We’ve now reached the mid-point of 2019, so let’s look back and see how oil markets have fared since the beginning of the year. Having crashed massively in Q4 2018 (down $30 per barrel), we were fairly confident back in January (see report; https://stabilityfromvolatility.co.uk/market-reports/oil-market-report-01-19/) that prices were unlikely to fall any further. In fact, prices didn’t just stabilise in the new year, they seriously bounced back, with Brent Crude rising from $53 to $68 by the end of the first quarter (Mar 31st). The reasons for the rapid correction upwards were fairly straight-forward. Ongoing demand growth from India and the Far-East created a largely bullish air (prices up), coupled with two key factors on the supply side; continued discipline from OPEC in maintaining production cuts and Venezuela’s worsening economic situation.
Historically, production cuts by OPEC have been poorly maintained, with public declarations (“we will now cut production”) not matching operational reality (“let’s maximise production to take advantage of rising prices”). But this time around, OPEC’s restraint has been impressive and almost all members of the cartel have stuck firmly to their allocated quotas. As for Venezuela, their production woes are quite simply calamitous. The South American oil giant is the world’s longest established oil producer, has 20% of proven global oil reserves and is an OPEC member. But despite having a production quota of 2m bpd, such is the desperate state of the economy (and the oil industry within it), that volumes this year have dropped to below 400,000 bpd. Frequent electricity power outages are shutting down production facilities on a daily basis, whilst refineries stand idle waiting for maintenance and new parts that can no longer be afforded. Product embargoes prevent export flows, whilst those ships permitted to trade with Venezuela cannot fully load because silted-up jetty facilities have not been dredged for months on end.
These then were the clear dynamics that made a Q1 price recovery inevitable. But holding these bullish influences in check once the oil price hit the $65 mark, was the steady return of US shale oil and the prospect of a US-Sino trade war. US shale oil production has certainly been rising in the USA over the last 12 months and most observers will remember that over-production in this sector caused the enormous price crash of 2014. But as our January report also pointed out, many shale operators remain heavily in debt and are struggling to meet operational costs, both of which are curtailing the scale and speed of production growth.
Turning our attention to the on-off trade war between the USA and China, this clearly has spooked oil markets, because any downturn in global trade would inevitably reduce oil consumption. But making an intelligent call on this one remains extremely difficult, as so much depends on the individual (and often erratic) actions of US President Trump. Probably the safest conclusion is that neither the USA nor China really want a fully-fledged trade conflagration and therefore, once symbolic penal tariffs have been placed (and counter-placed) on flag-ship industries, then business as usual for the vast majority of “under the radar” trade will resume and with it, we will see continued oil demand growth.
If the trade war does end up being a damp squib, then that would leave precious few downward price drivers, just as one massive upward price factor is rearing its ugly head. Surprisingly few column inches have been taken up by the looming potential conflict between Iran and the USA (such is our obsession with Brexit), but any dispute between these two countries would have seismic consequences on oil prices. Firstly, any interruption to Iranian oil flows (4m bpd) is a significant supply factor in its own right, but even more significant is a bum-squeakingly narrow shipping lane called the Straits of Hormuz.
This channel sitting at the mouth of the Persian Gulf, sees a full fifth of the world’s oil consumption (20m bpd) travelling through it, not to mention around 30% of the global Liquefied Natural Gas trade. At its tightest point, the straits only provide 2 miles of navigational width for the 30+ vessels that pass through on a daily basis (some of which are in excess of 400m in length). Any interruption to this trade flow, for example as a result of a blockade, would absolutely send prices through the roof. Shipping and insurance markets have already responded to the increased risks, with Persian Gulf oil cargoes now costing more than $500,000 to insure – up by a factor of 10 since the beginning of the year. Making guesses on the potential impact on oil prices is nigh on impossible, but back in 2011, civil unrest in Libya removed 2m bpd from the market. The result was a spike in oil prices from an already inflated $90 per barrel to an incredible $126. So make your own conclusions on what the impact would be of removing 20m bpd from global markets…
Once again, oil markets are teetering on the edge of a major price surge. For the moment, there is just about balance between signals of a bearish (trade war) and bullish (actual war) nature. But as the likelihood of the former recedes, the prospect of the latter is rapidly advancing and until tensions are eased in the Middle East, an eye-watering price escalation remains a distinct possibility.