Vontobel Multi Asset Boutique
The gloves have come off. US president Trump will not extend the waivers on Iranian oil imports that are due to expire on the 2nd of May. Despite his assurances that America and other OPEC members will pick up the slack, oil prices have surged sharply on the back of an already undersupplied market that will soon face a new supply drop. Iranian crude oil exports in the first quarter of 2019 were approximately 1.2 mbd, and we expect them to drop to around 500 kbd in May.
In the short term, the market will continue to tighten since Saudi Arabia is only likely to act once the supply gap from lost Iranian oil exports becomes visible in the market. In addition, US shale oil producers will not be able to step in any time soon since low oil prices at the end of last year have hampered costly shale oil production and infrastructure investments.
While we expect oil prices to rise across the board, the shortfall of Iranian barrels will have a large impact on the price differentials between different qualities of petroleum products recovered from crude oil. As a result, we expect the spread between diesel and gasoline to widen significantly.
The lost Iranian exports are predominantly medium sour crudes, while the potential extra exports from Saudi Arabia and the US are mainly light crude. This quality difference is problematic for refineries, which tend to be tuned in on certain types of oil. Saleable petroleum products are recovered by a distillation process, which separates crude oil into a range of components that are fractions of different qualities. These fractions correspond to different saleable end products. Generally, the processing of crude oil of any quality yields the entire range of petroleum products but in differing quantities depending on the input quality. For example, light sweet crude oil typically gives a higher yield of lighter products, such as gasoline, while heavier types of crude tend to yield larger quantities of lower quality products.
The Iranian shortfall exacerbates a global situation marked by mismatches in supply and demand for different crude qualities. For one, Venezuela, one of the largest exporters of heavier crudes has been grappling with political difficulties for a while which has severely affected its oil production capacity that has been limiting global supply. Second, growing US oil production extracts crudes of very light quality. Furthermore, IMO regulations coming into force at the end of the year, will impose new restrictions on the sulfur content of all marine fuels that large ships are allowed to use. As shippers switch from bunker fuel to higher quality fuel, such as diesel, global demand for both crude oil in general and certain distillate type of products will rise. This is because more crude oil is needed for higher quality products. We expect IMO to increase distillate demand by at least 1.0 mbd implying that an additional 2.5 mbd of crude oil has to be refined in order to satisfy this demand. However, since the processing of crude oil inevitably also yields gasoline in different qualities depending on the input quality, we estimate that an approximate 0.8 mbd of gasoline will be produced. This is based on the assumption that the additional crude oil demand will mainly be matched by light oil, which tends to yield higher quantities of gasoline than other types of crude oil do. This means that oil refineries a) will consume more crude oil and b) might struggle to produce all additionally required distillate products in the quantities that are demanded by the market. At the very least, they need sufficient price incentive to do so. As a result, a supply/demand deficit should be expected in certain distillate markets, especially for diesel, while gasoline could trade in a supply/demand surplus.
For active commodity investors there a three important insights to be gained from this situation: they should a) position for more upside in crude oil, b) position in the right type of qualities or products (gasoil, diesel), c) position for or hedge against underperformance in other products such as gasoline.