Very little middle east risk premium in Brent crude

SEB - Prognoser på råvaror - Commodity

Though the market was duly warned about upcoming Iranian retaliation attacks on US installations and armed forces the oil price still spiked up to almost $72/bl following the Iranian rocket attacks on two U.S. Iraqi bases tonight. Again, not a single drop of oil supply has been lost due to the recent incidents and that is why the oil price so quickly has fallen back down again. What the market fears is that the situation spirals out of control. An uncontrollable escalation leading to outright war is what the market fears.

Bjarne Schieldrop, Chief analyst commodities at SEB
Bjarne Schieldrop, Chief analyst commodities, SEB

This morning Brent crude is trading at $69/bl which is up 1% versus close yesterday. Brent crude had a good bull-run in Q4-19. From Oct 3 to Dec 30 it moved up $10.75/bl with a close of $68.44/bl on Dec 30. Since then it is up only $0.6/bl. So, if we look at the current Brent crude oil price trading close to $70/bl there is almost no premium from the recent events in the middle east. Not so strange as we so far have lost no oil either.

The point is that the current Brent crude oil price has derived very little of its current price level from the latest events in the middle east. It is mostly about other things. One should thus not expect the oil price to fall back all that much if/when the current middle east geopolitical tension eases. A sell-off should be temporary and not so deep if the current middle east tension eases.

The current Brent crude oil price level of close to $70/bl and its upwards journey to get there through Q4-19 is about a global manufacturing PMI finally halting its long deterioration and instead moving higher again since bottoming out in July. It is about a weakening USD since the end of September. It is about central bank quantitative tightening shifting back to quantitative easing. It is about increasing monetary stimulus and expectations of ditto fiscal stimulus in 2020. It is about a market finally stopping believing that the bottom is about to fall out of the global economy following an almost continuous deterioration in global manufacturing from the end of 2017 to July 2019. The weakening global oil demand growth was/is in other words not about to fall off a cliff in 2020 either.

On the supply side of the equation we’ve had US shale oil drilling rigs being kicked out of the market from day one in 2019 and then relentlessly lower all through 2019. In Q4-19 it finally started to dawn on the market that US shale oil production was going to slow down sharply in 2020 as a result of this. So instead of booming production growth in 2018 and 2019 due to a huge infusion of debt into the shale oil sector the US EIA in December projected that US shale oil would only grow by 310 k bl/d from Dec-19 to Dec-20.

In other words what Q4-19 brought to the market was a relief and a belief that global oil demand growth would not fall out of bed in 2020 while booming US shale oil production growth in 2018 and 2019 would instead look more like a trickle-growth in 2020. Then this was topped up by further cuts by OPEC+ though the latest deal is so far only valid in Q1-20.

So, in terms of looking for downside price risks from the current Brent crude oil price level of close to $70/bl one should look for 1) A USD shifting from current weakening to instead a strengthening trend. 2) A reviving global manufacturing PMI starting to weaken instead of strengthening. 3) US oil rig count starting to rise again. 4) Lack of compliance within OPEC+ coming from Russia, Nigeria and Iraq (primarily) or signals of no extension of cuts beyond Q1-20 for the current OPEC+ deal.

And on these points, we could of course be concerned. The global manufacturing PMI did fall back a little again in December. Russia recently stated that they cannot hold back production forever and that they will need to start to think about is global market share at some point in time. Of course, when/if the current geopolitical tension in the middle east recedes there will follow a sell-off in crude oil prices, but they should be temporary and not very large. What could lead to a larger sell-off in the Brent crude oil price would be more due to the points above. Price over volume as a choice of strategy should be the preferred strategy for OPEC+ in 2020. Basically, because oil market surplus primarily is estimated to be a temporary issue during H1-2020 with a close to balanced market expected in H2-2020. So current cuts by OPEC+ is calculated to be a bridge to a balanced market in H2-2020. That is of course a highly endurable period for the group.

There is no good reason for OPEC+ to let global oil inventories to be bloated in H1-2020 just to have to struggle with surplus inventories for an extended period. When global oil inventories are high the spot price typically trades at a $10/bl discount to the longer dated price anchor of $60/bl. When inventories are normal to low, they can instead get a $10/bl premium which is what they are getting now with Brent at $70/bl.

Ch1: The front month Brent crude oil price has been moving up in Q4-19. The recent middle east events have added very little.

The front month Brent crude oil price has been moving up in Q4-19

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