Why oil will keep breaking down

Oil is collapsing amid fears that tensions between Iran and Saudi Arabia will lead to a deeper price war in an oversupplied crude market — rather than a shooting war in the Middle East.

Tensions are at decades highs between Saudi Arabia and Iran, but the market is more focused on the likelihood that the two will drive more oil into an already oversupplied market and that Iran will undermine an already weak pricing environment with discounts.

The flare-up between the world's largest oil exporter and Iran comes as global supply shows no signs of ebbing — and global growth keeps coming up weak.

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While there was a drawdown in oil supply, there was another build in stocks at Cushing, Oklahoma, the physical hub for Nymex crude, and that fanned continued concerns about strains in global storage capacity.

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Chinese data this week showed continued weakness in manufacturing, and one survey suggested sluggishness in the service sector. That and concerns about devaluation of the yuan weighed broadly on the energy and other markets.

But the irony is that geopolitical headlines that once were guaranteed to inject a quick pop into oil prices have done nothing. The rift over Saudi Arabia's execution of a Shiite cleric moved crude higher for just a few hours Monday before worries about the Chinese economy reversed gains.

"It's part of a 30-year war," said Edward Morse, global head of commodities research at Citigroup. "It's not going to go away. It will flare up from time to time, but I don't think it's going to flare up into direct confrontation that has to be worried about."

The situation intensified after Saudi Arabia on Sunday, and then some of its allies in the Gulf, broke diplomatic ties with Iran. That was after after a mob in Tehran burned the Saudi embassy, and Iran's supreme leader said there would be divine vengeance against Saudi Arabia's Sunni royal family.

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"People were confused by some of the reporting around the Saudi-Iran row, but I think it's clear now that it's an intense throw down over market share," said John Kilduff of Again Capital.

Brent crude futures for February sank more than 5 percent Wednesday, trading as low as $34.13, an 11-year low, and West Texas Intermediate crude futures also lost more than 5 percent to settle at $33.97 per barrel, a seven-year low.

The market share battle has been apparent in comments from both Iran and Saudi Arabia. Iran has been strident in touting it would immediately bring 500,000 barrels to market when sanctions against its nuclear program lift, and that it will bring on another 500,000 as soon as possible.

Meanwhile, Saudi Arabia shows no signs of backing off its commitment to keep pumping oil while letting the market set prices. That strategy has generated a budget deficit and forced it to cut back on domestic subsidies on fuel and other services.

But as some speculate Iran may now be concerned about the negative impact of its bravado on the oil market, officials this week have been quoted saying they do not want to hurt oil prices when they return crude to the market.

Mohsen Qamsari, director general for international affairs at the National Iranian Oil Co., told Reuters that Iran does not want to start a price war, that it will be more subtle in its approach and may gradually increase output. "I have to say that there is no room to push prices down any further, given the level where they are," he said.

While analysts do not expect the friction between Iran and Saudi Arabia to escalate into a military clash beyond the proxy wars in Syria and Yemen, there is still risk.

"There's a potential for this to cause further unrest, and I think that's the real issue," said Michael Cohen, head of energy commodities research at Barclays. "The thing to understand is while the threat may be higher, the ways in which Saudi Arabia has mitigated that threat has improved over the last decade."

Analysts say that the kingdom has improved security around its oil facilities, but its operations are in the east, home to its Shiite minority.

Helima Croft, chief of commodities research at RBC Capital Markets, said it will be important to monitor that area for any signs of trouble, noting a company bus carrying oil workers was set on fire Tuesday.

"It may not be a shooting war between the Saudis and Iranians, but they fight proxy wars," said Croft. "You have Shiite demonstrations in the east. that is problematic." She said a concern is that Saudi Arabia may now have created a martyr by executing Shiite cleric Nimr al-Nimr.

Croft said Saudi Arabia knew the regional consequences of its actions but that both the Saudi and Iranian governments are acting more for domestic audiences. Iran has elections coming up in February.

The cleric was executed along with 46 other individuals, many of them said to be members of al-Qaeda. "He did advocate civil disobedience. He did advocate overthrow of the Saudi monarchy but he was never known to be calling for a violent overthrow," she said.

But Morse does not expect the events to change the outlook for oil.

"The literature is filled with how this is going to deteriorate but I think the Saudis are going to pull back a little bit, and things will get a little less awful," he said.

Morse, and others, have been expecting oil to plunge further — possibly into the $20s per barrel — before stabilizing and moving higher later in the year.

"They are vying for market share, and Iran will not come into the market by denting Saudi's market share because the Saudis sell everything in terms of contracts and those contracts last a long while," he said. "Those that are going to suffer will be the ones that sell into the spot market."

Saudi Arabia did reduce its selling price to Europe Tuesday, with Saudi Aramco saying it was increasing the discount for its light crude by $0.60 per barrel to northwest Europe and $0.20 a barrel for February delivery along the Mediterranean, according to news reports.

Morse said Iranian oil will find buyers in Europe. "There are a half dozen companies in Europe that used to import collectively over 600,000 barrels of Iranian crude," he said. "They are going to do that by backing out Russian and Iraqi oil. It won't be at the Saudi's expense, and it will be at Russia's expense or Iraq's expense."

In a note, Morse and other Citigroup analysts noted that there is potential for a further escalation that could put the 17 million barrels a day of oil flowing in the Strait of Hormuz at risk.

"But of more immediate concern is stocks hitting capacity constraints. If the market remains oversupplied and the conflict remains indirect, rallies are for selling. The risk of missteps remains, but Citi's view is that now — with Saudi already struggling with budget deficits and Iran on the cusp of returning to markets — would be a particularly bad time for either side to start a hot war," they noted.