Oil: Could Iran Risk Reverse Options' Bearish Signal?

The proximate cause of the oil price collapse in the fall and winter of 2014-15 was OPEC’s failure to agree on production cuts and Saudi Arabia’s gambit to thwart U.S. production growth by allowing prices to fall.  While that may be true, blaming shale oil frackers, Saudi Arabia and OPEC for oil’s abrupt collapse overlooks the question of why oil prices remained so high to begin with.  How is it that oil levitated in the $90 to 110-per-barrel range for so long given the potential downside price risks from surging U.S. production?  Fears of supply disruption from the conflicts in Libya, Syria and Yemen certainly contributed, as did instability in Egypt and tensions with respect to Iran and its nuclear program.

Changes in Washington D.C. are hardly the only reason to fear an upturn in geopolitical risk in the Middle East.  The conflicts in Syria and Yemen are unresolved.  The Syrian conflict is especially pernicious in that it involves so many different powers and groups: President Bashar al-Assad’s Syrian government, his Iranian, Russian and Hezbollah allies, ISIS, various rebel factions aligned with the Turks, the U.S., Saudi Arabia and Qatar, as well as the Kurds.  Not one of the combatants appears to have an exit strategy. The conflict also risks spilling across the border into Lebanon and has, at times, crossed into Iraq.  Outside of the hot conflicts, there is also the still unresolved diplomatic conflict between Saudi Arabia and the U.A.E. on the one hand and Qatar on the other.

In addition to conflicts between nations, there are plenty of problems within nations.  Iran has experienced significant domestic protests recently.  Across the Gulf in Saudi Arabia, details are leaking out about the allegedly brutal treatment and continuing legal limbo of many (formerly?) wealthy and powerful individuals recently released from the makeshift Ritz Carlton prison in Riyadh.  In addition to any potential domestic blowback if the new Crown Prince, Mohammed bin Salman, or MBS as he is known, fails to deliver on his promises of less corruption and more economic growth, there is also the question of the damage done to the initial public offering of state-owned oil behemoth Aramco from the perceived lack of due process and rule of law.  With respect to the recent round of arrests, MBS may have violated two core principals of the world’s greatest political theorist, Niccolo Machiavelli:

1. Crush your opponents completely.  Do not merely humiliate them but then let them survive.
2. People will sooner forgive a Prince for killing their relatives than they will for confiscating lands, assets or titles.

The reason why markets are so sanguine about upside risk is probably due to surging U.S. production (Figure 4) and still high levels of inventories (Figure 5).  But one should be wary of such logic for two reasons.  First, oil investment in the U.S. has stalled and, as such, it’s clear how much higher U.S. production can rise (Figure 6).  Secondly, while inventories remain high they are falling quickly from their peak levels and as such their ability to absorb a demand shock may not be as great as some options traders might believe (Figure 7).  The main downside risk to oil might be a collapse of OPEC’s production-cut agreement, although so far, remarkably, OPEC has largely stuck to it.

• Oil traders are pricing more downside than upside risk.
• That could change if the U.S. pursues a more muscular policy with respect to Iran.
• Options traders appear to fear downside related to possible OPEC cheating, surging U.S. production and still higher-than-normal inventories.
• The ability of U.S. production to keep growing is questionable given that rig counts have stalled.
• Inventories are high but are falling at the fastest pace on record.