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Is The Geopolitical Risk Premium In Oil Overrated?

Turkey, Iran and Russia

When OPEC instituted their recent production cuts, the theory was that oil markets would balance after crashing in 2014. After Donald Trump won the presidency, many speculated that price fluctuation would become the norm based upon his inexperience in public office and statements during the U.S. presidential campaign. Popular news outlets also conjectured that he would start World War III and possibly limit democracy. So far none of those fears have come to fruition and it’s now time to realize that the geopolitical risk which has caused oil prices to rise in recent weeks is overblown. Brimming crude inventories and U.S. shale record output are the key factors keeping prices depressed. But if prices were to rise, the reason should be a drawdown in inventories, not overheated, geopolitical rhetoric.

According to Matthew Kroenig Senior Fellow at the Atlantic Council:

“On almost every front, the U.S. is positioned for the challenges to come with the current team and policies in place.

There are, of course, worldwide geopolitical challenges that could affect oil prices and supplies. The U.S. deployed the controversial THAAD missile defense system in South Korea sparking fierce protests from China and further straining the already tense relationships between the U.S., North Korea, Japan and China over this issue. Around the same time, North Korea attempted another missile launch in mid-April and news surfaced that the test was disrupted using cyber-warfare. An increase in tension in this area of the world could, of course, impact oil markets. But through all of this chaos, President Xi of China has called for stability, “in what is the equivalent of an election year in one-party China.” Xi doesn’t want a war between the U.S. and North Korea with China caught in the middle. It’s simply bad economics for the U.S. and China. After the recent meeting between Trump and Xi, the Chinese are considering a tougher stance on North Korea, lessening the chance of a geopolitical standoff, which is welcome news for global oil markets.

Syria remains another important geopolitical factor for oil markets. French intelligence services reported forces loyal to Assad, “carried out a sarin nerve gas attack on April 4 in northern Syria.” , confirming earlier suspicions of Western intelligence services. The report also states that Assad has carried out over 140 gas attacks while being backed by Russia and Iran. These developments could potentially be troubling for oil price stability if the U.S. and other allies were to respond again with force. The Trump administration even alerted the Russians before his recent targeting of a Syrian airfield, and the U.S. is still a signatory to the landmark P5+1 nuclear deal between Iran and western powers.

Foreign Affairs Magazine reported that U.S. Secretary of State Rex Tillerson had “tense but engaging meetings,” with his Russian counterpart and Vladimir Putin in late April. Each side believes “the glass is half full in their relationship,” after the Syrian strikes, and neither side believes there will be any direct military or diplomatic conflicts taking place. It seems that at this point, Putin isn’t going to let Syria dictate his relationship with the U.S. or his stance on energy policies. Related: Russia Thwarts ISIS Attack In Far East Oil Hub

The current international environment is undeniably tense, but one should be wary of oil prices rising based purely on political or geopolitical risk. What should concern bullish investors are announcements by the Saudi Energy Minister stating, “It is too early to decide if OPEC will extend production cuts,” along with Libyan political instability, Venezuelan production going offline, and Nigerian unpredictability. These are geopolitical issues that can greatly affect crude prices. But even if we take these OPEC related factors into account, a pre-2014 crash price level for oil seems further away than ever before as the world is still awash in oil.

Next to outages and production cuts in OPEC member states, there are also a number of facts pointing to increased oil output, which could continue depressing prices in the long run.

According to Mark Papa, chief executive of Centennial Resource Development. “We are still in a carbon-based economy, and we see more demand than ever.” U.S. drillers are increasingly eager to invest money in short cycle projects, resulting in a surge in U.S. oil rigs employed, which have now hit a two-year high along with drillers in the Gulf of Mexico reporting a record high output of 1.7 million bpd in January based on numbers from the EIAs Short Term Energy Outlook. Related: GM Factory Seizure Threatens Oil Sector In Venezuela

Goldman Sachs has taken a somewhat contrarian view from other investment banks and firms who follow oil prices as it predicts oil at $50 a barrel based on:

“Improvements in technology and costs involved with shale extraction. Price fluctuations are now likely to be within the realm of 10-20 percent, rather than quadrupling noted when new technology methods were being tallied.”

The strategic case for oil rising has solid reasons, and while there is geopolitical uncertainty, the market is still flush with crude. It doesn’t seem wise to let geopolitical corrections cloud oil and gas investment decisions. With the Trump administration potentially adding to the supply glut by opening up federal lands and other previously untapped, U.S. offshore drilling sites through an executive order, it seems unlikely that U.S. oil production growth will subside anytime soon. Supply and demand along with large-scale supply cuts should be at the forefront of pricing decisions, and if geopolitical risk is part of that model, then it should be objective, unbiased geopolitical analysis, not simply the hype that we have seen recently.

By Todd Royal for Oilprice.com

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