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Why Oil Prices Are Headed Higher by Year End

Oil is up marginally to start the week, but it is still heavily underpriced

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Matt Winkler
Jul 23, 2019
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Tensions in the Middle East are flaring up and oil is barely responding. Reports are surfacing of tensions increasing on Israel's northern border with both Syria and Lebanon just after Iran seized a British-flagged oil tanker in the Straits of Hormuz late last week. Still, oil has been stubbornly calm, well below last Friday's high of $57.42 when news of the Iranian operation first broke. Now Goldman Sachs (GS) is joining up with the oil bulls, calling for a $6-per-barrel run from here.

Goldman's thesis leans more toward supply-and-demand dynamics, but the geopolitical situation cannot be ignored as a possible significant catalyst.

The trouble is not contained to just Iran or Syria. These disturbances are coming in the face of a growing U.S. military presence in Saudi Arabia on the back of “emergent, credible threats,” in the words of the Pentagon. According to NBC, U.S. rearmament in Saudi Arabia began back in June at Prince Sultan Air Base, before any of the most recent flare ups and tanker seizures. That base was deserted 15 years ago. Now, fighter planes are on their way back, and it should be operational by August.

To have a subdued oil price in the face of news like this shows exceptional bearish sentiment on the part of oil speculators. Even trading volume did not pick up substantially when news of the tanker seizure hit the wires on Friday. Trading volume in the U.S. Oil ETF (

USO, Financial) that day was, remarkably, 12% below average.

Oil bears do have one development on their side despite the ratcheting up of tensions, though. Senator Rand Paul, a known foreign policy dove who has vocally opposed war with Iran, has been appointed by President Trump as his liaison for possible negotiations with the Islamic Republic. This happened last Wednesday in a story broken by Politico, bringing oil prices down on the assumption that Paul could help calm the atmosphere.

That was not to be, it seems. If a direct conflict breaks out between the U.S. and Iran, oil prices could spike strongly.

Sill, geopolitics is not the only factor here that warrants an oil premium. Betting on a conflagration as an exclusive catalyst is generally not a safe strategy. In this case, though, market fundamentals back up the bullish case. According to the latest global production figures available, we could soon see a supply crunch, maybe not immediately, but momentum is building in this direction. Since the end of 2018, crude oil production has declined by 120,000 barrels per day in Russia, 861,000 in Saudi Arabia, 464,000 in Venezuela, 500,000 in Iran and 380,000 in Canada. China is still 500,000 barrels off peak production hit back in 2015.

The only country among the world’s top-six oil producers that is still increasing production to new highs is the U.S. However, the U.S. increase since the end of last year makes up only 313,000 barrels per day of the production deficit among the other top five.

Further, we are now only five months away from a demand increase due to what is known as IMO 2020. This refers to new global restrictions by the International Maritime Organization against high-sulfur fuel for the shipping industry, which will take effect in January, forcing tanker operators to switch to low-sulfur fuel oil from the current high-sulfur byproducts of crude oil processing. Most ship operators that don’t install fuel scrubbers will have to switch to low-sulfur fuel. According to the International Energy Agency’s Oil 2018 report, low-sulfur fuel demand will increase by just under 2 million barrels per day once the new regulations kick in.

It can be reasonably assumed that the recent downtrend in oil prices is due to fear of a global economic slowdown and recession, but even if that occurs by the end of the year, new IMO 2020 regulations should pick up much of that demand slack.

And so we are back to square one. With IMO 2020 potentially counteracting much of any ensuing fall in oil demand due to a recession, global production falling among the world’s largest producers, and the geopolitical situation becoming very tense, any supply shock to the global oil markets would necessitate oil prices climbing significantly from here.

Disclosure: Long oil.

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