August 27, 2014
June 19th saw the price of Brent crude rise to a one-year high of USD 116 per barrel. A week later, the price began to drop, eventually reaching its lowest since April last year, at slightly below USD 102 on August 19th.And all of this in a time when armed conflicts, which are far from being resolved, ravage Ukraine, Iraq, Libya and Syria, while tensions between Russia, the European Union and the United States are second only to those at the time of the Cold War. The wars have caused oil supply from North Africa and the Middle East to shrink by more than 3 million barrels a day. Our safety cushion, Saudi Arabia’s untapped reserves, is slowly becoming dangerously slim, currently offering a daily capacity of 3.2 million barrels – 700,000 above the lower end of the market’s comfort zone. What is going to happen next?
It is much easier to explain what has already happened. Markets are driven by expectations, which are in turn formed based on past events and experiences. Underpinning the process is uncertainty, which in the case of such unique events as geopolitical conflicts is very high, although not so high as to deprive us of the expectations through which we perceive real-world developments. Let us then look at the oil market as it was seen in May, before crude prices began to rise. Late-May projections indicated that Brent prices were to decline gradually in 2014 and 2015, down to the region of one hundred dollars per barrel, and that this would happen amid considerable price volatility. The decline seemed likely considering that solid supply growth in the US and Canada, unfettered by geopolitical risks, was alone sufficient to meet the anticipated increase in global demand.
However, the balance between oil supply and demand was maintained, albeit only with a relatively thin safety cushion formed by Saudi Arabia’s crude reserves. The 700,000 barrels a day separating the market from its comfort zone could soon be in jeopardy if active conflicts were to escalate or new ones erupt. Any such event, which could occur in a multitude of possible locations, would send oil prices rocketing. Although the forecasts I saw in May predicted that the supply of crude oil from Libya and Nigeria (and to a lesser extent from Venezuela) would continue to decline, they also projected a significant surge in oil production in Iraq, Kuwait and, to a lesser degree, the United Arab Emirates. The conflict in Ukraine and the sanctions imposed on Russia were both taken into account as risk factors affecting future oil supplies. However, the projections concerning the oil balance in 2014–2015 did not factor in reduced production.
This time, the drop happened in Iraq, a key player on the global oil market. OPEC’s second largest oil producer (at some 3.3 million barrels a day), Iraq is also among the world’s top potential oil suppliers in terms of available reserves. When the Islamic State of Iraq and Syria (ISIS) carried out its offensive in northern Iraq in June, capturing the provinces of Nineveh and Saladin and their capitals of Mosul and Tikrit, panic spread through various markets, including that of crude oil. Prices went up.
The fear premium on crude is typically at its highest at the start of a conflict. If supplies remain uninterrupted, as was the case here, the market eventually diversifies, forming different perceptions as to a conflict’s potential developments and possible hedging strategies. When on June 29th ISIS announced the formation of the ‘Islamic State’ caliphate in the area controlled by the group, concerns that the conflict would spread to southern Iraq, where current production is based, temporarily abated and the oil price began to drop.
On the top of these circumstances, a rare situation could be observed last week when all available information favoured a decline in prices. The American Energy Information Administration agency (EIA) reported that the production of oil from unconventional deposits (tight oil) in the US was higher than expected, with individual well efficiency above projected values. At the same time, the agency adjusted its demand growth forecasts for 2014 and 2015 downward, anticipating a global economic slowdown. EIA projections were consistent with Europe’s estimated GDP growth figures published at that time, which turned out lower than originally forecast. Iraq’s production prospects also improved when Nouri al-Maliki stepped down as Prime Minister, thus removing the risk of a coup from the equation.
What is going to happen next? There is no good answer to that question as it is difficult to foresee how today’s conflicts will develop. What the recent situation in Iraq has shown us is that the risk premium on Brent crude anticipated in May’s projections was too low and that we should expect higher prices in 2014 and 2015.
Although Ukraine and Syria produce little oil, the effect of armed conflicts ravaging the two countries extends far beyond their geographical borders. Sanctions imposed in connection with the Ukrainian crisis will affect future oil supplies from Russia. Hampered access to Western technologies and capital will delay production from difficult and expensive oil deposits indefinitely, which will likely result in reduced production from 2016 on. At the same time, the war in Syria has set off intense hostilities in Iraq, prompting the United States to become involved again. Libya is in a state of complete anarchy. At 1.45 million barrels in 2012, the country’s daily oil production has now halved and is likely to fall to zero. The Israeli-Palestine conflict is yet another potential source of trouble.
However, with the crude oil supply from the US increasing, there is also some good news. Rising dynamically since 2008, the country’s oil production has already more than offset the slumps in North Africa and the Middle East, ensuring relative tranquillity on the oil market. Compared to May’s forecasts, the US is now projected to produce an additional 300,000–400,000 barrels of oil a day in 2014 and 2015. In combination with global oil demand forecasts adjusted down by some 200,000 barrels a day, the new figures somewhat improve the global oil balance. In these circumstances, the price of Brent crude may stay in the region of one hundred dollars per barrel for some time or even drop below that threshold if oil prices prove especially volatile. Will this happen? Only time will tell.