The Fuse

U.S-Iran Tension Still Simmers, But Oil Market Well-Supplied

by Nick Cunningham | June 26, 2019

The U.S. pulled back from the abyss last week, with President Trump calling off a military strike on Iran at the last minute. While the world breathed a sigh of relief, the two countries are caught in a dynamic that makes ongoing escalation likely.

Against the backdrop of rising tension in the Persian Gulf, OPEC+ will meet to decide next steps. Supply outages are at a multi-year high, but non-OPEC production continues to grow. At the same time, demand has weakened amid a softening of the global economy, which will likely force OPEC+ to extend the production cuts.

U.S.-Iran conflict far from over
The U.S. withdrawal from the Iran nuclear deal in 2018 sowed the seeds of the current conflict. American sanctions aimed at blocking Iranian oil exports, along with a litany of other sanctions, put “maximum pressure” on Iran. In response, Iran appears to have lashed out, although some of the details surrounding the recent tanker attacks remain murky. The downing of a U.S. drone put the two countries at the precipice of war.

Despite the U.S. decision to stop short of a military strike, direct conflict is still a distinct possibility. For instance, Iran has already said that its stockpiling of low-enriched uranium would breach the limits laid out in the 2015 nuclear accord in the coming days. Having pleaded with the European Union to little effect, it seems the Iranian government has lost patience with suffering from withering sanctions while simultaneously complying with the nuclear deal.

Moreover, the recent U.S. decision to sanction high level Iranian officials, including both the Ayatollah Ali Khamenei and Iranian foreign minister Javad Zarif, makes diplomatic negotiation increasingly unlikely. It’s also entirely conceivable that the latest round of sanctions will lead to another Iranian response. In other words, the cycle of escalation, in tit-for-tat fashion, will inexorably push the two countries back to the brink of war.

The cost of insuring oil shipments through the Strait of Hormuz has climbed to $500,000, roughly ten times higher than earlier this year.

That raises the question of a supply outage in the Persian Gulf. Multiple attacks on oil tankers over the past few weeks highlighted the risk to supply. As Bloomberg reported, the cost of insuring oil shipments through the Strait of Hormuz has climbed to $500,000, roughly ten times higher than earlier this year.

President Trump seemed unconcerned with the risk. In a series of tweets on June 24, President Trump downplayed the importance of the Strait of Hormuz to U.S., citing a declining import dependence on the region.

The statistics are off, but the President is right that U.S. imports from the Persian Gulf are on the wane, down to just 1 million barrels per day (Mb/d) in March, roughly a third of the 3 Mb/d from the early 2000s, according to S&P Global Platts. Oil from the Strait of Hormuz only amounts to about 15 percent of total U.S. oil imports, a 32-year low, according to Standard Chartered. That is a direct result of surging U.S. oil production and also heightened imports from Canada.

While the tweet does not necessarily signal an official change of policy, it called into question several decades of U.S. security strategy in the region, namely, that the U.S. Navy patrols the Persian Gulf to prevent a disruption to oil flows.

But as energy analysts have argued ad nauseam, a supply disruption anywhere will affect oil prices everywhere. As a result, it matters little that the U.S. is no longer dependent on oil that specifically comes from the Persian Gulf. As long as the U.S. consumes 20 Mb/d –a fifth of total global consumption – supply disruptions will be acutely felt at home.

About 20.7 million barrels per day passes through Hormuz, or a fifth of global supply. An outage still remains a remote possibility, but the perception of risk is on the rise. The U.S. Navy has a heavy presence in the vicinity and any attempt to block shipments would likely provoke an American response. However, one of the most significant reasons why Iran would decline to take such an aggressive act – that it too needs to export oil through the narrow passage – is disappearing. Iran’s oil exports have plunged to just 800,000 bpd in May, down from 1.7 Mb/d in March, according to S&P Global Platts. If the U.S. succeeds in cutting off Iran’s oil exports entirely, Tehran would have little left to lose.

The impact of a disruption would be profound, but “critically depends on its geographic scope,” Standard Chartered wrote in a note. “In the worst case, any escalation that results in a spread of fighting across the region into Iraq, significant disruption to transit through the Strait and any intensification of attacks on Saudi Arabia launched from Yemen could take prices at least USD 20/bbl higher.”

According to S&P Global Platts, spot LNG prices could double if shipments were disrupted through the Strait of Hormuz. Nearly a third of the global LNG trade passes through the Strait as an outage would affect all of Qatar’s exports, one of the largest LNG exporters in the world. “This massive exogenous supply shock easily holds the potential to double spot LNG prices in short order,” Platts Analytics said.

Supply outages have topped 4 Mb/d, the most in nearly three decades

OPEC+ gears up for extension
Supply outages have topped 4 Mb/d, the most in nearly three decades, according to a recent estimate from Bank of America Merrill Lynch. Roughly half of that total comes from Venezuela and Iran. However, even with such a significant volume of oil knocked offline, the market is still struggling with weakening demand and strong U.S. shale production.

Global supply may grow by as much as 1.9 Mb/d this year, outpacing the roughly 1.2 Mb/d demand increase, according to the International Energy Agency. The IEA sees non-OPEC supply growing by even more next year, increasing by 2.3 Mb/d, which again exceeds demand growth. “The anticipated gains are such that even with higher demand growth versus 2019, the requirement for OPEC crude could drop to 29.3 mb/d in 2020, 650 kb/d below the group’s production in May,” the IEA said in its June Oil Market Report.

The U.S. and Iran are on a collision course, but as long as the confrontation does not lead to war, the oil market appears well-supplied. That leaves little choice for OPEC+ in Vienna next week but to extend the production cuts.

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