Geopolitical tensions in Iraq and Iran are supporting already strong oil markets led higher by seasonally robust demand and production cuts by the OPEC and non-OPEC alliance. The crisis in Iraq sparked by the Kurdistan Regional Government’s independence referendum has de-escalated following Baghdad’s swift takeover of the Kirkuk province from KRG forces but oil exports remain constrained and the political fallout from the turmoil remains uncertain. While increased tensions and uncertainty about whether the United States will impose fresh sanctions on Iran do not pose an immediate threat to oil exports, a number of potential flash points are expected to inject a high level of volatility in the short term and a very real threat to global oil supplies in the medium term.

Prices for international benchmark Brent and the OPEC Basket rose to their highest levels in more than two years in October on escalating political risks, in a $55-58 per barrel (/bbl) range. Prices year to date over annual 2016 levels for Brent are up just over $9/bbl, and are now trading in a high $57.50-58/bbl range. The OPEC Basket, a weighted average of selected crudes from member countries, has gained an even stronger $9.75/bbl for the same period, with prices most recently pegged around $56-56.50/bbl. Futures prices for U.S. West Texas Intermediate (WTI) have risen every month since June but robust shale production and high inventories have tempered increases relative to other benchmarks. From January to mid-October prices were up by a smaller $6/bbl from average 2016 levels, and are now trading in a $52-52.50/bbl range.

Oil Stock Surplus Halved

Against this backdrop of heightened geopolitical tensions, OPEC’s 10-month production cutback and strong oil demand have combined to trigger a drawdown in stock levels since the second quarter, according to the latest data from the International Energy Agency’s (IEA) monthly Oil Market Report and the OPEC Secretariat’s Monthly Oil Market Report. The surplus to the 5-year average of OECD inventories was pegged at 170 million barrels in August compared to almost 340 million barrels in January and 310 million barrels when OPEC reached its agreement to curtail production levels in November 2016.

Global oil supply and demand are now growing around the same pace but latest forecasts show divergent views for the timing of a drawdown in stocks in the five-year average. After posting a stock drawdown of around 300,000 barrels per day (kb/d) in 2017, the IEA sees a small build of just over 200 kb/d in 2018, signaling a rebalancing to the five-year average of markets won’t take place until 2019. “Taking 2018 as a whole, oil demand and non-OPEC production will grow by roughly the same volume and it is this current outlook that might act as the ceiling for aspirations of higher oil prices,” the IEA noted. By contrast, OPEC now expects stocks to fall to the five-year average in the third quarter of 2018, largely because it sees much smaller growth than the IEA in non-OPEC production, especially from the United States.

IEA and OPEC Diverge on Non-OPEC Supply Outlook

The OPEC Secretariat is projecting supply growth from non-OPEC countries in 2018 of 940 kb/d, with the U.S. supply rising by 860 kb/d. The report cites lower drilling efficiency and cost inflation as contributing to an expansion of supplies in U.S. shale. By contrast, the IEA is forecasting much stronger production growth of 1.5 mb/d in non-OPEC countries, with the United States supplying a sharp 1.1 mb/d of the increase. The IEA noted that while new rig additions have stalled, well completions at tight oil fields have been accelerating from the low levels seen at the start of the year and that trend is expected to continue in 2018: “Earlier this year, completions had significantly lagged the number of wells spudded [i.e., drilling started], causing the number of drilled but uncompleted wells to surge to record highs.”

Forecasting U.S. shale production trends is riddled with complexities. Many U.S. independent producers are highly dependent on access to financing from Wall Street to fund their growth but investors are growing weary of supporting companies that have yet to post a profit as they focus instead on growth. In 2016, access to capital markets surged after OPEC reached its agreement to curtail production and prices soared, which triggered a resurgence in shale oil production. In 2017, however, investors are pushing U.S. independents to focus on profits instead of production growth, which may lead to more constrained access to capital markets. Shale producers typically unveil their spending plans in November and December for the following year.

Global oil demand growth is set to accelerate in the final three months of the year, helping to support stronger markets. The IEA sees global oil demand growth accelerating by 1.7 mb/d year-on-year in the fourth quarter after a weak third quarter, in part due to hurricane activity in the United States. Global oil demand is now forecast to increase by an average 1.6 mb/d, to 97.7 mb/d, for 2017 and by just over 1.4 mb/d, to a record annual 99.1 mb/d in 2018, according to the IEA. Demand in non-OECD countries is forecast to account for almost 80 percent of growth in 2017 and as high as 95 percent in 2018.

Rising OPEC Production Sparks Market Concerns

OPEC oil production has risen in recent months but the higher output was almost entirely due to increased production by Libya and Nigeria, the two members that are exempt from quotas. OPEC production for all 14 members rose by 90 kb/d to 32.8 mb/d in September, to the second highest level this year. The recovery in production from Libya and Nigeria is undermining confidence in the agreement but, so far, officials have refrained from addressing the problem. Libya and Nigeria were exempt from the agreement in November 2016 given the chronic civil unrest that has disrupted their production. However, the group’s failure to adopt a mechanism to impose quotas on the two members when output rebounded will likely require the other 12 OPEC countries to reduce production further, which will be no easy task. Currently, there appears to be no serious discussion about Libya and Nigeria leading up to the ministerial meetings of the OPEC and non-OPEC producer alliance on November 30, with officials apparently focusing on building a consensus for extending the agreement through 2018, according to OPEC Secretary General Mohammad Sanusi Barkindo.

However, heading into the November meeting, OPEC can report stellar compliance for the 12 members with target levels. From January to September, compliance was a high 97 percent, though the near-perfect level masks the uneven adherence to target levels, with Iraq and the United Arab Emirates lagging far behind other regional producers, at just 52 percent and 68 percent, respectively.

Equally, compliance by the 10 non-OPEC countries participating in the agreement held largely steady at a strong 125 percent in September, boosting their year-to-date level to 75 percent, according to the IEA. The higher level of compliance was in large part due to extensive seasonal maintenance work in Russia and Azerbaijan.

Given the uncertain outlook for U.S. production, the burden of rebalancing markets will fall on OPEC to maintain or even make deeper cuts in order to reduce stocks to the five-year average but based on the latest date from the forecasting agencies it is unclear whether that goal will be reached in 2018 or 2019.

Iraq and Iran Pose Risks to Market Supplies

The geopolitical tensions in Iraq as well as the war of words between Tehran and Washington do not pose an immediate problem for global oil markets and OPEC but potential problems could emerge. Iraqi oil supplies have been cut in the wake of Baghdad’s military takeover of Kirkuk in the north but the high level of global inventories has mitigated the impact on markets. After weeks of escalating tensions following the KRG’s controversial referendum vote on independence, Baghdad moved swiftly with a military offensive on October 16 to retake from Kurdish forces the oil-rich province of Kirkuk, a major fault line in the power struggle between the central government in Baghdad and the KRG.

That the operation was conducted with little bloodshed took the market by surprise, which helped lower the risk premium in oil prices. However, the military operations forced further closures of oil fields in the region and it is unclear when full exports will resume. Crude oil exports from the Kurdish region, which are shipped to world markets via a pipeline running to the Turkish Mediterranean port of Ceyhan, were sharply lower following the military takeover, averaging around 200-250 kb/d by October 22 compared with normal flows of around 600 kb/d.

In the near term, the KRG referendum and Baghdad’s military takeover of Kirkuk will have far-reaching and potentially destabilizing implications for the future of Iraqi oil production in the north. The central government and the KRG have been fighting over control of oil production rights, exports, revenue-sharing, and payment mechanisms for years but the latest military victory for Baghdad may have given it the upper hand in negotiations, which would be a further blow to the KRG.

Meanwhile, on October 13, U.S. President Donald J. Trump, as expected, refused to certify to the U.S. Congress that Iran was in compliance with all the terms of the nuclear agreement, the Joint Comprehensive Plan of Action. However, his failure to do so does not automatically mean the deal will be terminated. Although, it has paved the way for an expedited congressional review process that could potentially lead to reimposing oil export-related sanctions, which were lifted as a key part of the JCPOA, effectively killing the deal. U.S. reimposition of sanctions could affect financing for Iranian oil sales, potentially reducing exports by 400-500 kb/d. Congress now has 60 days to review the deal but there are deep divisions among its members and reaching agreement on additional legislation that would placate Trump and, at the same time, not torpedo the deal will be difficult.

Global oil markets are partially insulated from the geopolitical risks in Iraq and the escalating tensions between Washington and Tehran by the still considerable surplus inventories. However, as the global market rebalancing gathers pace in 2018 and inventories decline, oil prices will be increasingly exposed to more risk-related volatility.