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Another geopolitical jolt for oil markets?

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WisdomTree
WisdomTree

Oil prices surged in the first week of the new year following a US airstrike which killed Qassem Soleimani, the head of the Iranian Revolutionary Guards’ overseas forces. Tensions are rife in the region as the Iraqi parliament has since voted to expel US military from their soil prompting US President Trump to threaten sanctions against the country. Brent, which was trading at around $59/barrel at the end of Q3 last year, was hovering around $69/barrel on 8 Jan 2020. 

In our annual outlook for 2020 published last month, we stressed that oil markets have not been pricing at a reasonable level of geopolitical risk premium given the fragility in the Middle East. In this blog, we will review why we believe that to be the case, analyse what is being priced in by oil futures curves and discuss where oil markets may head from here.

The missing geopolitical risk premium

Brent prices were trading around $85/barrel in October 2018 when the US announced sanctions against Iran. Since then, prices have fallen considerably as markets have been fixated on demand growth destruction on account of lukewarm global economic growth. But the period in between has not been devoid of volatility. What has been most curious is how quickly oil prices have reset after spiking sharply every time a ‘geopolitical’ event has taken place. The most vivid example of this came in September 2019 when Saudi oil facilities were hit by a drone attack raising major oil supply concerns among global markets. Prices fell back quickly when Saudi authorities assured markets that the damage was well within their control (See Figure 1). We believe a reasonable level of geopolitical risk premium has been missing from oil prices given the tensions in the region in recent months. Recent price action may be an early sign that markets are beginning to price in this premium to take us closer to a fairer price range for Brent around $70-$75/barrel. 

Figure 1: Geopolitical risk premium has vanished from oil prices

Geopolitical risk premium has vanished from oil prices
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What the backwardated futures curves tell us

A backwardated futures curve typically indicates that people are willing to pay more for prompt delivery than wait, suggesting near-term tightness for the commodity. Brent and WTI curves have become considerably more backwardated in the last three months (See Figure 2). Front-end prices started rising in October last year when markets started to price in further supply cuts by the Organisation of the Petroleum Exporting Countries (OPEC). OPEC and its allies, known as OPEC+ delivered by cutting supplies by 0.5mn barrels per day to bring total cuts to 1.7mn barrels per day compared to October 2018 levels. The steep backwardation in the curves, however, tells us that oil futures are pricing in the following:

  1. Supply will be plentiful over longer maturities as any tightness from a near-term shock may be offset by more sources of oil opening up (e.g. OPEC could loosen supply)
  2. Geopolitical risks are gradually getting priced in making the curve steeper at the front end.

If geopolitical tensions persist, or indeed escalate, oil prices are likely to experience upward pressure. Front end prices for oil can be volatile and, in recent months, oil curves have become more backwardated following geopolitical events before flattening out again. To infer that a geopolitical risk premium has been reasonably priced in, the backwardation would need to persist while the risks remain alive.

Figure 2: Brent and WTI curves have become more backwardated

Brent futures curves
WTI futures oil curves
Source: Bloomberg, WisdomTree. Data as at 06 January 2020.

The events from last week have had a slightly bigger impact on Brent, which is a more international oil benchmark, compared to WTI, which tends to be impacted more by US supply and demand dynamics. 

Where do we go from here?

Oil markets are likely to remain reactive to developments between US and Iran. An outright conflict between the two could result in a major supply shock and the Strait of Hormuz could become inaccessible to a third of global oil volume which currently flows through it. Equally, a de-escalation in the most recent tensions may calm market nerves and lower oil prices yet again as they have following other geopolitical incidents in the region over the last year. 

Given the uncertainty and the stakes, rationality would dictate that markets bake a geopolitical risk premium into oil prices until we see a meaningful resolution of major issues between the US and Iran. As tensions persist, markets will likely become more cognizant of this and oil prices will be supported. If however markets become complacent yet again and the premium erodes before all issues are resolved, oil could serve as a very good hedge for geopolitical risks as prices theoretically would rise whenever a geopolitical ‘event’ takes place.  

A futures curve is said to be backwardated when its spot or cash price is higher than the forward price. The opposite situation is called contango in which the forward price is higher than the spot or cash price.


This material is prepared by WisdomTree and its affiliates and is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date of production and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by WisdomTree, nor any affiliate, nor any of their officers, employees or agents. Reliance upon information in this material is at the sole discretion of the reader. Past performance is not a reliable indicator of future performance.

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Brent rises on prospect of Middle East flare-up

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SEB - analysbrev på råvaror

Brent crude prices have extended their recent rally, reaching USD 74.3 per barrel this morning, marking a gain of USD 1.25 per barrel since last evening.

Ole R. Hvalbye, Analyst Commodities, SEB
Ole R. Hvalbye, Analyst Commodities, SEB

Earlier in the week, signals pointed towards a potential de-escalation in Middle East tensions, with Israel reportedly considering a US-led initiative to address the conflict in Lebanon. However, as noted in yesterday’s crude oil comment, Israel’s military chief issued a strong warning, vowing a significant response should Iran attempt further aggression.

Fueling the recent surge in oil prices are reports from Axios (an American news outlet) suggesting that Iran is preparing to launch a retaliatory strike on Israel from Iraqi territory in the coming days. This heightens the likelihood of additional hostilities potentially erupting before the US election on November 5th.

According to the source, the anticipated attack would likely involve drones and ballistic missiles, with Iran potentially relying on allied militias in Iraq to carry it out. This approach may be a strategic effort by Tehran to avert a direct potential Israeli re-re-retaliation on Iranian soil.

While the situation in the Middle East could escalate sooner than expected, both Israel and Iran seem reluctant to ignite a full-scale regional war. Thus, any additional responses from Iran might remain restrained, similar to Israel’s limited strike last weekend, hence primarily intended as a demonstration of strength rather than an invitation to open warfare.

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Crude oil comment: Recent ’geopolitical relief’ seems premature

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SEB - analysbrev på råvaror

Brent crude oil prices have rebounded from a low of USD 70.7 per barrel on Tuesday to USD 72.7 per barrel currently. Since Friday, the market experienced a significant nosedive, with prices collapsing by almost USD 6 per barrel. This drop was triggered by the long-awaited Israeli attack on Iran, which was milder than anticipated and did not target any oil infrastructure. The market’s reaction – a textbook example of ”buy on rumors, sell on news” – reflected this.

Ole R. Hvalbye, Analyst Commodities, SEB
Ole R. Hvalbye, Analyst Commodities, SEB

In the past two days, however, prices have rebounded, driven by tightening US crude stockpiles (reported yesterday), ongoing potential for further unrest in the Middle East, and rumors that OPEC+ may delay its planned oil output hike, originally scheduled for December. Currently, Brent crude is nearing USD 73 per barrel.

Geopolitically, there are both potential risks and reliefs: An Israeli minister suggested that hostilities with Hezbollah might end by the year’s end. Nevertheless, Israel’s military chief has issued a stern warning, promising a severe response against Iran if it launches further attacks on Israel.

The market’s recent ”geopolitical relief” seems premature, with oil prices swiftly dropping 3-4 USD per barrel from last Friday’s close of approximately USD 76. The threat of further escalations with Iran persists, indicating possible future volatility without any immediate diplomatic solutions.

Much depends on Iran’s reaction. Will their responses escalate tensions, or will they seek to de-escalate, considering the limited damage inflicted? The drop in oil prices suggests that Israel’s attacks did not cause substantial damage, reassuring the market temporarily by not affecting oil installations.

However, it is uncertain if this was Israel’s final move. There could be additional minor and targeted attacks, potentially leading to repeated assaults to diminish Iran’s military capabilities. i.e., there could be more rounds of such attacks from Israel before Iran manages to do anything. Israel lives in constant fear and is tired of getting rockets from left, right, and center, and likely wants to eliminate Hezbollah, Hamas, the Houthis, and Iran’s ability to continue with this.

Further influencing oil prices, recent US DOE data showed a reduction in US crude inventories by 0.5 million barrels last week, slightly less than the API’s reported 0.6-million-barrel drop but significantly less than Bloomberg’s consensus forecast of a 1.4-million-barrel increase. Moreover, reductions were also observed in gasoline and distillate (diesel) inventories, exceeding market expectations and offering bullish signals at a drawdown of 2.7 and 0.97 million barrels respectively.

Looking forward, attention is on OPEC+’s plans to gradually increase production starting this December. The market is split, with rumors suggesting potential delays in OPEC+’s output increase. These delays, along with the ongoing drawdown in US inventories, could further bolster Brent prices fundamentally. However, we believe OPEC is likely to stick to a production increase in December to maintain integrity.

As of now, the OPEC+ production hike of 2.2 million barrels until December 2025 together with a weakened macroeconomic picture and fears of a long-lasting economic slowdown in China is holding a lid on global oil prices. Yet, during 2025 we believe the cartel will likely continuously evaluate the planned production increase, to see if its room for those volumes. We don’t see them going for full punishment and flooding the oil market like they did in 2014/15 and 2020. With oil prices, over time, in the low 70-dollar range we see that OPEC will reconsider the volumes that are to enter the market every single month.

In the current short-term market environment, an oil price of below USD 73 per barrel is still a buying opportunity. Yet, the oil price is not going to shoot up over USD 80 per barrel any time soon, but there is more upside than downside and it pays to be secured.

Additionally, the historical average oil price over the last 20 years is around USD 75 per barrel. Adjusted for inflation, the actual average price would be about USD 90-95 per barrel. Given the current macroeconomic and geopolitical climate, which is far from normal, securing prices on the upside and being cautious about betting on a significant price drop is prudent.

Key events next week include the US election and a legislative session in China, the world’s largest crude importer. China’s economic policies are crucial, significantly influencing global demand growth each year.

In conclusion, while US inventory data offers some bullish signs, the overarching impacts of OPEC decisions and Middle Eastern geopolitical tensions are significant factors that will drive prices higher.

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Crude oil comment: It takes guts to hold short positions

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SEB - analysbrev på råvaror

The oil market has experienced a retreat in bullish sentiment over the last few weeks, as shifts in geopolitical tensions have influenced the market. Notably, the anticipation of Israeli military actions, which are now expected to avoid critical Iranian oil infrastructure (though not with 100% certainty), has led to a recalibration of risk assessments.

Ole R. Hvalbye, Analyst Commodities, SEB
Ole R. Hvalbye, Analyst Commodities, SEB

Despite these geopolitical developments, underlying market fundamentals, including inventory levels and production rates, continue to influence price movements. There appears to be a balancing act between the continuously uncertain geopolitical landscape and concerns over an oil surplus in 2025.

Recent IEA reports suggest that OPEC must cut an additional 0.9 million barrels per day next year to balance the market. This is in contrast to the cartel’s strategy of gradually regaining market share and increasing production by 180,000 barrels per month starting December 2024, culminating in an increase of 2.2 million barrels per day by December 2025.

OPEC will continue to closely monitor market conditions and perform monthly evaluations of their planned production increase, adjusting the production scale as needed to stabilize prices within the mid-70-to-80-dollar range.

We anticipate the planned OPEC December 2024 production increase of 180,000 barrels will occur, which is likely looming in the consciousness of market participants trying to balance the bulls and bears.

However, even though Brent prices have retreated from their largest peaks during the height of the Middle East unrest in early to mid-October, we now see Brent crude prices trading in positive territory since opening on Monday this week, climbing by USD 3 per barrel over the last four days and currently trading at a strong USD 76.2. This returns to the September peaks before the worst escalation in the Middle East.

As zero Israeli retaliation has materialized and with less focus on vital Iranian oil infrastructure, investor sentiment has been impacted, with hedge funds and money managers reducing their long positions in major petroleum contracts. Specifically, there was a notable decrease in positions across Brent (down 28 million barrels) and WTI (down 12 million barrels), reflecting a, so far, relaxed approach to potential supply disruptions.

Yesterday evening, we also received a slightly bearish US inventory report from last week’s data. There was a sizeable increase in US commercial crude oil inventories, which rose by 5.47 million barrels. However, keep in mind that total inventories remain about 4% below the five-year average for this time of year, totaling 426.0 million barrels.

Notably, gasoline inventories also experienced a rise, increasing by 0.88 million barrels, yet still tracking approximately 3% below the five-year average. In contrast, distillate (diesel) inventories saw a decrease of 1.14 million barrels yet remain a very bullish 9% below the five-year average. Overall, total commercial petroleum inventories experienced an upward movement, adding 5.9 million barrels over the week. This is slightly bearish indeed, but likely not enough to counter the geopolitical uncertainties ahead.

As market participants monitor the fundamentals, the potential for a hard Israeli retaliation remains an important risk, with possible impacts on Iranian oil facilities still on the table. Such geopolitical risks are juxtaposed with fundamental calculations, such as the enforcement of sanctions and adjustments in OPEC+ production strategies.

In summary, while current market conditions suggest a greater stabilization of prices and concerns for a surplus in 2025 are holding back Brent prices from spiraling, the underlying risks related to geopolitical actions should weigh heavier. The more time that passes without any Israeli retaliation, the more likely the risk premium will fade. Yet, more time also means more Israeli preparation, and the retaliation will likely be well-planned with significant consequences for Iran. In essence, it takes courage to maintain a short position in the current market. Again, the continuous potential for upside risks outweighs the downside risks.

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