Blogs | Fuelling Innovations | Unipetrol a.s. | Czech Republic

Increased uncertainty and higher oil prices


Oil prices were expected to stay low for long, but here they are on the rise again. The increase in spot prices to more than USD 70 per barrel of Brent crude was driven by geopolitical factors, which can disrupt short-term supplies. The key ones include the risk of conflict in the Persian Gulf, but also the collapse of the petroleum industry in Venezuela. The result is an environment where higher oil prices are likely to persist for some time. Suffice it to say that the forecast Brent crude prices for 2018 and 2019, anticipating the aftermath of the US withdrawal from the nuclear deal with Iran, are now higher by USD 7–10 or more than just a month ago.

Commentators agree that with the nominations of General Mike Pompeo as US Secretary of State and of John Bolton as National Security Advisor, the American foreign policy has moved to a more confrontational stance. The oil market reacted promptly. On March 23rd, the price of Brent crude topped USD 70 per barrel. Another risk factor emerged on April 11th, when Steven Mnuchin, US Secretary of the Treasury, signalled that the United States could impose ‘very strong’ sanctions on Iran as President Donald Trump was seeking to renegotiate the deal restricting Iran’s nuclear programme. After this statement, the price of Brent crude jumped above USD 72 and kept climbing with the approaching deadline for the decision, set for May 12th. The increase in oil prices was attributable to the widespread conviction that the re-imposition of sanctions on Iran by the US was in fact a foregone conclusion, with slight declines only a sign of uncertainty about how severe the sanctions would be.

On May 8th, President Donald Trump drove another wedge between Washington and its European allies by deciding on the US’ unilateral withdrawal from the Iran deal. What will be the consequences? They are difficult to predict today, the only certain thing being that Iran will bear the brunt. Before the decision, the general belief was that it would be less severe than the international sanctions imposed in 2012, given the likely opposition from China and Russia as well as the European Union’s resolve to stick to the nuclear deal with Iran. According to IHS Markit estimates, Iran’s oil exports may shrink by 200,000 barrels per day in 2018 and by 500,000 barrels in 2019. Iran's reaction remains a puzzle – on the one hand, it has pledged to remain committed to the deal without the US, but on, the other hand, the country’s behaviour is unpredictable in the long run.

The difficulty in assessing the possible consequences stems mainly from growing uncertainty over further developments in the Middle East, and in the relations between the US and Europe, North Korea, Russia, and China. Tensions in the Persian Gulf have lingered for quite some time, sparked mainly by political changes in Saudi Arabia. Like Israel and the United Arab Emirates, Saudi Arabia fears a revival of Iran's nuclear programme, striving to curb its influence on neighbouring countries. Saudi Arabia’s ambitions to become a strong regional player and its economic transformation plans require massive financial outlays. Hence a shift in the country’s oil production strategy: rather than defend its market share, it has focused its efforts on pushing oil prices up, to USD 80 per barrel or more.

Following President Trump’s decision, the price of Brent crude jumped and is now hovering in the region of USD 77 per barrel. Does this herald a longer spell of high prices? Personally, I believe not – as long as no other risk factors crop up. There are self-regulatory mechanisms on the oil market which can, over the next few quarters, significantly rein in price hikes resulting from supply disruptions.

We should bear in mind that demand for oil is now growing at a rate of approximately 2 million barrels per day, driven largely by the prolonged period of low prices. Oil prices staying around current high levels for several quarters would adversely affect demand for oil and the economic growth of importing countries. Higher fuel prices reduce disposable incomes, making private consumers switch to cheaper public transport and, consequently, buy less fuel. Business enterprises have no such choice. They have to spend more on transport costs, generating less value added, earning less and cutting back on investment, and usually need two to three quarters with higher oil prices to adjust. On the other hand, higher oil prices do favour exporters, but according to the IMF, in global terms, growing oil prices tend to slow down the world’s economy.

If, as is currently the case, a rise in oil prices is triggered by global geopolitical tensions, such a situation leads directly to a global economic downturn and, in consequence, weakens future demand for oil. Importantly, these geopolitical risks have appeared late in the global economic cycle, going back nine years now, and coincided with the beginning of an interest rate hiking cycle across the globe. Christine Lagarde, head of the IMF, warned about the fallout of increasingly likely trade wars and the rapid worldwide growth of debt. In her opinion, the rules underpinning global trade might be broken, with a direct adverse impact on global economic growth and demand for oil.

According to IHS Markit, within the next twelve months, the geopolitical factors discussed above may reduce the global growth in demand for crude oil and liquid fuels to 1.2–1.5 million barrels a day in 2019, that is 0.7–1.0 million barrels of oil and refining products.

If nothing unforeseen happens, oil production in the US should be sufficient to satisfy this reduced demand growth. According to IHS Markit, with WTI crude oil prices averaging more than USD 60 per barrel in the US (which corresponds to more than USD 65 per barrel of Brent crude), production volumes will increase by 1.2 million barrels a day this year and by 1.1 million next year. To compare, non-OPEC countries will increase oil output by 0.3 and 0.6 million barrels a day, respectively. Why is oil production from shale deposits constantly on the rise? A crucial factor here are the advances in production technologies, increasing daily yields from a single well. For instance, new technologies have rekindled production from the Permian Basin, which is now delivering over 700,000 barrels of oil per day. To compare, oil production from the Gulf of Mexico is ten times lower.

The return of the geopolitical risk premium is ushering in a period of higher and extremely volatile oil prices. In the long run, though, oil will surely not be in short supply, with uncertainty concerning chiefly the strength of demand. Such balance of market forces does not create pricing pressures. In the long term, oil prices will, on the one hand, be driven by technology developments diminishing the role of oil in transport, and, on the other, by environment and climate protection regulations, creating pressures to reduce transport-related emissions. Markets may be unprepared for either of these factors, which is bound to trigger price cycles. This, however, will be discussed in my next post.

Adam Czyżewski

Adam B. Czyżewski, Ph.D., has been the Chief Economist at PKN ORLEN since 2007. He specialises in the changes of the global energy sector that are driven by economic policies and revolutionary innovations.