Oil View: Market does not seem to fully price geopolitical risk

by: Hans van Cleef

After the attack on key Saudi oil production facilities last Sunday, oil prices jumped higher. However, in the aftermath, Saudi officials assured the market that the production facilities will be up-and-running before the end of the month. As a result, oil prices eased to levels only a few dollars above the Friday close. This is remarkable for three reasons. First, if the Saudi statement is correct, oil production will be back to normal at the end of the month, with global inventories sufficient to meet demand. Still, the rumoured request from Saudi Arabia to Iraq for 20 million barrels of oil to supply refineries triggered fresh support for oil prices. This suggests that the market is still somewhat suspicious and highly sensitive to supply-related news. The second reason is spare capacity. Before the attack, the market was mainly driven by supply-related news, which suggested oversupply (US crude production, US inventories, US/Iran diplomatic talks, economic slowdown). But after the attack, the focus seems to have shifted towards risks of supply/production shortages and the impact on the Saudi’s spare capacity. As long as Saudi production is not fully restored, and demand is partially met by tapping strategic reserves, the oil market is extremely vulnerable to new shocks. In case of a new event – this can be a new attack on global oil supply or for instance a hurricane in the Gulf of Mexico – markets could fear that supply would drop further and inventories will quickly dissipate resulting in possible shortages. This could trigger a dramatic price jump. The third reason is geopolitical tensions. Although these tensions have been lingering already for a long time, recent events increase the risk of an escalation. Iran threatened an ‘all-out war’ in case of any US or Saudi military strike. Such an escalation of the situation seems in nobody’s interest, but cannot be fully ruled out. Therefore a higher risk premium than is priced in at the moment may be justified.

We are not revising our forecasts for now. For the coming quarter, upside risks to our base case scenario have increased. If production is brought back to normal and no new shocks are seen in the meantime, downside risks may return again in Q1 2020 and could even rise if other oil producers make use of the momentum to step up their own crude production. We see Brent oil prices at USD 60 at the end of Q4 and Q1 2020, while we see it rising to USD 70 by the end of next year.