Shock and roll: the geopolitics of oil

Oil prices have risen 8.7% since two tankers were attacked in the Strait of Hormuz on 13 June. Escalating tensions in the Gulf region, including a US drone downed by Iran, a cancelled American airstrike and accusations of cyberattacks, are underlining the wider stakes for oil and trade in the global economy and should not obscure price pressures on a well-supplied energy market.

The already-limited relations between the US and Iran have rapidly worsened. In May 2018, the US stepped away from 2015 commitments with European governments through the Joint Comprehensive Plan of Action to re-impose sanctions on Iran. That has left Iran little negotiating leverage and few survival options given the US pursuit of a regime change. The Trump administration’s ‘maximum pressure policy’ aims to destroy the Iranian economy through sanctions. Since the US pulled out of the nuclear deal, Iran’s oil exports have fallen from 2.5 million barrels per day (bpd) in April 2018 to an estimated 0.3 million bpd in the first three weeks of this month (which Iran denies).

The Iranian economy has suffered. In 2017, the country’s economy expanded by 3.8%, it then contracted 3.9% in 2018 and will decline another 6% this year, according to an International Monetary Fund forecast in April. The US sanctions are testing its own alliances, as well as further highlighting the Trump administration’s differences with China. While Turkey and India have cut back on their purchases of Iranian oil, China remains Iran’s biggest customer. President Trump has now applied new sanctions to Iran’s leadership this week and Iran says it will accelerate its nuclear weapons programme unless European governments facilitate trade to sidestep US restrictions before an 8 July deadline.

This April the US designated Iran’s Revolutionary Guards a terrorist organisation, the first time the label has been attached to a state’s military. Days later, Saudi Arabia, Norway and the United Arab Emirates reported that four tankers were sabotaged.

Although Iran denies involvement in the most recent tanker attacks, the Tehran government has repeatedly said that without the ability to export its oil, it would disrupt others’ shipments. One-third of the world’s seaborne crude oil flows through the Strait of Hormuz, which narrows to a shipping channel only a few kilometres wide between the Iranian coast and Oman’s Musandam Peninsula, and there are few alternatives to re-route supplies.

On 24 June, President Trump questioned in a tweet why the US is protecting other nations’ oil supplies through the Strait of Hormuz “for zero compensation,” pointing in particular to China and Japan. Given the US’s position as the world’s biggest energy producer (see chart 1), “we don’t even need to be there,” he added.

Propping up petrol

The Organisation of the Petroleum Exporting Countries (OPEC), plus Russia, has postponed its scheduled meeting from later this month to 1-2 July. The OPEC postponement places the meeting after the G20 in Japan, where Trump and China’s Xi are scheduled to discuss their trade spat. Any indication of a thaw in Chinese-US relations would reassure the markets about the demand for oil, potentially encouraging OPEC to raise production. On the other hand, a frosty G20 meeting may see OPEC look to deepen their cuts in anticipation of weakening demand.

Back in November 2018, OPEC+ agreed to cut production by 1.2 million bpd, below October 2018 levels (consisting of 0.8 million bpd from OPEC and another 0.4 million bpd from Russia and others) to ensure that global crude inventories will normalise around the five-year average. Based on May data, OPEC+ is now producing some 2.94 million bpd below October levels, driven by over-compliance from key members (Saudi Arabia, Russia), and the dramatic fall in Iranian and Venezuelan production.

Better balance

We expect growth in global oil demand of around 1.2 million bpd in 2019, with a risk that continued trade tensions undermine that, along with an unchanged US supply growth of 1.3 million bpd. That would leave the market in a small surplus for the year. The International Energy Association recently reduced its demand forecast to 1.2 million bpd for this year.

In the last quarter of 2018, Brent crude prices fell more than 40% in three months (see chart 2) as the global economy slowed. In May of this year, oil dipped below USD 60 per barrel and traded around USD 64 as we went to print. With exports under pressure from Iran, Libya and Venezuela, and US production close to record levels, supply and demand is in better balance today than late last year, and inventories are close to their five-year averages. In our view therefore, Brent crude may reach USD 70 per barrel by the year-end, with a 2019 average of USD 64 per barrel.

Shock and roll (over)

The postponed OPEC+ meeting also means that there will be no agreement before the current production quotas expire at the end of June. Three Gulf producers, Saudi Arabia, the United Arab Emirates and Kuwait (the only OPEC members with spare capacity), may agree to roll over June’s ceiling into July and our base scenario assumes that Russia (which also has some additional capacity) will also maintain its production levels.

The oil crises of the 1970s as much as quadrupled prices in the short run, but in each case triggered later recessions that undermined prices. Nearly half a century later, the world is less oil-dependent. Any dramatic rise in the oil price would likely accelerate the development and viability of alternative energies, complicating the efforts of oil-producers who are already struggling to diversify their economies away from petrochemicals.

In the meantime, the risk of rising regional tensions combining with a sharp slowdown in oil demand following the US/China trade war is high and, we believe, remains a significant challenge to the global economy.