Is oil price no longer a barometer of Gulf tensions?
Last week was the worst for oil since May. It started out with Brent at $67.47 per barrel and reached a low point of $61.35 on the negative sentiment surrounding US-China trade negotiations and a weakening outlook for the global economy. This was underlined when the International Energy Agency’s (IEA) Executive Director Fatih Birol lowered the demand forecast for this year to 1.1 million barrels per day (bpd) in a Reuters interview. This came barely a week after the IEA’s monthly oil market report had pegged demand growth at 1.2 million bpd after several downgrades from the 1.5 million bpd the IEA had forecasted last year for 2019.
The sentiment changed quickly after Iran’s Islamic Revolutionary Guard Corps confiscated the Stena Impero, a Swedish-owned oil tanker sailing under a UK flag. Oil stood at $63.35 in early Asian trading, steadily rising thereafter.
The Stena Impero incident happened on the heels of no less than six tanker sabotage incidents, a couple of downed drones and several drone hits, namely on Saudi Aramco’s East-West pipeline. The Swedish tanker was taken under the pretext that it violated maritime law and rammed a fishing boat. The real reason behind the incident was retaliation for the UK impounding the Iranian tanker Grace 1 off Gibraltar because its cargo was destined for Syria, in violation EU sanctions. As of now, British ships have been advised to stay clear of the Strait of Hormuz.
The UK government has held several Cobra emergency meetings, the latest of which was chaired by Prime Minister Theresa May. Foreign Secretary Jeremy Hunt advised that the response would be “robust, but measured” — preferring diplomatic solutions to the problem.
The Strait of Hormuz is incredibly important to oil, with 20 percent of global production passing through this narrow waterway. Most of the oil passing the strait is bound for Asia. The incident particularly impacts the security of oil supply to the East Asian economies and India. Transporting oil through the Arabian Gulf has become more expensive because security has to be beefed up and insurance premiums have risen. NATO allies will send their aircraft carriers and frigates to help secure the waterway, which also comes at considerable cost.
The Strait of Hormuz remains important, as does the security of the Gulf Cooperation Council, which is an island of stability in the sea of unrest that is the Middle East.
Why then did we only see a hike in the oil price of 3.2 percent between its lowest point last week and early Asian trading?
Helima Croft, managing director and global head of commodity strategy at Royal Bank of Canada Capital Markets, argues that oil is a broken barometer for Middle East tensions. While the oil price was a good measure for the seriousness of a Middle East crisis only a few years ago, this no longer holds true, according to Croft. She has a point that long gone are the days in 2007 when oil flirted with $150 per barrel. While one would have expected the price to spike to $100 during a geopolitical crisis, $80 is the maximum that can be expected now. There are several reasons for this.
Firstly, while still significant, the Middle East has lost in relative standing as a major oil producer. The shale revolution in the US propelled the country to the position of No. 1 producer, followed by Russia and only then by Saudi Arabia. Materiality is one of the reasons behind OPEC’s alliance with 10 non-OPEC producers, commonly referred to as OPEC+. Indeed, the IEA forecasted a 2.1 million bpd wave of non-OPEC crude hitting the markets in 2020. This supply glut, combined with a slowing global economy, is the main reason behind an overall rather bearish outlook on the oil price.
Secondly, markets have also revised their view of geopolitical risks. Because they cannot be quantified, traders tend to leave them to one side. They will cause temporary spikes in the commodities/goods affected and revert to trend rather quickly, because history seems to suggest that the crisis will either blow over or the situation will normalize. Markets wait for the new normal until they permanently find new price levels.
Thirdly, oil’s share among primary energy sources was close to 40 percent in the 1980s. While the total amount produced increased by about 34 percent between 1990 and 2015, its share has decreased to 33 percent. Going forward, we can expect oil to lose further percentage points when compared to other sources of energy. The total amount consumed will still rise in accordance with a growing world population and its increased demand for energy, but the decline of oil’s relative weight in the energy mix may well accelerate.
Climate change goals, as well as heightened popular focus on the environment, will change people’s behavior and incentivize non-carbon dioxide-emitting sources of energy. Car-sharing schemes, electric vehicles and new fuels for aircraft are on the rise. Even before the Extinction Rebellion movement gained prominence, investors and insurance companies increasingly turned away from financing fossil fuels in favor of renewables. This investor sentiment is yet another reason that markets have failed to react commensurately when pricing oil throughout the latest crisis in the Arabian Sea.
We can expect Brent to rise further until a new event captures the imagination of traders. Don’t expect it to go to $100 a barrel though. This being said, the fact that the oil price no longer reflects Middle East tensions one for one does not mean that we can afford to neglect them. The Strait of Hormuz remains important, as does the security of the Gulf Cooperation Council, which is an island of stability in the sea of unrest that is the Middle East.
- Cornelia Meyer is a business consultant, macro-economist and energy expert. Twitter: @MeyerResources