OPEC: Crude oil is set for upside

Quantitative Investments
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OPEC has no choice but to extend the production cuts in their next meeting on July 1 (OPEC) and July 2 (OPEC+). Production cuts are needed to provide further support to the oil price that has come under pressure lately due to global recession jitters and trade war fears. However, expectations that the cuts will be deepened are misplaced. Only if OPEC believes that crude oil demand will weaken considerably, for example due to a full blown trade war between the US and China, could they feel pushed to deepen the cuts. What’s more likely is that OPEC’s focus will be on production quota compliance. This means that more pressure will be put on Iraq and a few other quota cheaters to fully comply in the second half of the year.

Looking further ahead, now that a friendly Trump-Xi meeting has appeared on the horizon, fears of worsening US-China trade relations could dissipate and give a boost to the oil price that could reach previous highs of 75 USD per barrel in a relatively short period of time. The second half of 2019 could see the oil price rally even more as result of three main bullish indicators:

  • Resolution of the US-China trade dispute
  • International Maritime Organization (IMO) regulation forcing shipping companies to use higher quality fuel
  • Potential supply disruptions in the Middle East due to worsening US-Iran relations

Having said that, Saudi Arabia is unlikely to allow the oil price to approach the 100-USD mark and will step up production to put a lid on further price increases.

Iran

While OPEC+ is likely to provide support to crude oil prices, Iran could make them soar. Much depends on how the US and Iran settle their spat. Donald Trump has two main choices in how to respond to the alleged Iranian tanker and drone attacks in the Strait of Hormuz: a military strike or more sanctions. Both are problematic for Trump but bullish for crude oil.
He could opt for a military response. However, this would mean breaking his “America First” election promise. Moreover, a military escalation is unlikely to bring Iran to the negotiating table.

The lesser evil of the two options and the more likely alternative is imposing additional economic sanctions on Iran. How effective this will be is questionable though, since economic pressure on Iran via US sanctions has almost reached a maximum. However, compared to open military conflict, this strategy has at least a chance at Iran resuming negotiations, albeit a small one. As a result, the more likely outcome is that we will see more disruptive events around the Strait of Hormuz, eventually forcing a military response from the US. The best outcome that Iran can hope for is that disruptions of oil flows will become too costly for the world to bear, either forcing the US to back down, or alternatively (and more likely) pushing China, Europe and other countries to circumvent US sanctions by increasing their Iranian crude oil imports. In this context, there are some key dates to keep in mind, which will heavily influence Iran’s next move:

  • June 28 + 29, G20 summit: Iran has built up significant amount of crude oil inventories in China that could be sold if China chooses to circumvent US sanctions and with it the Eurodollar/SWIFT payment system provided they find an alternative transaction mechanism. The probability for this to play out rises with an escalating trade conflict between China and the US. For now this seems unlikely given that a friendly Trump-Xi encounter at the G20 summit is widely expected.
  • July 7, Iran deadline: Iran set a deadline for the EU to come up with a response to the withdrawal of the US from the Iran nuclear deal. Should the EU remain silent, Iran might feel tempted to further disrupt petroleum shipping via the Strait of Hormuz. Even with a vehicle in place to bypass the Eurodollar/SWIFT payment system, it is unlikely that the EU will be able to provide sufficient economic support to Iran. Should the attacks in the Strait of Hormuz continue in July, this would send a clear signal to shippers that security cannot be guaranteed when passing the Strait of Hormuz as long as Iranian oil exports are capped.

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