Crude oil has run up a bit, now time for a cool-off

By Navneet Damani

Oil prices rallied for much of the week and are near three-year highs.

The reasons are not far to seek: US President Trump walked away from an international nuclear deal with Iran and re imposed “the highest level of economic sanctions” against the country, OPEC-led supply cuts remained and strong demand gradually drew down excess supplies.

The main trigger for the oil market will be the geopolitical tension in the Middle East after President Donald Trump pulled out the United States from the Iranian nuclear agreement.

Oil market is turning extremely tight as consumption outpaces production and is expected to tighten even further for the next six months as second half of the year normally sees higher consumption traditionally. Backwardation seems one of the most reliable signs of tightness in the market.

Saudi Arabia seems to be the biggest beneficiary of Trump’s action. The quick embrace of Trump’s announcement reflects a sense of vindication by Saudi Arabia and the UAE, which have pushed President Trump to take seriously Tehran’s ballistic missile programme and purported support for militant groups. Saudi Arabia has been condemning that Iran used economic gains from the lifting of sanctions to continue its activities to destabilize the region, particularly by developing ballistic missiles and supporting terrorist groups in the region.

Saudi Arabia now enjoys a double-whammy windfall as crude oil prices may remain strong and state producer Saudi Aramco will also likely to be able to pump more oil to replace any Iranian barrels lost because of the re-imposed sanctions.

Moreover, the customers who shifted to Iran for their crude purchase such as world’s top importer China will be forced to buy from the kingdom at higher prices. This would allow the Saudis to regain market share lost since the 2016 deal between the OPEC and allies, including Russia, to reduce output in order to tighten the global oil market.

However, despite all pugnacity, not much is likely to happen for several months. The US Treasury Department has indicated that sanctions won’t be re-imposed immediately. It will take up to 180 days to allow Iranian oil customers and other companies involved in doing business with Tehran to make plans.

It’s also not clear what sanctions will be re-imposed and in what form, with the main risk being the so-called secondary sanctions that would target companies that do business with other entities involved with Iran. Investors are speculating the amount of crude that will be wiped out and it is estimated that approximately 2,00,000-5,00,000 bpd are currently at risk.

In addition, crude exports from the US have the capacity to increase as higher prices provide incentives to Shale producers to drill more wells. It also remains uncertain as to how buyers of Iranian crude will respond to the US decision. Virtually all of them, from Europe to Asia, vehemently disagree with Trump’s move.

We believe that Europe, Russia and China would continue the deal with Iran, leaving US isolated and weakened in handling challenges like North Korea.

Besides geopolitics, oil traders will continue to weigh a steady increase in US production levels in the week ahead as the rise in US drilling marked one of the few factors tamping back crude in an otherwise bullish environment.

The US government has boosted its forecast for domestic crude output both this year. Next year, crude production is seen averaging 11.86 MMbpd, up from a prior forecast of 11.44 MMbpd. Domestic output will average 10.72 MMbpd this year, still above the 1970 record of 9.6 MMbpd and raised from a 10.69-MMbpd forecast in an April report.

Stocks of crude oil and refined products in OECD industrialised countries have fallen to just 43 million barrels above the five-year average, from a surplus of 340 million barrels at the start of 2017. If OECD stocks are adjusted for the rise in consumption, current inventories are now below the five-year average.

Stocks are expected to decline even further in the second half of the year, which traditionally sees higher consumption. Global oil consumption is expected to rise by more than 1.5 million barrels per day in 2018, mostly as a result of strong economic growth. Production from Venezuela is already falling.

The story of oil production in Angola, the second largest oil producer in West Africa, is getting less attention from the international oil community. This country is seeing a steep decline in its production for some time and its shipments to China are reflecting that situation.

Angola, which was always among the top three suppliers of crude to China, has shipped 2.9% less crude to the Asian country in the first quarter over a year ago. Angolan production in the first quarter of this year averaged 1.57 million bpd down, from 1.64 million bpd in the fourth quarter of 2017.

Angolan crude oil is facing a hard time in Asia. Its crude is linked to Brent who is now at the highest level since 2014. Other crude that is linked to Dubai or WTI is becoming less expensive. Thus, Angolan oil exports will drop this month to the lowest in seven years, according to loading programmes.

Market participants would also be taking cues from the rising rig count in the US. Drillers added 10 oil rigs in the week to May 11, bringing the total count to 844 — the highest since March 2015.

In coming weeks, it is yet to be seen how Saudi Arabia and Russia will likely be reactive rather than proactive and wait until a supply disruption is actually recorded or stocks will be heavily impacted to make any new decisions.

Markets will keep an eye on monthly report from OPEC and IEA due this week to get further clues on oil. Meanwhile, OPEC will meet in June to decide whether the production-cut agreement should be adjusted based on market conditions.

We expect crude oil prices to take some breather after the recent run-up. For the WTI, $ 72 could act as a strong hurdle while on the MCX, Rs 4,800 will be a barrier for the short term. A breach above the same could trigger next rally, but until then some cool-off could be expected.

(Navneet Damani is AVP Research at Motilal Oswal Commodities. Views expressed in this article are author’s own and do not represent those of