Highlights Oil and Gas

Why Oil Is Still Underpriced

Oil prices seesawed over the past week, jerked higher by tension in the Middle East but dragged down by fears of the fallout from the U.S.-China trade war. In fact, crude is trapped between those two forces, and will likely bounce around in the near future based on which factor appears to exert more influence on the market.

Oil saw upward pressure in recent days as the U.S. government seems in danger of rushing into yet another war in the Middle East. National Security Adviser John Bolton appears dead set on trying to escalate conflict with Iran – even as tensions ratcheted up quickly over the past two weeks, officials on Bolton’s National Security Council “were initially dismissive of the need to draw up de-escalation options,” CNN reported, a clear sign of Bolton’s intentions.

However, President Trump appears to be trying to tap the brakes even as he largely agrees with the “maximum pressure” campaign on Iran. He reportedly told the Pentagon that he does not want a war. After all, he campaigned removing the U.S. from endless wars in the Middle East. Nevertheless, having pushed the U.S. to the brink of conflict, dialing down tensions may not be so simple, especially with Bolton and Secretary of State Mike Pompeo still running the show.

Trump’s decision to withdraw from the nuclear deal last year, followed by sanctions on Iranian oil, sanctions on Iranian metals exports, and more recently, sending naval ships to the Persian Gulf – all of the moves are calculated to ratchet up the pressure and arguably to provoke Iran into reacting. The danger is that either side miscalculates.

In fact, the Wall Street Journal reported on May 16: “Intelligence collected by the U.S. government shows Iran’s leaders believe the U.S. planned to attack them, prompting preparation by Tehran for possible counterstrikes.” Those moves by Iran have then been cited by U.S. officials as evidence of an imminent threat from Iran. In short, the Trump administration is playing a dangerous game. Any misstep or misinterpreted maneuver could theoretically lead to the breakout of war.

The good news is that Trump seems to want to de-escalate. Trump met with Swiss president on Thursday, which many view as an attempt to jumpstart negotiations with Iran. The Swiss have acted as an intermediary between the two sides in the past. Trump also said on twitter on May 15, “I’m sure that Iran will want to talk soon.”

Against this alarming backdrop, oil prices shrugged off serious concerns about the global economy, with Brent rising back to $72 per barrel over the past week. Even still, the market is “underpricing Iran risks,” according to Bank of America Merrill Lynch.

Meanwhile, the Brent futures curve is in a rather steep backwardation – in which front-month contracts trade at a premium to longer-dated futures. This suggests that the market is tight, at least for now.

At the same time, oil faces enormous downside risks from the U.S.-China trade war. In fact, demand was already slowing before the latest round of tariffs. “[G]lobal oil demand growth has decelerated sharply in recent months, averaging just 680k b/d in the past two quarters compared to trend demand growth of 1.46mn b/d in the past 5 years,” Bank of America Merrill Lynch wrote in a note to clients. Weaker manufacturing activity in the U.S., China and Germany have translated into weak distillate demand, the bank noted.

The trade war could make things worse. Tariffs have impacted “some pockets of the global economy,” Bank of America said, but the recent increase could begin to trickle down to more and more consumers. As the bank notes, models based on the U.S. Treasury yield curve suggest there is a one in two chance of a U.S. recession over the next 12 months, although there is disagreement over how important this metric is.

The downside risk to crude oil is magnified by the fact that speculators have bought up a huge volume of positions in oil, which could exert influence over prices in the short run. “[T]here is a risk that a large portion of the speculative community will nervously rush out of their positions if chances of a US recession increase again,” Bank of America warned.

The trajectory for crude oil prices hinges very much on what happens next with the U.S.-China trade war. “In our view, the global business cycle is at a key junction. Weakness in manufacturing may drag down services if trade wars eventually hurt consumer sentiment. In a global downturn, Brent could slip to $50/bbl,” Bank of America analysts wrote. “On the other hand, under a US-China deal scenario, business confidence may return with a vengeance, resulting in a weaker USD and stronger global growth. If a cyclical global demand upturn coincides with an IMO2020 boost, Brent crude oil prices could spike to $90/bbl.”

In short, the oil market is “underpricing the upcoming tail risks,” Bank of America said.

Bob McNally, president of the Rapidan Energy Group put it more bluntly in a statement to Axios. “The oil market has rarely seen so much two-way risk. China, trade and macroeconomic weakness could send crude prices at least $15 lower and intensifying geopolitical disruption risks in the Middle East and Venezuela could propel them higher by a similar amount,” he said.

Source oilprice

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