Renewed U.S. sanctions on Iran have lifted oil prices to multiyear highs. And while we believe investors can expect a hawkish policy stance to keep supporting prices, the possible extension of waivers presents a downside risk.
Brent crude oil settled at a high of $86.30 per barrel (bbl) last week, the highest level since late 2014, when OPEC elected not to cut output to fend off a growing market imbalance (see chart). The rally in oil, which is up nearly $20/bbl year-to-date, is particularly notable given the strengthening U.S. dollar and weakening of most other commodity markets, most notably base metals. Crude oil’s outperformance is attributable primarily to geopolitical factors, namely the continued decline in Venezuelan output and the now-declining exports from Iran. These output losses have more than offset any concerns over slowing global economic activity (in part due to escalating trade tensions) and accelerating U.S. domestic crude and natural gas liquid output.
While Russia and key OPEC producers, such as Saudi Arabia, have increased output to help offset the decline in Iranian exports, the response has not been sufficient to quell the price rally; if anything, it has brought the lack of spare capacity in the market into sharper focus. We expect that Saudi Arabia, Kuwait and the United Arab Emirates, the primary holders of spare capacity, will need to produce at levels exceeding previous record highs to make up the lost output, leaving the market to rely on reported (rather than proven) spare capacity in case of a new interruption. As history has shown, when commodity markets are operating with so little slack, price risks become skewed to the upside.
We believe the collective market concern over the decline in spare capacity is evident in the rise in long-dated oil prices, which initially received support when the U.S. withdrew from the Iran nuclear deal (Joint Comprehensive Plan of Action, or JCPOA) back in the spring. They have traded higher yet again since it became evident that the U.S. was not following the previous administration’s playbook of inducing oil consumers to step down their purchases every 180 days by granting waivers. This more aggressive policy to discourage oil lifting is straining the system even more than expected, elevating prices above what we would otherwise view as warranted by supply and demand.
Looking forward, we believe the U.S. determination whether or not to grant waivers to oil consumers will greatly influence the price trajectory. While Europe, Russia and China all appear interested in facilitating oil trade with Iran and in sustaining the JCPOA, continued threats from the U.S. will likely discourage corporate users and limit trade to companies that do not touch the U.S. financial markets and to payments in non-U.S. dollars (or even in goods).
Should concern over potential economic damage brought by high oil prices lead to some short-term flexibility in the U.S. policy, perhaps ahead of the upcoming midterm elections, we would expect oil prices to retrace back into the $70s. Importantly, we do not believe a Strategic Petroleum Reserve (SPR) release would have the same impact; rather, we think it would only further highlight the limited spare capacity. Of course, should the current U.S. policy continue – as National Security Advisor John Bolton, Secretary of State Mike Pompeo, Senior Policy Advisor to the Secretary of State and Special Representative for Iran Brian Hook and President Trump have all indicated – this scenario could easily support oil prices in the mid-$80s, or even higher in the event of additional supply disruptions.
Bottom line? In either of these outcomes, the oil market will likely remain sufficiently tight to allow for continued backwardation in the oil price curve, which we view as a positive backdrop for commodity investors.