It’s been a long time since geopolitical developments caused major movements in the oil price, but the escalating tension between the U.S. and Iran, combined with the sudden military clashes in Iraq, has pushed geopolitical risk back on to the agenda for the oil market.
“Geopolitical risks to the oil market have continued to intensify,” Goldman Sachs wrote in an October 17 research note. In addition to Iraq and Iran, the decline in Venezuela’s oil production “appears to be accelerating,” while the resurgence in output from Libya and Nigeria continues to be fragile. “There remains high uncertainty on the potential impact of these new tensions on the oil market.”
But it’s Iraq and Iran that have really raised fears of outages. As of October 17, preliminary reports suggest that about 350,000 bpd of oil production from the Kirkuk oil fields were disrupted, with conflicting reports about whether or not that output has come back online. Iraqi officials said that the interruptions would be temporary and short-lived, and the Kurdish government insisted that it wouldn’t block exports through its pipeline system.
It’s in the interest of both sides to keep the oil flowing, but there’s still a risk of miscalculation and escalating conflict. The problem for Baghdad is that the oil must continue to flow through Kurdish pipelines, as the Iraqi government’s preferred pipeline system is damaged and needs repair. That means that both sides need to agree to some sort of revenue sharing arrangement, but that’s been an intractable issue in the past.
Unlike Iraq, Iran presents very little near-term risk. Instead, it will take time to see the response from Washington. If the U.S. reimposes sanctions, “several hundred thousand barrels of Iranian exports would be immediately at risk.” But because the Trump administration will go it alone, without the help of Europe, China and Russia, “it appears unlikely that production would fall by 1 m/bpd to pre-deal levels,” Goldman concluded. While the U.S. would have trouble cutting down Iran’s oil exports in a major way, it could scare away investment in new production, which would cast “doubt on the likelihood of any increase in oil supply from Iran in the medium term,” Barclays said in a note.
So, what does this mean for oil prices? Goldman estimates that a 500,000 bpd outage for three months (or a 250,000 bpd outage for six months) would increase Brent spot prices by $2.50 per barrel.
With that in mind, Goldman sees the $1.50 per barrel increase in prices since Friday (when Trump announced the decertification of the Iran deal) as evidence that the market is pricing in expectations of a 250,000 bpd outage for three months. Put another way, the price increase can be interpreted as assuming a 30 percent chance of a six-month, 500,000-bpd-outage.
“It is the first time since 2014 that we have had geopolitical risk add a premium to the oil price in a reflection that the oil market is getting tighter,” said Bjarne Schieldrop, chief commodities analyst at SEB Markets, according to the Wall Street Journal.
To be sure, though, that is a relatively mild response to what appear to be serious risks. The outages are mostly theoretical at this point, particularly in the case of Iran, and we’d expect much more serious price increases if and when supply is actually cut off.
But in the past, oil prices might have immediately spiked by a few dollars per barrel on such tension, even if barrels weren’t taken off of the market. The muted response this time around is a reflection of a still well-supplied oil market; inventories are coming down but are still at elevated levels. Also, another significant difference between today and the $100 oil market of pre-2014 is the expectation that U.S. shale could add new supply in short order. That has helped shave off the rough edges that geopolitical tension tends to have on short-term oil price movements.
One final reason why geopolitical risk is having a smaller impact than it used to is that OPEC now operates with a much higher level of spare capacity—the direct result of the production cut deal. If a large source of supply is unexpectedly taken offline, OPEC could scrap its deal and return to full production, filling the void left behind. Goldman Sachs estimates OPEC is working with spare capacity on the order of 2.4 mb/d (the EIA puts the figure just over 2 mb/d), which is essentially double the size the cartel had before its 2016 deal.
In this context, a supply outage from a geopolitical crisis could be viewed as “fast forwarding the normalization in excess inventories rather than requiring a renewed risk premium,” Goldman wrote. In other words, instead of the huge price spikes of the past, geopolitical risk in the current market would lead to a milder bump in prices.
By Nick Cunningham of Oilprice.com
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