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Geopolitical risk will shape next twist in crude oil prices

Warning lights are on but the oil market's focus is softening demand

U.S. President Joe Biden holds an event about American retirement economics in the State Dining Room at the White House in Washington, U.S., October 31, 2023. REUTERS/Leah Millis Reuters/Leah Millis
President Biden's lifting of sanctions on Venezuelan oil is not a panacea for supply issues

Brent crude rose 8 percent after October 7 in the immediate aftermath of the disturbing violence in Gaza, the West Bank, south Lebanon and northeast Syria. But the benchmark has given back its geopolitical risk premium as the global wet barrel market now concludes that a war between the IDF and Hamas in Gaza and its regional spillover will be contained. What on earth is happening? 

In the futures market, the narrowing of Brent and WTI backwardation spreads – the difference between prices for immediate and future delivery – suggests that the physical oil market’s September tightness has begun to ease in October, confirming that the demand curve is flashing a softening SOS.

Instead, the oil market’s focus is now on the softening of demand due to higher recession risk in Europe, the UK, China and swathes of emerging markets where sovereign debt trades at distressed levels.

It is significant that tanker traffic in energy choke points such as the Straits of Hormuz, the Gulf of Oman, the Red Sea and the Suez Canal have not – yet – been impacted by the regional tensions.

Geopolitical risk still simmers. But not even news that Saudi Arabian forces are on red alert after clashes with Iran-backed Houthi rebels in Yemen or the US air strikes on Iran proxy militias have been sufficient to offset bearish data points.

These include a sharp contraction in Chinese manufacturing PMI and BP’s admission that fuel data margins are under pressure because gasoline and diesel markets are glutted. 

In Europe, an economic slump in Germany, one third of EU GDP, has led to a sharp contraction in diesel, naphtha and biofuel demand.

Germany’s economy is in recession, as construction and industrial output plunge. The industrial woes are best epitomised in Das Auto, otherwise known as the vehicle sector which makes up 18 percent of German GDP, where the loss of cheap gas imports from Russia’s Gazprom has been traumatic.

These trends are echoed in France, the second largest economy in the EU. 

Europe’s energy terms of trade have deteriorated sharply since the Ukraine war, a major factor in the Euro’s depreciation against the US dollar.

Apart from contraction in Europe, two mega deals announced by America’s integrated supermajors portend a significant rise in US shale output.

Exxon has made a for $60 billion takeover bid for Pioneer Natural Resources, a shale oil drilling colossus in West Texas’s Permian Basin.

Chevron, meanwhile, has acquired Hess Corporation for $53 billion, primarily for its shale assets in North Dakota’s Bakken field and a 30 percent stake in a consortium that owns the right to drill in Guyana. Here, the 11 billion barrel-of-oil-equivalent offshore Stabroek reservoir is the 21st century’s equivalent of the game-changer oil strikes in Britain’s North Sea, Alaska’s North Slope and Libya Sirte Basin in the 1970s.

These two deals demonstrate that the world’s largest oil and gas supermajors are doing their best to increase their proven reserves and output metrics in low geopolitical risk locales.

This is a clear response to the escalation of geopolitical tensions in the Levant, the wider Middle East and Russia.

It is ironic that Exxon and Chevron became global energy colossi due to their access to vast oil reserves and gusher fields in Saudi Arabia, Iraq, Iran and Kuwait.

But they are now rewarded by Wall Street when they return cash to shareholders in share buybacks and dividend increases because of their access to low-cost shale assets in the US. Four decades of war, revolution, regime change, asset seizure and nationalisation have dramatically reduced the allure of the world’s high geopolitical risk oil provinces.

That said, President Biden’s U-turn on Venezuelan oil sanctions and diplomatic rapprochement with Caracas is not a panacea to ease a potential oil supply shock from the Middle East. Venezuela can only increase its output by at most 200,000 barrels a day in 2024.

The opening of the Maracaibo Basin, whose 304 billion barrels of proven reserves make it a bigger energy El Dorado than either Saudi Arabia or Iraq, is a 2025 story at best.

Saudi Arabia is also producing at 3 million barrels per day below spare capacity so tighter sanctions on Iranian oil output, now at 3.2 million barrels per day, must be offset by the kingdom’s willingness to play its traditional role as Opec’s swing producer, as it did during past supply shocks in August 1990 and March 2003. This prospect can also contain any supply shocks in the oil market this winter. 

We should nonetheless be clear. As long as the war in Gaza and south Lebanon continues, the odds of a spike in crude oil’s geopolitical risk premium remains. The major issue is a confrontation between US military forces in the Middle East and Iran’s proxy militias in Lebanon, Syria, Iraq and Yemen.

Matein Khalid is the chief investment officer in the private office of Abdulla Saeed Al Naboodah and the CEO designate of a venture capital firm. He is also an adjunct professor of real estate investing and banking at the American University of Sharjah