To my mind, since the turn of the year we have seen two big — and related — changes in financial markets relative to 2018, ie greater uncertainty and the return of volatility. Nowhere is this more true than for oil.
At the very start of the year benchmark Brent crude stood at USD66.57 per barrel (pb). On 12 February it hit a year-to-date (YTD) low of USD62.59pb. Then on 23 April we saw a YTD closing high of USD74.71pb (having briefly topped USD75pb during the day), ie an increase of better than 20% in just ten weeks. Furthermore, this was the highest level at which we had seen Brent since the big sell-off triggered by Saudi Arabia’s blocking of any cuts in output at the 27 November 2014 Opec Ordinary Meeting. Compare this to 2017 when a rise of around 20% took pretty much the whole year!
Most oil experts seem to agree that the broad upward trend in the price since mid-February is in significant part thanks to a tightening in the market, as a recent analysis by Reuters’s John Kemp makes clear. I agree.
However, and with all due respect to Mr Kemp, I think the headline to his article that this amounts to “mission accomplished” for Opec is giving the organisation — together with Russia — a little too much credit, its worthy (and uncharacteristically successful) efforts in constraining its members’ output since the start of 2017 notwithstanding. For starters, even though Venezuela is a member, Opec can hardly be credited with the fall in output there of almost 20% last year, attributed largely (and correctly, in my view) to a combination of incompetent management and the country’s dire domestic political situation.
The 'POTUS Premium'
This has not, however, prevented US President Donald Trump from claiming that this year’s increase is down to Opec’s pushing the price “artificially very high”. His characteristic tweeting to this effect on 20 April caused some immediate (though short-lived) softening in the price. And this is by no means the only occasion in the past few weeks when one could legitimately point the finger at Mr Trump for directly or indirectly affecting the oil price. Consider.
- On 22 March Mr Trump named John Bolton as his National Security Advisor. This put over USD1.50 (ie over 2%) on a barrel immediately. Furthermore, futures leapt by 5.7% over related geopolitical jitters. This was described by Bloomberg as the “Bolton premium” but is more accurately seen, in my view, as part of a de facto Trump premium.
- Between 29 March and 6 April, Brent slid from USD70.27 to USD67.11pb over concerns that Mr Trump was about to start a trade war with China which would have a negative impact on economic growth and therefore on demand for oil. This despite the fact that Yemen twice launched missile attacks on Saudi Arabian oil-related assets in that period. As David Sheppard highlighted in the 5 April edition of the Financial Times (subscriber access only):
"Oil traders, distracted for now by a brewing trade war between the US and China, are at risk of growing complacent. But it is unlikely they will be able to discount Saudi Arabia’s conflict in Yemen much longer.”
- Mr Trump’s reaction to 7 April reports of an apparent chemical attack in Syria sent Brent sharply higher again — to USD72.58pb by 13 April. When the reality of the 13 April cruise missile strikes failed to match some of his earlier rhetoric, we saw the price ease again, back to USD71.42pb.
- It is fair to assume that, since then, the resumption of upward movement in the price has been driven significantly by the war of words between Tehran and Washington; and that the latest slight down-tick was thanks to Mr Trump’s not entirely dissing (so far) French President Emmanuel Macron’s efforts to persuade him to sign the sanctions waiver related to the Joint Comprehensive Plan of Action (JCPOA) when it comes up for renewal no later than 12 May. However, Iranian President Hassan Rouhani’s response to the proposal to scrap the JCPOA in favour of forging a new and bigger deal was enough to ensure that this dip was short-lived.
All of this has been taking place against a backdrop of persistent reports that Saudi Arabia wants Brent at USD80pb (or possibly higher still). If these are well-founded (and I believe they are), one prime motivation must surely be Crown Prince Mohammad bin Salmon’s (MBS) domestic political need to see Saudi Aramco listed sooner rather than later as the potential key to kick-starting his economic reform programme — and on the basis of a generous valuation of the firm which most experts believe Brent at USD70pb would certainly not support.
Thus, we have at least three possible contributory factors to our 20% price rise since mid-February. However, I frankly doubt that Saudi talk of the desirability of a higher price would have had much, if any, impact had it not been for the favourable context. But I do believe that both the tighter market and (discounting the possible trade war-related dip) perceived political risk have both made their mark. Quite how much is attributable to each is hard to say; but, in my opinion, based on movements around the events outlined above, I would attribute at least USD3pb and possibly as much as USD5pb to the Trump premium.
It is possible that trade may again drive this into reverse. Nevertheless, even though we may see serious talks between China and the US to stave off the imposition of tariffs on up to USD150m of imports by both countries, reaching an agreement which would satisfy the economic nationalists who now dominate White House thinking on trade looks to me to be a tall order. And keep in mind that Mr Trump reportedly rejected deals negotiated by one of those economic nationalists, Commerce Secretary Wilbur Ross, last year.
However, the prospect of farm belt states, which the Republicans need to win to retain majorities in the two houses of Congress in the 6 November midterms, taking a hit from Chinese retaliation which could further widen the existing ‘enthusiasm gap’ between its supporters and Democrats may encourage some slowing down, if not softening, on trade in the coming weeks.
Nevertheless, there would appear to be at least some politics-related downside risk here to the current price of crude, which may begin to weigh if the US does indeed impose tariffs on USD50bn of imports from China on 29 May, as it is currently scheduled to do.
…but upside skew
This being said, it still seems to me that the political risks to the current price are skewed to the upside. The 12 May deadline is a real one and even Mr Macron has conceded that he doubts Mr Trump will sign the sanctions waiver again.
I am still personally sceptical that, in such circumstances, Iran would quickly relaunch large-scale uranium enrichment, as Foreign Minister Jared Zarif has claimed it couldl. But I do believe that there will be some sort of defiant action taken by Tehran, heightening tensions in the Gulf region still further and therefore exerting additional upward pressure on the oil price.
Although it seems unlikely that the US would be able to win international agreement to reimpose oil sanctions in response — Iran was limited to 1.1million barrels per day (mbpd) pre-JCPOA but now exports around 2.6mbpd — it is not impossible that an escalation could disrupt the flow of oil through the Strait of Hormuz in other ways, eg by causing the insurance sector to cancel cover on vessels entering the Strait. This would certainly trigger a sharp uptick, the magnitude and length of which would depend on exactly what action Iran had taken and how the US in particular responded. As I have argued in various articles in recent weeks, I see this as a tail risk; but it does appear increasingly to be a fat one.
History may mislead
Even putting to one side perceived political risk, expert opinion appears to be leaning increasingly towards the price of crude going higher over the coming months. This is something of a change from the start of the year when the US Energy Information Administration (EIA) was leaning towards the global increase in demand being more than matched by increased output in the US.
As a non-expert, I am not about to argue with the current view that the market is set to tighten further in the second half of this year. But I would note that it is based in part on historical performance; and I would suggest that this may no longer be a good guide. Tight oil/shale has been, by general consensus, a huge game changer, not least for the speed and relative cheapness with which one can switch wells on and off. And the industry as a whole is much more efficient and cost effective today thanks to the three-year slump in the oil price. In consequence, as John Kemp notes in the 24 April Reuters article to which I referred earlier:
“The number of rigs drilling for oil in the United States has already resumed its upward trend over the last three weeks in response to higher prices, which will increase shale output even further by the end of 2018.”
Onwards and upwards
However, as Mr Kemp also points out, Opec seems to believe that its mission is not yet accomplished and therefore to be determined to keep its current curbs on output in place until at least the end of this year. So, unless there is a major change of heart at the organisation’s 172nd Ordinary Meeting on 25 May, I think that, despite the tight oil boom, we must assume continuing upward supply/demand-related pressure for the coming months. Even putting to one side political risk, as Mr Kemp says:
“The oil market is already tight and…traders expect it to become even tighter during the second half of the year, when oil consumption moves seasonally higher.”
Thus, the two main forces to which I have attributed the oil price rise so far this year seem set to continue to conspire to push prices higher still, not only in the next couple of weeks as we approach the 12 May sanctions waiver deadline but probably through to year-end.
[Image credit: Nasdaq]