Oil price strength signals critical phase in coming months

The oil market is likely to volatile during the coming northern hemisphere winter

After subsiding by US$10 to $70.50 a barrel during the summer, Brent crude oil prices bottomed mid-August and surged to $86 a barrel before dipping slightly. The key worry is what happens to the market when the US reimposes sanctions on Iran next month. Two factors are at work, according to Goldman Sachs. First, oil refiners, airlines and other industrial consumers are worried about a shortage of supplies ahead of the northern hemisphere winter. They have stepped up physical oil purchases and also purchased futures and option derivative contracts to hedge against further price rises. Second, rising oil prices have encouraged hedge funds and other speculators to also buy derivatives. Trader after trader report that the market is extremely difficult to gauge.  Prices are volatile and Brent oil is at a hefty $10 premium over West Texas Intermediate (WTI) oil. In previous years prices were almost the same and Brent even traded at a discount to WTI.

Brent crude price has rallied, but it is still well below  2012 peak

WTI is currently at a discount mainly because the fracking revolution boosted US oil production by 50 per cent in the past four years to 15.2 million barrels a day.  Brent produced in the North Sea and Asia is regarded as the benchmark price for geopolitical events, especially Middle Eastern and North African instability. It is thus more sensitive to events in Iran, Syria, Iraq and Libya.

The Iranian Factor

The latest report of the International Energy Agency (IEA) states: “We are entering a very crucial period for the oil market.”

Iran’s crude production has dropped “significantly” to 3.63 million barrels a day, the lowest level since July 2016. Exports of crude fell by more than production, tumbling from its recent peak of 2.4 million barrels a day to 1.9 million. Iran’s main buyers, China and India, have cut back orders sharply. The National Iranian Oil Co (NIOC) may also be starting to store some oil at sea. The situation in Venezuela could deteriorate even faster, strife could return to Libya and Nigerian output is unreliable.  It remains to be seen if other producers decide to increase their production.

Supply from some countries has grown since OPEC’s Vienna meetings in June.  OPEC countries are sitting on about 2.7 million barrels a day spare production capacity, 60 per cent of which is in Saudi Arabia.

But the IEA cautions that since the spare capacity has been idle, it may not be easy to bring it on stream swiftly.  Refiners used to processing Venezuelan or Iranian crude have also been competing for similar quality oil to maintain optimal operations.

Crude Oil Supply and Demand Fundamentals

The gap between demand and supply is narrow.  The IEA estimates that global demand will average around 100.3 million barrels a day in the fourth quarter compared with 99.8 million in the third quarter of this year. World supplies were just over 100 million barrels a day in August.

Much depends on Saudi Arabia which is fighting an expensive war in Yemen. In August it was producing 10.42 million barrels a day and according to market estimates can raise the total to 12 million. Vladimir Putin has also said that prices are too high. He has promised to increase Russia’s production, which is currently 11.59 million barrels a day.

Clearly, both OPEC and non-OPEC producers are boosting their revenues at current prices. But they and analysts realise that continual high prices—with some analysts predicting a Brent rise to almost $100— would be inflationary and contribute to a downturn in the global economy. China, India and other Emerging nation importers have experienced devaluations which raise the domestic prices further. Higher crude oil prices and the stronger US dollar are also hurting Britain, the rest of Europe and Japan. There is thus a reasonable probability that falling demand will cause a decline in oil prices from the first quarter of next year.

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