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Crisis in the Middle East: Oil Scenarios

Our Team analyses the impacts of a Saudi supply disruption. The article explores the potential implications for emerging markets, known to be major oil consumers, along with the cascading effect on inflation as the world struggles with rising commodity prices.

Hamas' assault on Israel was a geopolitical shock. As the situation worsens, potentially involving other actors in the Middle East, there are implications for crude oil prices. This article looks at the geopolitical links of the oil market and the potential for supply disruptions. ‍ The initial market reaction was stronger than that Russia-Ukraine in 2022 The Monday following the attacks saw an immediate reaction in the raw materials and safe haven market. Crude oil prices rose by about 5%. Gold rose 1.5%. And U.S. government bonds rose, with 10-year yields down about 12 basis points. These abrupt market movements give a glimpse of the uncertainty that is being seen in this conflict. As our first chart shows, these movements were net when compared to the first two trading days after Russia invaded Ukraine last year. (To be honest, market reactions in other assets were relatively contained: the S&P 500 was initially sold, but quickly reversed).

Day on day % movement: Comparison between conflicts in Ukraine and Middle East
Day on day % movement: Comparison between conflicts

Moving to the options market, there was a sharp drop in the ratio of put volume to call volume for the West Texas Intermediate (WTI) oil price, as the second box of the next chart shows. This is indicative of rising price risks. A put/call ratio below 1 implies that there are more expectations of a price rise than a fall. On Monday, the put/call ratio dropped sharply to about 0.4 from the previous level of 1.25. The top panel of the chart represents the price of the WTI in 2023 and shows the grey shaded periods when the put/call ratio was below 1; in general, these coincide with rising crude oil prices.

WTI crude oil Put/Call volume ratio for 2023
WTI crude oil Put/Call volume ratio

The importance of Gulf producers

Israel and the Palestinian territories are not the main oil producers, but many nations in the wider region are. The Middle East as a whole accounts for almost a third of the global oil supply; Saudi Arabia accounts for about 12% and Iran about 4%. Iraq, the United Arab Emirates, Kuwait and Qatar are also important producers. The following graph traces the oil production of the countries bordering the Persian Gulf over the years.

Oil supply from Middle East countries from 2009 to 2023
Oil supply from Middle East countries: 2008 - 2

The lower box of the chart traces the relationship of the price of Brent crude to Middle Eastern oil production as a percentage of world supply. This is where we see the impact of OPEC's cuts and production increases on prices: the move to pump more oil since late 2014 is clearly visible, as is the prolonged period of low prices that followed. You can also see the cut in OPEC production at the end of 2022.‍

Downside risks for supplies from Saudi Arabia and Iran

The war between Israel and Hamas comes at a delicate time.

Prior to the attacks, Saudi Arabia had signaled to Washington that it could increase production in 2024, if necessary, to keep pressure on oil prices under control – but also as part of an agreement that could see a normalisation of Saudi diplomatic relations with Israel and increased Defence. cooperation with the United States (according to the Wall Street Journal). As the war reduces the likelihood of a Saudi rapprochement with Israel in the short term, it also diminishes the chances of such an increase in supply in 2024. There are also downside risks to Iranian production. Prior to the Hamas attack in mid-September, the U.S. and Iran had agreed to release the prisoners in a move that was seen as a easing of tensions and potentially allowing for a gradual increase in Iranian oil sales. However, given Iran's ties to Hamas, the conflict instead raises the possibility of tougher US sanctions against Iran. The next chart is a different visualisation of the importance of Saudi and Iranian crude, which together account for about 16% of global supply. A month-on-month decline in Saudi and Iranian combined oil production in the past has quickly translated into more marked price changes month after month and strong volatility. Pandemic-related disruptions are the most notable, but there are other monthly peaks of up to 25%.

Saudi and Iran oil production vs Brent price, month on month movement from 2018
Saudi and Iran oil production vs Brent price

Price scenarios: oil at more than $100 in 2024?

Crude oil prices are a function of different supply and demand dynamics.

Demand is driven by 1. overall economic growth; 2. growth potential in emerging markets, which are large oil consumers; 3. demographic and employment trends; 4. macroeconomic indicators, such as growth, inflation and exchange rates. (We are currently seeing a world characterised by slowing GDP growth, concerns about oil demand in China, and slimy inflation that is affecting consumer purchasing power.) Supply factors include: 1. different sources of oil that become vital for production at various price levels; 2. technological advances that affect substitute production; 3. weather patterns; 4. regulatory changes, especially environmental policy; and 5. geopolitical events. Using Macrobond's partnership with Indicio, we've built forecasting models to help assess general Brent price trends for: Status quo – no supply impact resulting from the war; And A scenario where oil supply is reduced The input parameters of our models included general macro indicators, such as world GDP growth; demand, i.e. oil consumption reported by OPEC; and oil production trends. Estimates of oil supply and GDP growth on an annual basis have the greatest influence on price developments. All other things being equal, given a context of slowing economic growth, Indicio's weighted production from univariate and multivariate models predicts that Brent crude will slide towards $86 per barrel next year. We then carried out the scenario analysis for the adverse geopolitical repercussions resulting from a continuing war in Gaza. If we consider a 0.3 mbpd reduction in Saudi Arabia's oil production, we will end up with a significantly higher oil price in a year, closer to $103 a barrel.

Brent crude price forecast above $100
Brent crude price forecast

5 November 2023

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