Market Insider

Oil prices vulnerable to 'super spikes' again as geopolitics heats up

Key Points
  • The long era of too much oil sloshing around the world and low prices is coming to an end, just as global events are heating up crude prices.
  • That means there's a new higher floor under oil prices as the peak summer demand season approaches, and it also makes the market vulnerable to a "super spike" if there's any significant supply disruption.
  • Oil is pricing in a risk premium for the first time since Russia and OPEC struck a deal to curb production as a way to reduce oil supplies and support prices.
Iraqi forces flash the sign for victory while driving past an oil production plant as they head towards the city of Kirkuk during an operation against Kurdish fighters on October 16, 2017.
Ahmad Al-Rybaye | AFP | Getty Images

The long era of too much oil sloshing around the world and low prices is coming to an end, just as global events are heating up crude prices.

On Friday, President Donald Trump ordered U.S. forces to join France and Britain in launching targeted strikes in Syria, in retaliation for an attack on civilians that employed chemical weapons. With other parts of the world already in turmoil, fallout from Syria could upend the dynamic, as the peak summer season for oil demand approaches, keeping oil prices in a new, elevated range.

"Syria is a client state of Russia and Iran," said John Kilduff, energy analyst at Again Capital. In his speech, Trump singled out both countries for their support of Syrian President Bashar Assad.

"We wait to see if her enablers step up and respond on Syria's behalf," he said — just as Russia warned of "consequences" for the U.S.-led attack.

Gasoline prices are also vulnerable. They are already expected to hit a four-year high this summer.

"The supply cushion is gone. There was a security cushion, and that's gone," said Daniel Yergin, vice chairman of IHS Markit. "A lot of things are happening at the same time."

Brent crude, the international benchmark, was up 7.8 percent in the past week and was trading near $73 a barrel in the futures market for the first time since December 2014. "It's probably in an orbit around $70," said Yergin, adding the floor could be high $60s to low $70s for Brent.

This week could prove pivotal for crude oil as it surges to new highs
This week could prove pivotal for crude oil as it surges to new highs

Prices jumped this week after Trump said the U.S. would respond militarily to Syria's use of chemical weapons on its citizens last Saturday, killing dozens and wounding hundreds more. That sparked a blunt response from Russia, which warned the U.S. against the strike.

While industry analysts aren't calling for sharply higher prices, they say the market is vulnerable to more erratic pricing because global supply has drained dramatically over the last year as demand has grown.

"As the inventory overhang drains, we're vulnerable to a super spike again," said Kilduff. "That would only be if there were losses of significant size in any major oil-producing countries, particularly in the Middle East."

Oil's price also has been firming as Houthi rebels in Yemen have increased a campaign of firing missiles into Saudi Arabia, both at oil facilities and civilian areas, but those efforts have so far failed. Even so, Yemen is viewed as a proxy war between Iran and Saudi Arabia that easily could heat up.

"When you see an escalation in Syria, it raises the risk of escalation in other places. Whether it's Yemen, whether it's eastern Saudi Arabia, or Iran or Iraq, it can foment tensions all across the Middle East," said Michael Cohen, head of energy commodities research at Barclays.

"If the fundamental backdrop is strong, these things are going to matter. If the fundamental backdrop is weak, it's not going to matter," he added.

But there are already other factors that could be wild cards for oil supply, affecting oil's price.

One is the Iran nuclear deal, which the U.S. may choose to exit in May. Newly named national security advisor John Bolton is expected to encourage the president to abandon the deal, which would mean a return to U.S. sanctions on Iran's oil production and its financial sector.

Another uncertainty is Venezuela, where the state oil company PDVSA has seen its production cut in half as its economy teeters and its ability to pump and process crude deteriorates. The U.S. could sanction its already distressed oil sector if President Nicolas Maduro proceeds with an election in May.

Expect US oil production to go onwards and upwards in 2018: IEA
Expect US oil production to go onwards and upwards in 2018: IEA

Helima Croft, the head of global commodities strategy at RBC, said it is "realistic" to start thinking about Brent nearing the $80 a barrel mark. "To move beyond that we'd have to see Venezuela really drop fast. Iran would have real problems, and Yemen would have to visibly look a lot worse," she said.

This is the first significant political premium to show up in crude prices since OPEC and Russia joined forces in late 2016 to steady a market faced with a serious global glut.

As oil prices were in free fall then, Saudi Arabia and Russia led other oil-producing nations to agree to curb production by 1.8 million barrels a day. At the time, oil supplies for OECD nations had surged to near 400 million barrels above their five-year average, and were still running at about 300 million barrels above the average at the end of 2016.

The Organization of the Petroleum Exporting Countries reported this week that those stocks have fallen to just 43 million barrels above the five-year average, and that average is a line where oil producers would see the market as more balanced.

Until now, "geopolitics didn't matter because we were swimming in oil," said Croft.

In its monthly oil market report, OPEC said Thursday that the cartel's total crude output declined by 201,000 barrels a day in March, to average just below 31.96 million barrels a day. The decline was mainly from lower output from Angola, Venezuela, Algeria and Saudi Arabia.

Croft said there's a strong case to be made for both bulls and bears currently, depending on Middle East tensions and the outcome of trade conflict between the U.S. and China. "Which war is going to win out? The Middle East war or the trade war? If the trade war comes back and dominates the headlines, you could have a broad-based macro sell-off that takes oil down with it."

The other unknown is the U.S. shale production, which has increased as OPEC production decreased. OPEC also said Thursday that the world's total oil supply rose by 180,000 barrels a day last month, mainly because of non-OPEC producers such as the U.S., Norway and the U.K.

"Shale is the reason we're not trading over $100 a barrel, way more than $100 a barrel," said Francisco Blanch, global head of commodities and derivatives at Bank of America Merrill Lynch. Production from shale "has been the incremental barrel for years. Not for the last year or two but for seven years."

Analysts are watching for any changes to come with Bolton as national security advisor and a new secretary of State, Mike Pompeo, who is awaiting Senate confirmation.

"I think the escalation of tensions with Russia is a major factor that could impact oil prices," said Blanch. He pointed to the steep drop in aluminum prices this past week, since the U.S. sanctioned Russian oligarchs and companies for meddling in the election.

Saudi Arabia and Russia are expected to try to extend their production arrangement after it expires in December. The agreement will be reviewed when OPEC meets in June. Saudi Arabia Energy Minister Khalid Al-Falih recently told CNBC that it's important to keep the agreement going.

"We will review in June what are the specific targets for a balanced market," said al-Falih, during a visit to the U.S. last month. He said even if the market is balanced, the producers may not want to "lift our hands from the steering wheel and leave the market without stewardship" because it could quickly become out of balance.

"The bottom line is they're committed to holding back supply from the market, which combined with the continued decline of PDVSA in Venezuela is going to make for higher oil prices," said Kilduff.

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