Oil is once again vulnerable to a price spike from geopolitics: RBC's Croft

  • Market pundits have held the belief that any oil price spike driven by geopolitics would be capped because short-cycle U.S. production was waiting in the wings to fill any supply gap.
  • But today, the oil market has tightened significantly in no small part due to the effectiveness of OPEC in draining bloated global inventories as well as the healthy demand outlook.
  • A geopolitically driven supply disruption will now have a much more outsized influence, and price spikes can no longer be dismissed as things of the past.
Houthi supporters hold up rifles as they rally to protest the killing of Saleh al-Samad, a senior Houthi official, by a Saudi-led coalition air strike in Hodeidah, Yemen April 25, 2018.
Abduljabbar Zeyad | Reuters
Houthi supporters hold up rifles as they rally to protest the killing of Saleh al-Samad, a senior Houthi official, by a Saudi-led coalition air strike in Hodeidah, Yemen April 25, 2018.

Following the 2014 crash in oil prices, a number of leading market commentators concluded that the era of geopolitics mattering for the oil market was over.

In their view, short-cycle U.S. production was waiting in the wings to fill any supply gap and would swiftly cap any price upside. It was in this context that OPEC's obituaries once again abounded, with the sovereign producer group seen as resigned to lower for longer (or even lower forever) and too hopelessly divided to return to active market management.

Yet even now, despite the recent run-up in oil prices, this narrative continues to carry considerable currency. The teaser for the panel on energy markets that I am speaking on at the Milken Institute Global Conference, highlights relentless U.S. production offsetting OPEC reductions, renewables disrupting traditional energy markets, and the geopolitical implications of U.S. production growth displacing Russia as the world's largest oil producer.

Yet we think that there are broader geopolitical factors at play, as geopolitics has returned to the fore for a number of major producer states as well as the oil market generally in 2018. The oil market has tightened significantly in no small part due to the effectiveness of OPEC in draining bloated global inventories as well as the healthy demand outlook.

Against this improving fundamental backdrop, a geopolitically driven supply disruption will now have a much more outsized influence, and price spikes can no longer be dismissed as things of the past. The prolonged period of low prices pushed many stressed producer states to the breaking point, and these casualties of the market share war now are threatening to push the market into an acute deficit situation, putting shale's superman status to a serious test.

Venezuela

No producer country has fallen as far or failed as fast as Venezuela. The country's GDP has declined by nearly 50 percent since 2013 and the IMF forecasts that it will contract by another 15 percent in 2018. The IMF also estimates that consumer prices will climb by an astronomical 13,000 percent this year due to the monetary financing of large fiscal deficits and the loss of confidence in the country's currency. Venezuela's debt liabilities total nearly $200 billion, and it has already missed the deadline on more than $1.7 billion in payments. Oil production has fallen to around 1.5 million barrels a day, which represents a nearly three-decade low (barring the 2002–03 strike).

The Maduro government has lost the ability to maintain critical energy infrastructure, obtain diluents and other vital imports, and pay service providers and PDVSA employees on a regular basis. Against this bleak backdrop, Venezuela's year-on-year production losses are likely to total at least 800,000 barrels a day this year based on current trends and could top the 1 million barrels a day mark. The controversial May 20 presidential elections could prove to be a catalyst for additional U.S. sanctions, which could accelerate the pace and magnitude of the production declines.

Iran

May is also shaping up to possibly be a monumental month for Iran. President Donald Trump has not hidden his desire to be done with the 2015 Iranian nuclear deal that facilitated the return of roughly 1 million barrels a day to the oil market. The president can exercise this exit option later this month by revoking Iranian sanctions waivers, a move that would effectively end U.S. participation in the nuclear deal.

While the Europeans are working around the clock to salvage the agreement by expanding its scope and lengthening its term, the Iranians have consistently balked at reopening the terms of the deal. Moreover, any fixes that would be onerous enough to satisfy the Trump administration's increasingly hawkish foreign policy team would likely be a difficult sell in Iran. Given that the deal also faces strong opposition from hardliners in Iran, its prognosis has only darkened with the appointment of ardent Iran foe John Bolton as national security advisor. Even if President Trump takes a pass on opting out this time around — potentially because of the North Korea negotiations — it is hard to see the deal surviving the full year given the constellation of domestic and foreign foes aligned against it.

A U.S. exit raises the specter of a snapback of extraterritorial sanctions that could curtail foreign investment in Iran's energy sector and cause consuming countries to curb their Iranian crude imports. The U.S. would be going it alone this time, but such a policy could conceivably reduce Iranian exports by 200,000 to 300,000 barrels a day by the end of fourth quarter.

Yemen, Libya, Nigeria

In addition to these imminent issues, a number of other geopolitical stories have the potential to put added upside pressure on the market this year. Yemen bears particularly close watching as Houthi missile attacks pose a direct risk to critical Saudi infrastructure, and the proxy war could prove to be the tripwire for a direct confrontation between Riyadh and Tehran.

Similarly, Libya and Nigeria still retain their disruptive capacity, and with all of the risks percolating, we continue to caution market participants against complacency and warn that further turbulence appears on the horizon. These geopolitical stories would not have been as salient two years ago, but given the changed fundamental landscape, they matter now.

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