The rising tensions in Middle-East and the rising oil prices only show how strong the link between oil prices and geopolitics is. There are many fronts: Israel and Gaza, Trump and Iran deal, Iran and Saudi Arabia. Then there are vested interests, wherein Trump, Saudi Arabia and Israel form one alliance and Russia, China and Iran another. All in all unrest in Middle-East is reshaping relationships and shaking markets. Understanding the bigger picture while delineating relevant factors can help provide us track the potential implications of matters in this region and thereof of oil prices in posterity.
Adding an influential voice to the chorus of energy analyst, Pulitzer Prize winning author, Daniel Yergin recently said that oil prices might hit $85 in July. Bank of America, last week, caused quite a stir saying that oil can hit $100 by next year. Not to mention an oil hedge fund manager who, see oil at $300, a possibility (he deleted his tweets afterwards). Over all the market sentiment is very bullish and rightly so.
What are the underlying reasons? Declining Venezuelan production, sanctions on Iran and of-course the geopolitical wildcards: war in the ever raging Middle East.
Production in Venezuela has been in decline, from 2.3 million bpd in 2016 to 1.5 mbpd in April 2018. However, it is only its combination with Trump’s decision to repudiate Iran deal (with it the fear of sanctions and a reduction in supply) that the oil prices haverallied up to levels not seen after 2014: $80 for Brent and $72 for WTI.
Few days back the inauguration of U.S. embassy in Jerusalem and the ensuing protests, wherein many people were killed, can have spectacular consequences in future and can trigger another rally. One can recall the time of intermittent Arab conflicts between Israel and Muslim countries. Below we dive into a complex geopolitical soup that can shape the future ofoil prices.
Taking Iran as the focal point, we can disentangle the present and future possibilities. Iran and Saudi Arabia have always been vying for the regional balance of power. Any move that is perceived to tilt that balance in either direction has caused protest from the other side. Obama’s Joint Comprehensive Action of Plan (JCPOA) commonly known as Iran deal, was probably one of the most important acts that Saudi Arabia perceived to be threatening to the existing balance of power and therefore, regional stability.Therefore, Trump’s move was welcomed by the Saudi’s. The consequences despite having a strong geopolitical and security dimension have a commensurately important economic side as well: Oil prices. The cancellation of the deal will ease the markets off by anywhere between 300,000bpd to 500, 000 bpd. It is instructive to note that it comes at a time when both Iran and Saudi Arabia are party to what is called the Vienna Agreement—the prime reason for the rebalancing of the markets.
As Saudi Arabia vows to use its spare capacity to offset the effects of sanctions on Iran this represents nothing short of a dilemma for the Kingdom. MbS’ plan to transform the Saudi economy into a diversified one rests on Aramco’s IPO scheduled for 2019. To get desired evaluation the country needs oil prices to rise. $80 is desirable. Now, the question arises why Saudi Arabia would stop oil prices from rising, which suits them, and that too without cutting further production? Also, doing so may hurt the Vienna agreement as other might protest. There is another factor, China, one of the largest buyer of Iranian crude, is exempt from any sanctions by U.S. hence free to do business with Iran. It’s record oil consumption which made headlines few days back, shows that it will not be difficult for Iran to sell those sanctioned barrels to China making the overall effect of supply zero or insignificant. Some have even said that this can threaten Petrodollar dominance in oil trade.
The next front is that of Israel. Further unrest in Gaza will lead to a heated rhetoric about Hamas which brings in Iran that further drags Saudi’s completing the picture for conflict. This can spill over to war in Yemen. All of this can make the geopolitical risk premium stay for a very long time hence, prospects of oil prices sky-rocketing ($100, may be?).
But here is the opposite scenario. One should remember (and expect), quite gleefully, that such tensions cannot go for good. Either they end in a military escalation, a war of sorts, or some agreement is reached. If the latter happens we can bring in another factor into the puzzle that is not temporary: rise in U.S. shale production. The number of rigs, 844, now stands at highest since 2015. The production has surpassed 10.7 mbpd. Shale drillers are exercising restraint and tackling some bottlenecks, but for how long?
We can pose the same question regarding Vienna agreement. How long can the oil producing countries continue cutting production? Can the pact afford a disgruntled Iran which might leave the oil pact? What about Russia’s commitment . . . if matters in Middle-east turn out ugly, Russia will evidently side with Iran rather than Saudi Arabia.
Also, if production is increased that would undermine or even jeopardize the deal and if it doesn’t that will, if on one side serve the Kingdom’s purpose of increasing oil prices (due to a fall in supply), on the other hand help U.S shale producers drill even more. Higher oil prices, if on one side reduce demand; at a certain point can also jeopardize the Vienna pact itself as the countries will have no incentive to continue it.
Lastly, if oil prices continue to rise then demand might slow down, at the same time when Shale production continues to rise. As an article in The Guardian noted, the oil prices might “come back to earth with a bump”. It is therefore quite early to call whether we’ll see a three digit oil price very soon. We are in the middle, prices can go both ways. All depends upon how events will unfold in Middle-East in the days to come.