The oil market’s somewhat muted reaction to explosions that damaged two oil tankers in the Gulf of Oman on June 13 is a fairly good indicator of market sentiment. Brent crude oil futures moved up immediately after news broke of the tanker incidents, rising to $62.64 per barrel (/bbl) for a gain of 4.5 percent. But the rally was short lived, and prices sank back to end the day just over one dollar higher at $62.01/bbl. Considering this was the second time in a month that commercial vessels had sustained damage under mysterious circumstances near the strategic Strait of Hormuz, the market’s response is rather baffling.
Why has the oil market remained relatively complacent in the face of a serious threat to maritime oil traffic? An estimated 20 million barrels of oil and refined products transit the Strait of Hormuz daily en route to global markets, making the narrow waterway the most important oil chokepoint in the world. It is also the only outlet for some 110-115 billion cubic meters of liquefied natural gas exported from the Gulf.
Although there is no conclusive evidence yet to support U.S. assertions that Iran or any groups affiliated with it are responsible for the events of the past month, the latest suspected attacks raise the stakes in the highly charged atmosphere in the Middle East.
A one-dollar net increase in the price of oil is not much of a risk premium given these multiple threats in the region that holds 50 percent of global oil reserves and the majority of available global spare production capacity. This makes Saudi oil and the more than 2.5 million barrels per day (mb/d) of spare production the kingdom holds doubly important. However, should the need arise for additional Saudi oil, it would need to make it to the market without hindrance. One of the vessels that was damaged in the June 13 incident was a Japanese-owned tanker carrying a cargo of methanol, a highly flammable and light oil derivative, from Saudi Arabia to Singapore. The incident occurred at the end of a visit to Tehran by Japanese Prime Minister Shinzo Abe, the first by a Japanese prime minister since the 1979 Islamic Revolution. Japan was a big buyer of Iranian crude oil before the U.S.-imposed sanctions and Abe was hoping to mediate between Washington and Tehran in a bid to ease tensions.
If the Iranians were responsible for the recent attacks and the objective was to bring about a sharp rise in oil prices, which would hurt U.S. drivers at the pump, it failed. It would also appear to be a foolhardy policy since higher oil prices would benefit Iran’s oil-producing rivals in the region while hurting Asian consuming countries – the traditional buyers of Iranian crude.
Meanwhile, the Iranian economy, which has not yet recovered fully from the effect of sanctions that pre-dated the 2015 Joint Comprehensive Plan of Action agreed with world powers, has shrunk. The International Monetary Fund said in April it expected the Iranian economy to decline by 6 percent in 2019 but that was before the United States in May ended waivers it had granted to some buyers of Iranian crude oil.
For now, the oil market appears to have set aside concerns about the diplomatic storm brewing in the Middle East and is focused on the latest oil demand projections, which are bearish. The International Energy Agency and OPEC in their latest monthly reports cut their demand forecasts for 2019, citing trade disputes as factors that led to the downward adjustments. The IEA’s Oil Market Report issued on June 14 slashed the forecast for oil demand growth in 2019 by 100,000 b/d to 1.2 mb/d, citing concern over prospects for world trade growth and lower estimates for global economic growth, according to recent OECD data.
OPEC was even more bearish on demand prospects for the year in its June 13 Monthly Oil Market Report. It projects global oil demand will rise by just 1.14 mb/d, a slight change from its forecast a month earlier. There is plenty of supply to meet this demand despite continued high compliance by OPEC with production cuts coordinated with non-OPEC countries led by Russia. According to the IEA, the United States will account for 90 percent of the 1.9 mb/d increase in supply this year. In 2020, non-OPEC growth will be significantly higher at 2.3 mb/d with U.S. gains supported by contributions from Canada, Brazil, and Norway. Supply remains adequate despite significant production declines in Iran and Venezuela because of U.S. sanctions and political unrest in the latter as well as quality issues that have reduced the flow of Russian crude oil.
All this strengthens the case for an extension of output curbs by OPEC and non-OPEC states as proposed recently by Saudi Minister of Energy, Industry, and Mineral Resources Khalid al-Falih. According to Falih, the market is well supplied and inventories are rising, which would obviate the need for an increase in production in the second half of the year. Speaking at an economic forum in St. Petersburg, Russia in early June, Falih said that OPEC was close to agreeing to extend the 1.2 mb/d supply cut beyond June, but more talks were needed with non-OPEC producers that are party to the agreement. Russia appears reluctant at this point to commit and no date has been confirmed for the next OPEC meeting in Vienna, which was originally scheduled for June 25-26. Falih and his Russian counterpart Energy Minister Alexander Novak met in Japan ahead of next week’s G-20 summit but the issue does not appear to have been resolved. Some of the Russian oil companies are concerned that they are losing market share to the United States and are not too keen to see the output cuts extended to the end of the year.
On June 6, Russian President Vladimir Putin, also speaking in St. Petersburg, said that Russia could cope with prices in the $60-$65/bbl range, a level that is much lower than Saudi Arabia’s budgetary requirements. He also said the OPEC and non-OPEC alliance, or OPEC+, should take into account the decline in production in Iran and Venezuela and problems in Libya and Nigeria when they meet in Vienna.
Oil prices are some $15/bbl below the April high above $75/bbl, a rally that was partly due to compliance by OPEC+ with the supply curbs and a sharp drop in Venezuelan production and exports, and in anticipation of tighter sanctions against Iran.
Falih said that for OPEC, a rollover “is almost in the bag.” He added, “The question is to calibrate with non-OPEC.” However, the fact that the two sides have been unable to set a firm date for the Vienna meeting of all 24 producers party to the agreement suggests that positions may not be as aligned as the Saudis would wish. OPEC needs to maintain the relationship with the Russian-led group of 11 non-OPEC producers if it is to retain control of markets. The alliance that was formed in 2016 made clear that OPEC no longer felt it could manage markets without the support of the world’s second largest producer as it grappled with the seemingly unstoppable surge in U.S. light tight oil, or shale, production. Falih made clear in his remarks that Saudi Arabia would be flexible.
Indeed, according to the latest output figures, Saudi Arabia continued to produce below its allocation and has maintained production at around 9.7 mb/d since March. In May, it slashed output by more than 580,000 b/d – considerably higher than its pledge to cut 322,000 b/d under the January agreement. OPEC noted in its latest monthly report that according to secondary source production estimates for May, output fell from Iran, Nigeria, Saudi Arabia, and Venezuela while it increased in Iraq, Angola, and Gabon. Iran, Libya, and Venezuela are exempt from the cuts. Total OPEC production declined in May to nearly 29.88 mb/d, from 30.11 mb/d in April. Yet despite a high level of compliance with the cuts by OPEC and to some extent by the other non-OPEC producers, the market appears to be stuck in bearish mode. If anything, the rising tensions in the Gulf may have put a floor under prices rather than a staging ground for a rally. However, the situation might change should there be further escalation in tensions in the Gulf. Current production is close to what OPEC says is demand for its crude in 2019, which it revised down to 30.5 mb/d, some 1.1 mb/d below the 2018 level. This leaves OPEC with little room to raise production given the projected increase from non-OPEC producers and the lower demand forecasts.
Before joining hands with the Russian-led producers, OPEC was at a loss as to what policy to adopt to confront the relentless rise in U.S. oil production. It tried to defend its market share only to see oil prices plummet in 2014 and 2015. The market’s response to the tanker explosions indicates that while OPEC+ has succeeded in achieving some market balance, the U.S. shale producers are calling the shots. It’s a new market order that the traditional oil producers are trying to navigate.