Is Geopolitical Risk Premium Back In Oil price?

Is Geopolitical Risk Premium Back In Oil price?




The two crude oil pricing benchmarks around the world are the Brent price and the West Texas Intermediate or WTI price. The two benchmark oil trade in the futures market and attract tremendous hedging, investment, and speculative interest. Brent crude oil is the preferred pricing mechanism for around two-thirds of the world’s crude oil while WTI is the benchmark for the other third. WTI is sweeter crude, meaning it has a lower sulfur level and is more appropriate for gasoline production in the refining process. Brent’s characteristics made it easier and cheaper as an input for the refining of diesel fuels and other distillates. Meanwhile, Brent and WTI are benchmarks, and while oil production all over the world may use them for pricing purposes, there are many discounts and premiums to the prices depending upon the physical characteristics of the oil.


Many factors contribute to the price differential between Brent and WTI crude oil. Before 2010, WTI tended to trade at a small premium to Brent because it is less expensive to refine into the world’s most ubiquitous product, gasoline. However, in 2010 the Arab Spring caused concerns that Middle Eastern politics could impact production and logistical routes in the region. Brent rose to over a $25 premium to WTI as the price of both types moved north of $100 per barrel. Most recently, Brent remains at a premium to WTI of around $2-$2.50 per barrel due to the increase in U.S. shale production and the political “premium” in the Middle East.


Over recent weeks, the political temperature in the region of the world that has massive oil reserves has risen as Qatar has become an outcast to Saudi Arabia and has been embraced by Iran. Over coming weeks, the Brent-WTI spread may be the best measure of rising or falling tensions in the region.


OPEC’s blues


The international oil cartel has long suffered from rifts between members. Saudi Arabia and Iran have been enemies in the region for decades which made agreements difficult on many OPEC issues. Qatar, the tiny Persian Gulf nation, with massive natural gas and oil production served as a bridge or mediator when it came to divisive issues. However, in 2016 the Russians took over as the mediator and arranged an agreement to cut production. Russia stood between the KSA and Iran and mediated the terms for output quotas leaving Qatar on the sidelines as an observer. Over the years the tiny nation continued to maintain good relations with Iran.


After a recent visit of U.S. President Donald Trump to Saudi Arabia in May, the Kingdom and some of their allies in the region deemed it essential to force Qatar into a loyalty check. The Saudis with Bahrain, the United Arab Emirates, Egypt, and other allies thought Qatar and Iran had crossed essential red lines funding terrorist groups in the region and undermining the legitimacy of incumbent regimes. At the same time, Al Jazeera, the cable news network that operates out of Doha, has been persistently critical of the Saudi Royal family. At the same time, Qatar depends on the KSA for 40% of its food supplies. Most of the direct investments in the region are interwoven. On a per capita basis, Qatar is the richest nation in the Middle East, and their investment tentacles spread all over the world.


Saudi Arabia and its allies announced a land, seas, and air blockade of Qatar until they cease funding terrorist groups and take a giant step back from their relationship with Iran. The blockade further exacerbates the issues between KSA and Iran as both continue to fight a proxy war in Yemen.


Qatar’s strategic location


Qatar spent many years as a mediator within OPEC. When the Russians decided to get involved in changing OPEC production policy in 2016, the first meeting was held in Doha. Qatar’s location makes the country a strategic asset in the region, whenever it comes to fighting terrorism in Iraq, Syria, Afghanistan, and other nations in the area. The United States operates a military base with more than 9,000 troops. The U.S. finds itself in the middle of a minefield. The U.S. Secretary of State Rex Tillerson urged both sides for dialogue to end the blockade.


President Trump expressed support for the Saudis while greenlighting the sale of military hardware and fighter jets to Qatar. Qatar has been a cog wheel in OPEC for many years.


The current rift in the region would further undermine OPEC jeopardizing the quota policy. The recent plunge in the price of crude oil – the lowest price since August 2016 will add pressures on all OPEC members and the respective governmenst.


The blockade had a short term upward effect on the price of crude oil in the short-term. Since then, however, it has declined from $52.22 per barrel on May 25 to lows of $42.05 on June 21. The drop amounted to 19.5% in less than one month after OPEC announced an extension of production cuts through the first quarter of 2018.


US – the oil market maker


U.S. shale production has caused a surplus in the oil market and now that the price has dropped it is likely that any decline in U.S. output will be offset by under reported output by OPEC members, that need to sell more oil to maintain steady revenues. Meanwhile, the current slide in oil prices below support levels and the rising problems in the Middle East add volatility in the international crude oil market in the weeks and months ahead.


When oil recovers above the $50 per barrel level, analysts usually resort the growing global demand for energy and OPEC production cuts. When prices fall below the pivot price, attention shifts to U.S. shale production, the rise in alternative energy supplies, and the increasing inventories. Why prices of oil will continue to trade around $50 per barrel.


The biggest IPO in history and growing in the Middle East


Saudi Arabia intends to inject a significant amount of capital into their sovereign wealth fund with an initial public offering of the Kingdom’s crown jewel Saudi Aramco in 2018. The IPO is likely to be the biggest in history with the business’s valuation bumping up around the one trillion dollars’ level. In the strategic document – Vision 2030, King Salman and the Royal Family committed to diversifying the nation’s economy away from dependence on oil, announcing an intention to sell a 5% stake in Aramco, with a successful IPO leading to the sale of an even bigger stake. With a daily production at over 10 million barrels of crude oil each day, the Saudis claim to be the energy powerhouse of the world as for many years Saudi Arabia has been effectively steering OPEC. When oil fell from over $107 per barrel during the second half of 2014, due to the shale oil and gas substantially cutting energy import into the US, the Saudis decided to flood the market with cheap oil to crowding out US shale oil. This course had to be abandoned as shale flows continued from North America.


Russian and U.S. vested interest


Alongside the Saudis, Russia and the United States are the /two heavy weights/ in the world when it comes to crude oil production. Russia depends on petroleum revenues for economic survival. Technological advances in drilling and fracking and fewer regulations under the Trump Administration are likely to sustain low production costs over coming years in the United States, that has become the world’s swing producer and lead to energy independence for America. When the price goes above $50, the U.S. will join Russia and Saudi Arabia as a 10 plus million barrel per day producer. When the price falls below $40 per barrel, the U.S. will avail itself of cheaper oil from other producing nations of the world.


So both Russia and the United States have a vested interest in a $50 per barrel price for crude oil. The Russians from a cash flow perspective and the Americans from a production perceptive. An oil at $50 per barrel is the sweet spot for crude oil. It is a price where both producers and consumers can find a degree of satisfaction. After watching oil collapse to lows of $26.05 per barrel on February 11, 2016, the sweet spot price is almost double that disastrous for producers level. When it comes to consumers, $50 is half the price seen in June 2014 when the price was trading at over $107.


Global demand and technical signs


Crude oil is one of, if not the most political commodities in the world. With more than half the world’s reserves in the Middle East stability or rising tensions in that region tends to be reflected in the oil price.


OPEC’s decision to extend the current production quotas and cuts until the end of the first quarter of 2018 resulted in mass futures sales in the crude oil market. Sales increased further as the Saudis and their allies suspended diplomatic relations and essentially imposed a blockade on Qatar over its relationship with Iran and financial support for terrorist groups. With suspense in the oil market at a zenith, worth keeping an eye on the Brent-WTI spread as an indicator of the market reading into the political risk in the Middle East.


The price of Brent versus WTI crude shows, the Brent premium rose to over $27 in 2011 during the height of the Arab Spring and when crude oil prices were around the $100 per barrel level – a staggering 27%. The spread moved all the way to an almost $2 premium for WTI in early 2016 when oil was heading to lows. However, now that the energy commodity has fallen through support at $42.20 and is threatening to move lower, the Brent premium has been consolidating around the $2.50 level – a 5,9 %.


There are two reasons for Brent’s premium these days.

First, the increases in supplies from the U.S. have generated a persistent surplus of WTI crude oil.

Second, is the political situation in the Middle East. The proxy war in Yemen, the blockade of Qatar, the Iran-Russia relations, and the promotion of a proponent of an aggressive Saudi military strategy, to Crown Prince in the KSA all point to increasing potential for tension and military conflicts in the region.


Watch the Brent-WTI spread for leads into the future of political developments. Any increase in the Brent premium could be a sign of impending military action in the Middle East.


By Vasko Nachev

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