Welcome to The GERM Report by Dan Graeber, a commentary on the intersection between geopolitical events and the price of oil. GERM stands for Geopolitical Energy and Risk Monitoring. Our indicator is based on the expected price volatility by the end of the current trading week.
Risk level: Yellow
RED: Severe (+/- 4%) ORANGE: High (+/- 2%) YELLOW: Elevated (+/- 1%) BLUE: Guarded (+/- ½%)
THE BOOSTER SHOT
- Technical signals point to a tighter market.
- IMF: Saudi Arabia needs oil priced higher than $80/bbl.
- On national security, a defensive posture can lead to offensive actions.
A perfect storm of talk of war and a tightening market drove crude oil prices higher last week. Saudi Arabia accused Iran of ordering the Houthi rebel group in Yemen to hit its East-West oil pipeline with armed drones. The lack of clarity over how such a strike evaded Saudi air defense systems only speaks to the murky security dilemma in the Middle East. Meanwhile, both OPEC and the EIA last week warned the market was getting tight and the state of backwardation for Brent only confirms that. Meanwhile, US President Donald Trump made a confusing string of decisions that all but ruined any chance of a trade deal with China, but brought relief to regional neighbors when it comes to steel and aluminum. To some degree, Trump’s decisions must be viewed through the lens of a re-election campaign. But all of his decisions seem to be confusing, and deliberately so. This confusion not only leads to volatility in the marketplace, but adds to the risk of miscalculation in terms of national security.
The backwardation structure of Brent futures widened further, with the spot price now about $3.30 per barrel higher than the December contract. OPEC, in its market report for May, said demand would strengthen soon as refineries return from heavy spring maintenance. Meanwhile, oilfield services company Baker Hughes has been reporting a steady decline in rig activity in the United States. US foreign policy decisions impacting OPEC members Iran and Venezuela did not impact the global balance as much as feared because spring refining maintenance season was heavier than usual, but that buffer is ending and the price of oil is moving higher. The price for Brent crude oil ended up about 2 percent from the open on Monday, in line with last week’s Orange alert, to close the week at $72.21 per barrel.
Speaking Saturday ahead of a meeting of the joint committee monitoring voluntary OPEC production constraints, Saudi Energy Minister Khalid al-Falih told Reuters he was “not sure there is a supply shortage” that would indicate a need to open the spigot. That could be indicative of the kingdom’s need to keep oil prices around $80 per barrel in order to break even, according to the IMF, as most signals do point to a tighter market in the second half of the year. That is certain to rile a US president who needs a strong economy to boost his chances for a second term in office. Historically, incumbent presidents usually can extend their tenure when the economy is strong and high gas prices could threaten that chance. Trump has frequently called on OPEC to keep oil flowing, though a fool-me-once plea last year ahead of the US waiver decision on Iran may keep Riyadh deaf this time around. Scoffing at the cartel label, OPEC instead is bound by a sort of prisoner’s dilemma where, over multiple rounds, mutual cooperation is in everyone’s interest in a system where there is no other higher authority. By that logic, OPEC+ will follow the lead of Saudi Arabia. In a short-term game, however, that same prisoner’s dilemma means members such as Iraq will continue to cheat in order to take advantage of bullish market conditions. On balance, Falih’s comment indicates the market, whether on technical terms or by design, will get tighter and tighter.
On the geopolitical front, the risk of miscalculation is high. The US State Department last week made the exceptionally rare decision to pull non-essential staff out of the US Embassy in Baghdad and the consulate in Erbil. Bahrain, a frequent critic of Tehran, ordered its citizens out of Iran and Iraq on Saturday. This is spillover from the hijacking of US military policy by John Bolton, an avid supporter of war with Iran. Bolton last year told the Mujahedeen-e-Khalq that the exile group would “celebrate in Iran” when the clerical regime collapsed. Trump has nonetheless been vocal in his distaste for war. In international politics, however, the prisoner’s dilemma dictates that both sides of the conflict act in their own self-interest and maintain at least some form of defensive posture to avoid weakening their position. This leads to another quandary, the security dilemma, which holds that actions taken by a state to enhance its security leads other states to do the same. This can lead to escalating tensions and result in conflict, even when no side really wants it. Defensive action by one side leads to a reciprocal response by the other. Defensive moves take on offensive tones and war then becomes inevitable. Meanwhile, a 2013 study in the journal International Security found that at least 25 percent of all wars since 1973 were related in some way to oil.
In the economic calendar, Monday kicks off with a speech from US Fed Chief Jerome Powell at the Federal Reserve Bank of Atlanta, which revised its snapshot of GDP growth up ever-so slightly. On Tuesday, watch for data on existing homes sales in the US economy. Minutes from the May meeting of the US Fed and remarks from ECB Chair Mario Draghi are on tap for Wednesday. Japan’s year-on-year consumer price index for April is published on Thursday and on Friday, it’s US durable goods orders from April. Against all this is the ever-present trade war. Brent, meanwhile, remains in steep backwardation, a sign of tightening supplies. Brent still has room to move before bumping into resistance at perhaps around $73 per barrel and buy signals are still relatively strong. The dwindling chance of a breakthrough in US-Chinese trade talks could balance Middle East tensions. A Yellow alert is in place for the week, with Brent moving by plus or minus 1 percent.