The perfect petro-storm is rapidly brewing as a result of production inaction by OPEC and Russian oil producers with a high level of risk that near simultaneous supply disruptions can take place. It's a scenario that may result in an inexorable surge past the $100/bbl tripwire to as high as $120-130 bbl. This places OPEC and Russians in a vulnerable "wait & see" gray zone that fails to give them enough time to ramp up production to fill in for supply disruptions without oil prices spiking.
Russian president Putin has blamed President Trump for his harsh sanctions against Iran that would remove substantial if not all Iranian oil from the market resulting in considerably higher oil prices. On the other hand, the Saudis, Russia's petro-partner, lobbied intensely for Washington to "punish" Iran with draconian sanctions that are already resulting in higher oil prices. Now OPEC and the Russian petro-block are vulnerable to oil price spikes that will overshoot their price targets considerably and may trigger a drop in demand.
This risk was expressed by Fatih Birol, the executive director of the International Energy Agency (IEA), who was quoted in the publication Business Insider on 9 October 2018, "We should all see the risky situation, the oil markets are entering the red zone."
With current Brent prices averaging $85/bbl, the growing consensus in the market is that there's a growing probability that oil prices could reach $100/bbl by year's end, a major driver of that consensus is the impact of full US sanctions on Iran taking effect on November 4th. I project that this is a rather conservative projection given the back-drop of high-risk supply disruptions percolating elsewhere.
According to US Security Advisor John Bolton at the "2018 Iran Summit" in NY on 25 September 2018 during UN Delegates Week which I attended, he stated that the US will impose full sanctions on Iran's oil production. The markets can only guess whether this draconian measure will be applied or not.
Paraphrasing a savvy and experienced government official who described sanctions being "clumsy [foreign policy] tools", the US government apparently sees a narrow window of opportunity to apply a brutal and merciless economic squeeze on Iran's highly vulnerable economy to force a kind of political behavior modification to persuade the leadership to get "in line" in respecting international norms or persuade the Iranian citizenry to instigate internal civil unrest to destabilize it. However, one must beware the old adage, "Be careful what you wish for," in that it could result in a leadership change that's far worse than the present one.
Supply Disruption Pressure Points
- Iran - Estimates vary wildly from 500,000 to 2 million as to how many barrels will be taken off the global market once sanctions are officially imposed November 4th. Regardless, the reduction will be substantial enough to rattle a market that no longer enjoys a copious inventory overhang. Additionally, the non-dollar barter trade bantered about by the Europeans has not been formulated in-depth.
- Libya - Continued aggressive militant activity around oil facilities and foreboding attacks on the oil ministry itself have elevated the risk of supply disruptions.
- Nigeria - Militant activity is expected to increase as presidential elections are scheduled in early 2019.
- Venezuela: Continued rapid production declines with little remaining hard currency. It's unknown to the extent president Maduro still has control over the military and the tripwire which would result in a coup.
- Saudi Arabia: In his new role as crown prince Mohammad bin Salman despite his aggressive domestic and foreign policies, he has taken far more extreme personal security measures than his predecessors. Additionally, the disappearance of Washington Post journalist Jamal Khashoggi during his visit to the Saudi consulate in Istanbul does not help his credibility.
- US: Infrastructure constraints due to limited pipeline capacity from the Permian to refineries along the Gulf Coast as well as crude exports will continue until sometime in 2019.
My assessment is that OPEC has far less spare capacity to blunt an oil price spike if there's a precipitous drop in Iranian exports and/or other aforementioned supply disruptions scenarios. According to the International Energy Agency, OPEC's spare capacity was 2.69 million b/d in August with the Saudi's spare capacity at 2 million b/d. The Saudis would suffer an enormous credibility disaster if they are unable to successfully make-up for even a minor supply disruption.
Additionally, there are outlier events namely a coup d'etat in one of the aforementioned countries specifically Venezuela, Nigeria, and even Saudi Arabia. Even a bloodless new leadership promising continued foreign policies of the deposed regime is no comfort to markets and represents elevated risks.
From a domestic political perspective, another possibility is a GOP sweep in the November 6th mid-terms that would profoundly impact US foreign policy and embolden it further towards increasingly aggressive policies. Such a result may increase security issues because a cornered Iran is exceptionally dangerous and may result in some form of a backlash that would further heighten geopolitical tensions.
The only good news is that potential supply disruptions are not linked and are mutually exclusive because each potential flashpoint is region and politically specific. If these supply disruptions were linked, then it would result in a rapid and catastrophic domino effect.
Areas of Potential Demand Destruction
- Emerging Markets: Surging oil prices will only accelerate demand destruction for emerging market countries many of which are more vulnerable now due to a strong US dollar, rising interest rates, and who are heavily dependent on imported oil such as Turkey and the Philippines. Because Turkey is also large agricultural importer, these economic trends are quite troubling.
- China: Just over the horizon is the slowing Chinese economy that has the government concerned enough to take proactive measures and reduce the required bank reserves so that additional funds are available to maintain growth.
For risk-takers, it's going to be a wild, and probably profitable, ride of extreme volatility daily in this final quarter of 2018 going into 2019 with surging oil prices well above $100/bbl, probably closer to $120-130/bbl. Depending on developments, the rocket-ride upward will be swift but unlikely sustainable as demand will drop once oil prices exceed $100/bbl and remain above that mark.
Disclosure: I am/we are long VDE, FSNGX.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.