Why the oil price spike will run out of fuel

Brent crude rose above US$75 a barrel last Thursday for the first time this year. That’s up from US$51 at the start of 2019, a 47 per cent rise in less than four months.

Is oil heading, once again, above US$100 a barrel — where it was in the run up to the 2008 global financial crisis, and for much of the period between 2011 and 2014? Triple-digit oil pushes up costs and broader inflation, eats into profitability and generally slows growth — at least in oil-importing nations like the U.K.

Or will this rise in the price of the black stuff be relatively short lived? I think it’s the latter, although this recent surge isn’t over yet.

Oil prices are heavily swayed by geopolitics — and the geopolitical news has been coming thick and fast. Last year, U.S. President Donald Trump imposed sanctions on Iran, limiting crude exports from the Islamic Republic, the third-biggest producer in the OPEC exporters’ cartel.

Such sanctions bite, because the U.S. can make life difficult for countries failing to comply, given the extent to which America controls flows of dollars around the world, not least via the Swift banking system.

Washington has so far granted waivers allowing certain nations to keep importing Iranian oil without fear of U.S. disapproval. But Trump has announced that, from this Thursday, those waivers will end.

Over the last six months or so, Iranian exports have halved to between 1 million and 2 million barrels a day — going mostly to China, India, South Korea, Japan and Turkey. Waivers allowing these exports were expected to be rolled over, which is why the market was surprised by the White House’s newly stated resolve to “bring Iran’s oil exports to zero,” denying the Tehran government its principal source of revenue. Beijing may thumb its nose at U.S .sanctions, perhaps Turkey, too. But others are likely to comply, even if it takes them a few months. Given that the world consumes around 100 million barrels of oil daily, thwarting Iranian exports will knock a significant 1-2 per cent hole in global supplies — which is why prices have jumped.

Iran responded to this U.S. move by threatening to close the Straits of Hormuz linking the Persian Gulf to the outside world — the busiest oil-transit lane on earth. Closing Hormuz, the windpipe of the global economy, would blockade a fifth of the world’s seaborne crude flows. While that’s just bluster from Tehran, ending these sanction waivers does throw uncertainty into a market already dealing with lower global supply due to agreed OPEC production cuts.

The U.S. says there is plenty of supply in the market to manage the transition away from Iranian exports, maintaining relatively stable prices. Since October 2018, Saudi Arabia and UAE, along with Russia, have indeed cut around 1.3 million barrels daily from their combined output. Restoring that would replace Iranian losses, given that some exports would continue, defying sanctions by flowing “under the radar.”

Yet Iran isn’t the only country where supply is under threat. U.S. sanctions on Venezuela — which produces around 3 million barrels a day — are about to come into effect, as Trump turns the screw on the recalcitrant president Maduro. Libya is again on the cusp of full-blown civil war, which could knock out another million barrels or so. And Nigeria, another 2 million-barrel OPEC producer, remains vulnerable to conflict.

A pipe leaks oil at a Petroleos de Venezuela SA (PDVSA) facility in El Tigre, Venezuela. Bloomberg

Amid all the geopolitics, it’s also worth remembering that, as Iranian exports dry up, Saudi Arabia and UAE may not immediately ride to the rescue by pumping more. While poaching market share from their rival is attractive, so is the prospect of keeping supply tight to benefit from higher prices.

Last year’s 11th-hour U.S. decision to grant Iran sanction waivers annoyed even U.S.-friendly OPEC members. They flooded the market with oil too soon, only to see Trump dilute limitations on Iranian exports. That drove crude’s sharp fall below US$50 last autumn — costing OPEC members serious cash.

This time, then, the likes of Saudi Arabia, UAE and Kuwait will be sure that U.S. sanctions are operative before making any move to compensate. That reality, along with higher seasonal demand as we move into the Northern Hemisphere’s summer, means oil could keep trading between US$70 and US$80 for several months to come.

In general, though, the market is likely to remain well supplied, preventing prices from spiralling upward. U.S. crude production has risen by over 2 million barrels a day since early 2018 to 12.2 million, with America currently pumping more than Saudi Arabia and Russia. The doubling of U.S. production over the last decade, as shale producers have exploited “tight oil” fields in Texas, North Dakota and the Appalachians, is a heady story of ingenuity and commercial grit.

Soaring domestic production helped push U.S. commercial crude inventories above 460 million barrels last week, their highest since October 2017. That’s one reason West Texas Intermediate crude, priced in America, is currently just US$67 a barrel, while European-based Brent is up at US$75.

Trump knows U.S. sanctions on oil-exporting countries help “the boys down in Texas” and other domestic producers. As oil prices creep up, the frackers can raise more cash, increasing their output even more. Other major oil exporters see that as a threat, of course, given the ongoing battle for global market share.

While the Saudis recognize the danger of high prices provoking further U.S. production, the desert kingdom also needs cash. Despite running chunky budget deficits for the past six years, Riyadh has announced another big rise in welfare spending — as the House of Saud tries to cling on to power. So it won’t prevent prices heading upwards, at least not for a while.

But Moscow might. Despite much of what you read, the Russian government has a strong balance sheet, with vast reserves and having just run a budget surplus equivalent to 3 per cent of GDP.

What really motivates Russia isn’t short-term cash but long-term market share. Exports to China, up 20 per cent last year, mean Russia now easily outflanks Saudi Arabia as the main crude supplier to the world’s second-largest economy.

While Riyadh may want to maintain production constraints over the coming months, Moscow has other ideas. That won’t displease Trump. U.S. petrol prices, after all, are close to a five-year high. And there’s nothing his core voters hate more than paying through the nose to fill their tanks.

The Sunday Telegraph

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