The rally in oil prices appears to be stronger than what many analysts have expected. In the past few months, many negative events have taken place around the world. Starting with the failure of oil producers to reach an output freeze deal during Doha's meeting, the continuous growth of Iran's oil output and OPEC's in general, and most recently the concerns over the Brexit.
These events have imposed a huge threat to the rally in oil prices. In fact, during each event, we saw many oil market analysts doubting the rally in oil prices and expecting it to reverse a course. However, the actual impact of such negative events have been limited in terms of the duration and the oil price volatility caused. Throughout these events, the oil prices rally has shown a huge resistance and continued its upward path.
The recent oil prices recovery after oil prices retreated in mid-June as the rising likelihood of a Brexit raised concerns about the economic fallout in Europe is a simple example of such a fact. Oil prices fell sharply below $50/bbl aimed worries over a possible Brexit from the EU. The fall in oil prices didn't last long. Oil prices recovered to levels above $50 a barrel despite the huge volatility caused by such an event.
What is next for oil prices?
Given the current positive market sentiments along with other positive news coming from around the world, oil prices will not stay at $50 a barrel for quite long. In fact, in the coming weeks, oil prices could head above $55 a barrel reaching to $60/bbl, and here is why.
1. Unchanged Interest Rate and Weaker U.S. Dollar
On Wednesday last week, the U.S. Federal Reserve decided to keep interest rates unchanged. The decision came as no surprise, especially after the brutal jobs report of May. Keeping interest rates unchanged means a weaker U.S. dollar. Given the inverse relationship between the greenback and oil prices, weakness in U.S. dollar is directly translated into strength in oil prices.
The Fed has also cut its economic growth forecast by 0.1 percentage point to 2 percent this year. With the Fed expecting a slower economic growth, interest rate hike is questionable. It will take a while until the Fed makes sure there are signs of economy strength. Till then, keeping interest rate unchanged will support the rally in oil prices.
2. Expected Oil Outages
Oil outages in many countries such as Canada, Nigeria, and Libya have increasingly contributed to the rally in oil prices over the past few months up until today. According to the IEA, outages from OPEC and non-OPEC countries cut global oil supply by nearly 0.8 mb/d in May. Although Canada's shut-in production will be fully restored in the near future, outages in both Nigeria and Libya appear to be escalating.
In Nigeria, militants attacks on oil and gas infrastructures have decreased the country's oil production to thirty-year lows. While government official say they have reached to a one-month ceasefire agreement with the rebels in the Niger Delta, what goes on the ground proves opposite. In fact, yesterday, the Niger Delta rebels denied having any ceasefire agreement with the Nigerian government. This news tell us one thing; militants attacks on oil and gas facilities will intensify in coming weeks.
Adding to the existing troubles the country is going through, the Nigerian oil workers threaten to go on strike over what they call it as an engagement of some companies in anti-labor practices. The oil workers have given these companies seven days starting on Monday, June 20, to change what the workers believe to be anti-labor practices. If the workers go on strike, the oil and gas industry activities will shutdown completely resulting in more oil outages.
Libya on the other hand is not in a better place than Nigeria despite occasional signs of optimism. The country's oil and gas fields and facilities are also under attacks from different militia groups. With the troubles the country is going through, it appears that Libya has a long way to go before making a significant increase to its oil production. For Libya, expectations are only for the worst to come.
3. U.S. Crude Inventory Drawdowns
The summer session is officially here. That means the seasonal U.S. inventory drawdowns is here as well. According to the EIA, the current session started with crude oil inventories at 531.5 million barrels as of 10 June. Crude inventory has declined for 3 consecutive weeks since then.
Inventory drawdowns are expected to increase from July to September as gasoline demand increases during the U.S. summer season. According to a report by Deutsche Bank, the rate of weekly drawdown should increase from the beginning of July and accelerate further into August.
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Unplanned crude oil production outages for the Organization of the Petroleum Exporting Countries (OPEC) averaged 2.5 million barrels per day (b/d) in the first half of 2019, the highest six-month average since the end of 2015. EIA estimates that in June, Iran alone accounted for more than 60% (1.7 million b/d) of all OPEC unplanned outages.
EIA differentiates among declines in production resulting from unplanned production outages, permanent losses of production capacity, and voluntary production cutbacks for OPEC members. Only the first of those categories is included in the historical unplanned production outage estimates that EIA publishes in its monthly Short-Term Energy Outlook (STEO).
Unplanned production outages include, but are not limited to, sanctions, armed conflicts, political disputes, labor actions, natural disasters, and unplanned maintenance. Unplanned outages can be short-lived or last for a number of years, but as long as the production capacity is not lost, EIA tracks these disruptions as outages rather than lost capacity.
Loss of production capacity includes natural capacity declines and declines resulting from irreparable damage that are unlikely to return within one year. This lost capacity cannot contribute to global supply without significant investment and lead time.
Voluntary cutbacks are associated with OPEC production agreements and only apply to OPEC members. Voluntary cutbacks count toward the country’s spare capacity but are not counted as unplanned production outages.
EIA defines spare crude oil production capacity—which only applies to OPEC members adhering to OPEC production agreements—as potential oil production that could be brought online within 30 days and sustained for at least 90 days, consistent with sound business practices. EIA does not include unplanned crude oil production outages in its assessment of spare production capacity.
As an example, EIA considers Iranian production declines that result from U.S. sanctions to be unplanned production outages, making Iran a significant contributor to the total OPEC unplanned crude oil production outages. During the fourth quarter of 2015, before the Joint Comprehensive Plan of Action became effective in January 2016, EIA estimated that an average 800,000 b/d of Iranian production was disrupted. In the first quarter of 2019, the first full quarter since U.S. sanctions on Iran were re-imposed in November 2018, Iranian disruptions averaged 1.2 million b/d.
Another long-term contributor to EIA’s estimate of OPEC unplanned crude oil production outages is the Partitioned Neutral Zone (PNZ) between Kuwait and Saudi Arabia. Production halted there in 2014 because of a political dispute between the two countries. EIA attributes half of the PNZ’s estimated 500,000 b/d production capacity to each country.
In the July 2019 STEO, EIA only considered about 100,000 b/d of Venezuela’s 130,000 b/d production decline from January to February as an unplanned crude oil production outage. After a series of ongoing nationwide power outages in Venezuela that began on March 7 and cut electricity to the country's oil-producing areas, EIA estimates that PdVSA, Venezuela’s national oil company, could not restart the disrupted production because of deteriorating infrastructure, and the previously disrupted 100,000 b/d became lost capacity.
The UK has just designated the Persian Gulf as a level 3 risk for its ships – the highest level possible threat for British vessel traffic – as the confrontation between Iran with the US and its allies escalated. The strategically-important bit of water - and in particular the narrow Strait of Hormuz – is boiling over, and it seems as if full-blown military confrontation is inevitable.
The risk assessment comes as the British warship HMS Montrose had to escort the BP oil tanker British Heritage out of the Persian Gulf into the Indian Ocean from being blocked by Iranian vessels. The risk is particularly acute as Iran is spoiling for a fight after the Royal Marines seized the Iranian crude supertanker Grace-1 in Gibraltar on suspicions that it was violating sanctions by sending crude to war-torn Syria. Tensions over the Gibraltar seizure kept the British Heritage tanker in ‘safe’ Saudi Arabian waters for almost a week after making a U-turn from the Basrah oil terminal in Iraq on fears of Iranian reprisals, until the HMW Montrose came to its rescue. Iran’s Revolutionary Guard Corps have warned of further ‘reciprocation’ even as it denied the British Heritage incident ever occurred.
This is just the latest in a series of events around Iran that is rattling the oil world. Since the waivers on exports of Iranian crude by the USA expired in early May, there were four sabotage attacks on oil tankers in the region and two additional attacks in June, all near the major bunkering hub of Fujairah. Increased US military presence resulted in Iran downing an American drone, which almost led to a full-blown conflict were it not for a last-minute U-turn by President Donald Trump. Reports suggest that Iran’s Revolutionary Guard Corps have moved military equipment to its southern coast surrounding the narrow Strait of Hormuz, which is 39km at its narrowest. Up to a third of all seaborne petroleum trade passes through this chokepoint and while Iran would most likely overrun by US-led forces eventually if war breaks out, it could cause a major amount of damage in a little amount of time.
The risk has already driven up oil prices. While a risk premium has already been applied to current oil prices, some analysts are suggesting that further major spikes in crude oil prices could be incoming if Iran manages to close the Strait of Hormuz for an extended period of time. While international crude oil stocks will buffer any short-term impediment, if the Strait is closed for more than two weeks, crude oil prices could jump above US$100/b. If the Strait is closed for an extended period of time – and if the world has run down on its spare crude capacity – then prices could jump as high as US$325/b, according to a study conducted by the King Abdullah Petroleum Studies and Research Centre in Riyadh. This hasn’t happened yet, but the impact is already being felt beyond crude prices: insurance premiums for ships sailing to and fro the Persian Gulf rose tenfold in June, while the insurance-advice group Joint War Committee has designated the waters as a ‘Listed Area’, the highest risk classification on the scale. VLCC rates for trips in the Persian Gulf have also slipped, with traders cagey about sending ships into the potential conflict zone.
This will continue, as there is no end-game in sight for the Iranian issue. With the USA vague on what its eventual goals are and Iran in an aggressive mood at perceived injustice, the situation could explode in war or stay on steady heat for a longer while. Either way, this will have a major impact on the global crude markets. The boiling point has not been reached yet, but the waters of the Strait of Hormuz are certainly simmering.
The Strait of Hormuz:
Headline crude prices for the week beginning 8 July 2019 – Brent: US$64/b; WTI: US$57/b
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