Oil prices jumped higher on escalation tensions in the Middle East

by: Hans van Cleef

Brent oil prices touched USD 70/bbl on Monday as the tensions between Iran, Iraq and the US continued to escalate. These tensions follow the killing of Iranian General Soleimani by the US in Baghdad. Iran’s leaders have threatened to respond. Meanwhile, Iraq’s parliament voted to expel US troops from the country. US President Trump threatened Iraq with sanctions if US troops are forced to leave the country. Markets fear that a further escalation of the conflict may hurt oil production and/or -exports in the region. Up until now oil production has not been affected, and the higher oil price can be therefore for now be explained by the pricing in of a risk premium for possible future production disruption.

Middle East crucial for global oil supply

The reason that oil prices strongly react to these tensions is that a large part of global oil supply comes from this region. As can be seen in the table below, crude production in the region totals roughly 23 million barrels per day (mb/d). This accounts for 22% of global supply. The tension reminds investors of the last production disruption in September last year, when Saudi Arabia’s oil infrastructure was attacked by drones. Although never confirmed, many people assume that Iran was behind the attack. Another crucial risk is the Strait of Hormuz. This is a crucial transit point of oil and located between Iran and Oman. More than 17 mb/d of oil is transported via the Strait of Hormuz to a variety of destinations around the globe. On top of that, roughly one third of global LNG is passing the Strait of Hormuz on a daily basis as well. Any disruption to oil and LNG transportation, as often threatened by Iran, could result in large shortages and thus huge support for these commodity prices. Alternatively, US sanctions against Iraqi oil exports could be a big game changer. Iraq makes up 4% of global production and it would therefore take a serious bite out of available supply. Finally, direct military action, could potentially hit Iran’s crude production directly.

Crude production per country per day

Country oil x mb/d  
Saudi Arabia 9.89
UAE 3.07
Iran    2.11 *
Iraq 4.58
Kuwait 2.71
Qatar 0.62

* Iran produced 3.8 mb/d before the US sanctions were imposed in Aug 2018

Source: Bloomberg

Price reaction most likely short lived

As long as these tensions do not result in actual production disruptions, we judge that the upward pressure on prices will prove to be short lived. The forward curve pictures a steep backwardation, suggesting that the stress of possible supply constraints are anticipated to have only an effect in the very near term. Due to the global production oversupply – even despite an OPEC production cut – and ample global inventories as well as strategic oil reserves, there will be no shortages of oil in the near term. Furthermore, investors already extended their long positions since early December and are already therefore positioning for further price gains. If the tensions do not escalate, we expect that the market reaction will be short lived and oil prices will ease in the course of the coming weeks. In the unlikely event of an escalation which actually does affect oil production and exports in the region, oil prices will continue its rally. The first important technical resistance levels are USD 72-75 and USD 80/bbl.