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Geopolitical risks supporting oil

Edward Bell - Senior Director, Market Economics
Published Date: 28 January 2022


OPEC+ appears certain to agree to another monthly production increase of 400k b/d when it meets at the start of February. Judging from spot prices and time spreads oil markets are screaming out for additional oil. Brent futures have moved above USD 90/b for the first time since 2014 and a breach of the talismanic level of USD 100/b looks more a question of timing rather than possibility. Time spreads for 1-6 month Brent are above USD 5/b in backwardation and at the 99th percentile for the spread in data going back to 1990.

Blast from the past: Brent at highest level since 2014

Source: Bloomberg, Emirates NBD Research

According to the terms of the deal it reached last July, OPEC+ will add 400k b/d per month until all of the production it took offline in response to the pandemic’s demand destruction are returned. That is likely to be achieved at some point in Q3 this year as new higher baseline levels of production take effect from May 2022, allowing some producers a larger share of collective OPEC+ production, such as the UAE, Saudi Arabia, Kuwait and Russia.

While an agreement for March production levels looks like it can be approved quickly, whether the 400k b/d actually materializes is a more open question. Since the deal came into effect in August last year production increases from the OPEC+ alliance have been inconsistent. According to data from the IEA only 260k b/d of output was added in December as Russia missed its targeted increase by a wide margin and output from Nigeria also fell substantially short of target.

Stay on target: OPEC+ output from July 2021

Source: IEA, Emirates NBD Research

There are few producers within the alliance that we would describe as having “free capacity” to increase output; namely Saudi Arabia, the UAE, Kuwait and likely Iraq as well. By relying on a relatively small handful of producers, OPEC’s spare capacity to respond to upside demand shocks is particularly limited. The four producers have roughly 3.5m b/d of spare capacity between them according to Bloomberg estimates. When compared with a near balanced market expected this year the buffer provided by these nations would look comfortable to avoid oil prices blowing out excessively. But 2022 has started with a particularly elevated geopolitical atmosphere and a wider margin of error would be welcome to avoid oil prices sustaining at such high levels.

Political risk premiums wide at start of 2022

The threat of a conflict between Russia and Ukraine is unlikely to cause material damage to Russia’s oil production infrastructure though major gas and oil pipelines from Russian production centres do pass through Ukraine. However, in the event of a conflict, sanctions on exports of Russian oil or gas, similar to what the US, the EU and others have imposed on Iran in the past, would tighten markets considerably. Russia exported roughly 4m b/d of crude oil last year, larger than the spare capacity held within OPEC producers. While there remains no apparent disruption to supplies at present, the threat of sanctions on Russian exports is helping to add a considerable geopolitical risk premium to oil and natural gas prices.

At the same time there appears to be little movement on the US or Iran agreeing to renew the terms of the JCPOA and hence sanctions on Iranian oil are still in place. Our baseline expectation this year is for no material change in Iran’s oil production from where it ended 2021 – at roughly 2.5m b/d. However, should partners to the JCPOA reach a deal then Iran could potentially add another 1m b/d of output to markets, helping to take some of the sting out of the current tightness.

The binary impact of geopolitical events on energy markets is high. A conflict involving a major energy exporter means there could be considerable upside risk to our target level of Brent at an average of USD 75/b in Q1 2022. Should a geopolitical event occur we will necessarily adjust our oil market balance assumptions and revise our price outlook accordingly.