The U.S. State Department announced on April 22 that it would let all Iran sanctions waivers expire at the beginning of May as part of the Trump administration’s “maximum pressure” campaign on Iran. Oil prices shot up more than 2 percent on the news.
The administration also announced that it had secured pledges from Saudi Arabia and the UAE to increase oil production in order to offset disrupted supply from Iran. While there is enough spare capacity to compensate for the presumed outages in Iran, it is unlikely that OPEC+ will ratchet up supply on a barrel-for-barrel basis. As a result, reduced supply from Iran could push oil prices higher.
U.S. overly optimistic?
The U.S. State Department justified its decision to allow waivers to lapse by arguing that the oil market is “well supplied” while inventories are also “seasonally strong.” The U.S. government also said that Saudi Arabia and the UAE committed to “increase oil production to offset reductions in Iranian oil exports.”
The U.S. originally granted waivers to eight countries – China, India, South Korea, Taiwan, Japan, Turkey, Greece and Italy – not only because those countries had difficulty finding alternatives, but also because the oil market was tight globally. Brent oil prices were rising and had surpassed $80 per barrel by October 2018. This time around, the U.S. says the market has more room to maneuver.
However, some analysts have raised questions about those assertions. “Our analysis shows a global surplus of 2.3 million barrels per day (mb/d) in Q4-2018, but a deficit of 0.2mb/d in the current quarter,” Standard Chartered wrote in a report on April 23, disagreeing with the State Department’s assessment. “The market is 2.5mb/d tighter than it was six months ago.”
While the precise figures differ a bit, other market watchers voiced similar concerns. “The oil market is already undersupplied,” Commerzbank wrote. “If Iranian oil exports fall away completely, as the US wants, the deficit on the oil market will widen to as much as 2 million barrels per day.”
Moreover, the other main reason the U.S. was comfortable taking a hard line on Iran was that Saudi Arabia and the UAE said they would increase production. But Saudi oil minister Khalid al-Falih was quick to clarify, issuing a statement that seemed to downplay its commitment to respond. “In the next few weeks, the kingdom will be consulting closely with other producing countries and key oil consuming nations to ensure a well-balanced and stable oil market,” Al-Falih said, using notably vague and non-committal language.
Riyadh has good reasons not to make any rash decisions. Last year, Saudi Arabia abandoned its production cuts after the U.S. announced its plans to sanction Iran. After ramping up supply, the market crashed when Washington issued a series of surprise waivers in late October. Saudi Arabia does not want to repeat the same mistake, and will be determined not to prematurely increase production. The Gulf States will likely wait and assess the full impact on Iran before making any decisions.
In addition, Saudi Arabia and the UAE do not want to kill off the OPEC+ deal. Cobbling together a coalition was difficult to begin with, but unilaterally increasing production would likely put an end to coordinated cuts. If production increases are required to head off a price spike, any changes in output levels will likely go through Vienna in order to maintain group cohesion. There is a danger for Saudi Arabia in being seen coordinating with the U.S. government, benefitting at the expense of a fellow OPEC member.
Because of these political and market dynamics, the U.S. government may be overly sanguine about the Saudi response, and thus, overly confident about its decision to let waivers expire. U.S. retail gasoline prices had already been creeping up in tandem with crude oil prices, but moving higher from current levels raises domestic political risks for the Trump administration. National average regular gasoline prices rose to $2.841 per gallon on April 22, at about the same level as the highs of 2018 right before the Trump administration decided to issue sanctions waivers.
While the oil market is tightening and oil prices are heading in a bullish direction, there are upper limits to how high prices can go. Drastic increases in prices from current levels would likely lead to demand destruction. Higher prices would also stimulate a stronger U.S. shale response, although increases would come on a several-month lag.
Meanwhile, OPEC+ has higher spare capacity than it did last year, precisely because of the production cuts. “As a result of OPEC’s high compliance rate with the agreed supply cuts in the OPEC+ group, global spare production capacity has risen to 3.3 mb/d, with 2.2 mb/d held by Saudi Arabia and around 1 mb/d by the United Arab Emirates, Iraq and Kuwait,” the International Energy Agency said in a statement following the announcement by the U.S. that it was letting waivers expire. The IEA noted that the oil market is “now adequately supplied, and that global spare production capacity remains at comfortable levels.”
Ultimately, if prices rise too far too fast, OPEC+ would be under pressure to unwind the agreement. They will meet in May for a status update, before the official meeting in June to evaluate next steps. If Iran loses a significant volume of its supply and oil prices continue to rise over the next two months, the odds that the group will agree to lift output levels are high.
However, it is not as simple as a barrel-for-barrel replacement. Any increase to offset lost Iranian supply will only come after the fact. That opens up the possibility of a near-term price spike before the group can respond. Moreover, production increases also come at the direct expense of spare capacity. If Iran loses 1 million barrels per day (Mbd) and Saudi Arabia and its allies increase output by 1 Mbd to compensate, total spare capacity will fall by just as much. If history is any indication, periods of low spare capacity are ones that tend to exhibit higher prices and more pronounced price volatility.