Stronger demand for oil and gas combined with slower supply growth has been shrinking inventories, suggesting that markets can no longer shrug off global hot spots.
Has a tighter oil market suddenly put geopolitical risk back in focus?
In June, several countries, including Bahrain, Egypt, Saudi Arabia and the United Arab Emirates, cut diplomatic ties with Qatar, the world's largest source of liquefied natural gas. In late September, Iraq's Kurdish population voted for independence for three provinces of Iraqi Kurdistan, including the oil-rich Kirkuk. Then in mid-October, the Trump Administration raised the possibility of re-imposing sanctions with Iran.
Until a few years ago, any one of these developments would have impacted oil prices. Faced with a global glut of oil supply, markets have been largely immune to geopolitical risk. However, those days may be over. With economies around the globe recovering and supplies beginning to dwindle, oil markets may become increasingly vulnerable to political unrest.
According to Martijn Rats and Amy Sergeant, co-authors of a new report, “The Return of the Geopolitical Risk Premium," these geopolitical risks and supply shocks have become more relevant. “With several 'hot spots' around the world, and markets tighter than they used to be, this could become an ongoing feature of the market once again,” says Rats, Morgan Stanley’s head of European oil and gas research.
Inventory Builds in 2014-2016 Saw Days-of-Demand Cover Rise
(Total Oil in Days of 12m Forward Demand)
Geopolitical risks can send prices of most assets reeling. With commodities, such as oil, political instability has historically driven prices higher. That changed dramatically starting in late 2014, when global oil supplies began growing faster than demand. At its peak, supply exceeded demand by as much as two thousand barrels per day; OECD inventories stood at 368 million barrels above their five-year average.
With so much excess supply, says Rats, the markets could afford to be sanguine about geopolitical risk. To be sure, events that would have otherwise impacted oil prices had little impact on oil markets.
A Tighter Market Has Put Geopolitical Risk Back in Focus
(Implied stock build/(draw))
So far this year, markets have been under-supplied by about 300 thousand barrels per day, and OECD inventories have come down to about 190 million barrels above their five-year average. “We expect this to tighten further into 2018, driven by healthy demand growth, slowing U.S. shale growth and continuing OPEC restraints," Rats says.
Rats and his team estimate that oil prices recently incorporated a $1 to $2 per barrel premium, the equivalent of a supply disruption of about 40 to 50 million barrels. Although this suggests less apathy than even a few months ago, it is still modest given the many sources of geopolitical risk.
Mounting tension in Iraq following the Kurdish independence referendum is impacting oil production and exports; the ballot included three provinces of Iraqi Kurdistan and the oil-rich Kirkuk region. Since the vote, fighting has broken out, oil production has slowed, and flows through the Kurdistan Regional Government (KRG) pipeline to Turkey have dropped off. “The KRG-controlled pipeline is currently the only outlet for crude from northern Iraq, excluding transport by truck," says Rats, noting that the latest commentary from OPEC delegates suggests that they will extend their agreement to limit production. However, Rats adds that all parties are incentivized to keep oil flowing, so ongoing disruption is not the base case.
Outside of the Middle East, developments are putting the pinch on supply. In Latin America, supply growth has been faltering, while reports of Venezuelan oil containing contaminants, such as water, salt and minerals, portends further constraints.
In the U.S. market, operators have been reporting a range of operational difficulties as they grow output, and they face increasing pressure from investors to target returns rather than growth at any cost.
U.S. Oil Production Growth Forecasts
Meanwhile, a synchronous global recovery portends a growing need for oil. The latest data shows that world trade is growing at its fastest pace since 2011, with demand recently surprising to the upside. With the glut of oil receding and demand picking up, the market may find an increasing need to price in political risk.