Oil: Geopolitics Support But Risk Of Correction Growing‏

Why has oil been able to defy the move lower in EUR/USD? As pointed out by the International Energy Agency (IEA) in its monthly Oil Market Report published this week, at present there is increasingly a disconnect between OPEC spare capacity and Brent oil prices: the two would usually move inversely but the opposite has been the case of late. OPEC spare capacity in normal times act as the key buffer for global oil markets: as long as OPEC has the ability to respond to a rise in prices, there should be a limit as to how much oil prices can rise as OPEC would pump more if prices are favourable. This has indeed characterised the OPEC reaction function for years and fits well with the cartel’s own mission of stabilising oil prices.

However, it is crucial to consider the reasons behind the latest move higher in OPEC spare capacity: renewed political unrest in Africa has led oil companies to review security arrangements in countries such as Libya, Algeria and Nigeria, thus halting production, and Saudi Arabia and Iraq have also cut supplies. This has acted to increase spare capacity but should hardly been seen as bearish for oil.

Separately, the fact the IEA cut demand forecasts for 2013 in February did not have much impact on oil prices as the recent improvement in data out of, notably, the US and China coupled with seasonal strength ahead of the Chinese New Year have been supportive for the front end of the oil forward curve lately.

On top of the above supply-demand developments, the geopolitical factor has returned with a vengeance, as talks between the UN’s International Atomic Energy Agency (IAEA) and Iran have once again broken down. The IAEA had reportedly received information that Iran might have built a blast chamber for test of nuclear weapons (the IAEA is closing in on a 10-year anniversary on Iranian nuclear talks this year) but talks broke down this week. With no new date set for the talks to be resumed, the risk of Israel losing patience with its long-standing foe is high. And the market remains unsure where the US stands on this; President Obama is set to pay a visit to Israel in March. Israel later this year. However, Iran is set to resume multilateral negotiations with the so-called ‘P5+1’ later this month. The IEA estimates that over the course of last year Iran lost USD3.4bn per month in export income versus 2011, as the country’s oil exports fell around 1 mb/d to average 1.5 mb/d. Iran is thus increasingly under pressure for solution (be it diplomatic or military) to be found.

However, there is a caveat to looking at Brent oil as representative of global oil market developments: alternative benchmark crude prices such as the WTI and Dubai have seen their discounts to Brent widen lately, partly because of unplanned outages in the North Sea in January after a strong Q4 production rebound.

The rise in geopolitical uncertainty and the special factors surrounding the North Sea market underline that global oil market fundamentals are not quite as tight as the Brent price would tend to suggest. In the near term, we expect Brent oil to stay well supported albeit USD125/bl should be the pain threshold for the world economy (as seen last year). Also, the risk of a near-term correction lower is imminent from the build-up in speculative positioning in oil to fairly extreme levels at present.

To Read the Entire Report Please Click on the pdf File Below.