enough, and inventories fall below average levels, prices will spike to much higher levels.

Will Higher Oil Prices Destroy Demand?

At that point, say, $80 or $90 or $100 per barrel, demand will have to start taking a hit. To reiterate, forecasting the precise price level, and the magnitude of the demand response, is tricky. But, suffice it to say, the oil market won’t see consistently high levels of demand growth – at 1.5 mb/d – year after year if prices are approaching triple-digit territory.

Then there is the matter of the short-term versus the long-term. Demand destruction might not occur instantaneously. It will take an extended period of high prices before consumers start really cutting back in a big way. But if prices stay high for several years – and there are plenty of reasons why that might not occur – the hit to demand could have more permanent consequences.

In other words, this time could be different. Unlike a decade ago, electric vehicles are increasingly competitive with traditional gasoline or diesel-fueled cars and at some point in the 2020s will reach cost-parity without subsidies. Higher oil prices tilt that equation in favor of EVs and could shift that timeline forward. A sustained period of high prices could accelerate the energy transition that most analyst see as inevitable. – Nick Cunningham

 

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