Crude Oil Price Balancing Act For The Trader Community

By: Andrew_McKillop

MODERATION AND EXCESS
In the immediate wake of the Iran sanctions-unwinding agreement thrown together with many unanswered question in Geneva, Sunday night, Brent crude fell $2.29 or about 2.7% to settle at $108.76 a barrel, while US-traded West Texas Intermediate was down $1.44 to $93.40, in response to the agreement. Analysts were however quick to warn that Iranian exports are unlikely to jump in the short term because key limitations on sales – including a ban on crude oil but not finished product exports to the EU – will remain in place until a comprehensive deal is reached, starting six months from now.

US and EU sanctions have had a claimed impact of reducing Iranian exports from almost 2.5 million barrels a day (Mbd) or their equivalent in refined products, to a little over 1 Mbd since early 2012. The apparent squeeze on global supplies that resulted has allowed overpriced oil to be 'normal'. This is despite a global traded energy context, outside oil, where prices are falling, often far and fast.

Apart from the Syrian civil war crisis, Egypt's unresolved civil strife, and Libya's anarchy, Iran sanctions provided a clear storyline for the oil bulls, enabling them to overprice oil in day trading. The prospects of an Israeli, US or even Saudi military strike on Iran's nuclear facilities, which are widespread across its territory, enabled the so-called geopolitical risk premium on oil, especially Brent grade which benchmarks eastern hemisphere oil trade, to attain and sometimes hold about $10 - $15 on every barrel against US WTI.

Removing this premium will cut WTI grade oil prices to around $80 per barrel and Brent to around $95.

THE UNDERSIDE OF SANCTIONS
For close to 2 years, the threat of war against Iran or “Iran bombing” has buoyed oil prices. Spinoff and related trades or asset plays have included airline company fuel hedging, sometimes with unintended and very costly blowback, as deals unwound. Recurringly wrongfooted by elevated oil price volatility on global markets, their fuel price hedging strategies in some cases, as for Ryanair in 2011-2012, were non-performing and uber-costly.

Today's prospect of lower oil prices has already buoyed airline shares in companies such as IAG which owns British Airways and Spain’s Iberia, rising 3.1% and Easyjet up 2.5%. Main losers were of course the oil majors, with BP and other majors down about 0.5%.

Tucked away in the long and detailed US White House press release reviewing key points of the Geneva agreement, this will either suspend or scale back sanctions targeted at oil tanker shipping and insurance. This group of sanctions had numerous impacts, some of them “perverse”. While some analysts such as Fereidun Fesharaki of FACTS Global Energy believe the unwinding measures could lead to a rapid increase of between 200,000 and 400,000 b/d  (0.2 – 0.4 Mbd) in Iranian exports, the oil price impact is less sure.

Iraanian oil exports, claimed to have been reduced by a whopping 1.5 Mbd due to the sanctions (from 2.5 Mbd to 1 Mbd) were likely not cut by anywhere near that amount, in the opinion of many analysts, such as the Pegasus Consulting group of Karachi. They were however cut in price, that is the average “sanctions discount” applied in illegal or “sanctions-busting” trade. Dubai's so-called Dhow Trade, for example, may have transported an average 40 000 b/d out of Iran all through the sanctions regime, only as very small cargos, at prices as low as $50 per barrel. Other sanctions-busting transport and trade of Iranian oil is detailed by the IMO (former INCO), concerning large and very large crude carriers.

Between $50 a barrel and the present $93 for WTI there is a lot of room for arbitrage. One reason for global oil market prices declining that has had little attention from analysts is that EU imports of refined products from Iran – not crude – may increase rapidly. Again we have no consensus among analysts, but the major feature is that EU oil demand is weak, the continent's ability to import more oil (crude or products) without a major decline in price is low, thus the Brent price and the Brent premium against WTI look set to take a lot of flak. Put another way, the Brent price, by percent, has further to fall than WTI. Prospects for little or no price differential remaining, after the correction, are high.

IRAN OIL TRADE AND POLITICAL RELATIONS
Existing and previous diplomatic spats between the western partners to Iran sanctions (the US and EU), and the major Asian buyers of Iranian oil led by China, India, South Korea and Japan, are now set to taper down. All of them enjoyed what were politely called “waivers” on sanctions intensity and timelines for compliance with US-led sanctions. Their recent and apparent compliance was spurred by the oil tanker transport insurance and regulatory sanctions, and was in fact partly avoided through regrouping small-volume cargo shipments out of Iran, further down the coast, or across the coast of the Gulf, for onward shipping to the Asian final buyers. These buyers can now openly and rapidly step-up their imports of Iranian crude using their own-flag shipping.

For India, a major buyer whose government has wilfully published underestimates of Indian imports of Iranian crude since early 2012, the coming relaxation prompted relief, due to officials fearing a further decline in Iranian supplies. India “traditionally” buys about a fifth of all Iran's oil exports. Iran’s oil export sanctions had reduced New Delhi’s imports from Tehran by about a third. Anand Sharma, Indian commerce and industry minister, said his country had a “very special relationship” with Tehran and would now be “seriously taking all those measures which can improve our trade with Iran”.

This understates India's constant and permanent opposition to Iranian sanctions from the start. Like Pakistan, Israel and North Korea, India developed and exploded its own national atomic weapons outside the NPT, in India's case in 1974. It has no time or patience for Western hypocrisy on the nuclear issue. Indian cultural, historical and economic links with Iran are longstanding and Indian officials say they are only waiting for the green light to release due payments for supplies of Iranian crude already delivered. Very close behind India, China will do the same, followed by the other Asian buyers.

The Asian buyers will drive a supertanker through any vestiges of the sanctions that may remain after the Sunday agreement in Geneva. As India's ONGC (oil and gas commission) has frequently stated, it is ready and willing to move into Iran, to stop the decline in Iran's oil production capacity, whenever it is politically feasible.

THE TRADERS IN A QUANDARY
The Emerging economies dependent on imported oil headed by China and India, in 2012 attained a larger role in world oil consumption than the developed OECD countries. While the OECD countries continue to “taper down” their oil needs and consumption, this is not the case in the Emerging economies despite a sharp cutback in oil demand growth rates since 2008.

As Indian political leaders have repeatedly said, they can use every additional barrel that Iran can produce and export when sanctions end. In addition, they are poised to work with Iran to enable it it to rapidly stop and reverse its oil production decline.

This sets several major questions for the “trader community”, more interested in algorithms than basic supply-demand fundamentals. For the traders, Iran sanctions seemed permanent, like QE or the growth of Facebook share “value”, but they now have to painfully readjust to a thing called the real world. In that strange real thing, Iran is a major oil producer probably able to achieve 5 Mbd output in a short period of time going forward. Its historic peak was 6.6 Mbd in 1976.
Taking account that the claimed impact of sanctions on its net export surplus were exaggerated, and net exports did not fall to “a little above 1 Mbd” under sanctions, its rebound potential measured in net export terms has probably been underestimated. This oil will primarily be shipped East, not West, meaning that the eastern hemisphere benchmark price – Brent – has to fall more than WTI. Facing up to this reality may be painful for traders, who have doggedly attempted to rebuild and relaunch the Brent premium against WTI in recent months.

To be sure, oil is the No 1 commodity trade and therefore the most price-manipulated. To what extent and how fast the “trader community” will bend to reality, however unwelcome that reality is, will be a spectacle we can watch on a daily basis.

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

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