‘Zero Tolerance’ Policy On Iran Will ‘Likely’ Push Oil Prices To $120/bbl, One Bank Says

Back in May, days after Donald Trump pulled the U.S. out of the Iran nuclear deal, BofAML became the first major Wall Street bank to suggest that triple-digit crude might be in the cards.

“Looking into the next 18 months, we expect global oil supply and demand balances to tighten driven by the ongoing collapse in Venezuelan output [and] in addition, there are downside risks to Iranian crude oil exports,” the bank wrote, before introducing a 2Q $90/bbl Brent price target for 2019 and cautioning that they “see a risk of $100/bbl oil next year”.

Since then, Trump “succeeded” in badgering the Saudis into agreeing to a production hike in the back half of the year (in order to head off a scenario where rising prices at the pump end up eating away at the gains expected to accrue to U.S. consumers from the tax cuts). When Al-Falih first tipped that late in May, it was good enough for a dip, but by the time the OPEC meeting actually rolled around, it was no longer clear that any deal that came out of Vienna would in fact be enough to push prices lower, especially in light of lost production from Venezuela and the threat of sanctions on Iranian barrels.

Just days after the OPEC deal was announced (and it was short on specifics), the State Department told allies to cut imports of Iranian crude to zero by November 4. That was pretty much it for the fleeting dip in prices that started in late May.

Trump tried to drive prices lower with a series of tweets (see here and here), but ultimately, it looks like it’s going to be hard to convince the market that the Saudis are ready and willing to go completely rogue just to placate Trump.

It’s against that backdrop that BofAML is out with a new piece that describes oil as a “game of chicken.” They echo Goldman’s recent warnings about supply disruptions and here’s what they say about Iran:

The oil market has perhaps been more focused on Iran, as its future output depends mostly on the willingness of the US government to enforce sanctions on buyers of Iranian barrels. After all, the US Department of State could opt to grant waivers to all buyers of Iranian oil, to a few, or to none. So far, messages have been mixed. In recent notes, we looked at various Iran crude oil production scenarios (Chart 3), although we never factored in “zero tolerance”. In our view, a complete cutoff of Iran exports (Chart 4) would be very hard to manage and likely result in an oil price spike above $120/bbl. For now, the uncertainty around US government policy is leading to lower exports and an increase in Iranian oil in floating storage.

And how about the rest of OPEC and Russia? Can they mitigate this if Trump simply tweet-shames them enough?

Well, maybe, but the current environment might make it difficult and in any case, it would cut spare capacity (i.e., reduce flexibility to respond to subsequent shocks) to low levels. Here’s BofAML again:

A complete cut-off of Iranian crude exports would be particularly painful at this point. The previous sanctions episode was only possible, in our view, because US shale production was growing at a very fast clip and Libyan output came back to the market to replace some of the missing Iran barrels. Plus, other OPEC members were still running with some spare capacity and global oil demand was rather sluggish. In contrast, we now project global oil supply and demand balances to remain in a structural deficit for most of the next six quarters (Chart 5). On top of this, OPEC+ spare capacity projections, once we factor in the upcoming production increases (Chart 6), look rather low. And in contrast to 2016, global oil demand remains rather firm and inventories are below the five-year average.

Meanwhile, Venezuela continues its descent into what amounts to anarchy. It’s a failed state at this point and that obviously bodes ill for crude production which is collapsing along with the economy.

I talked at length about the current state of affairs in Venezuela last week, but if you want the short version delivered via anecdote, note that according to Bloomberg’s “Cafe Con Leche Index”, hyperinflation has driven the price of a cup of coffee in Caracas up to 1 million bolivars:

The point, for oil markets, is that the situation there isn’t likely to improve anytime soon.

“The latest figures suggest that Venezuelan crude oil production has fallen to just 1.36mn b/d as of May,” BofAML writes, in the same note cited above, adding that on their assumptions, it will fall a further 0.45mn b/d through the end of 2019.

“This figure could be much worse”, the bank adds.

Meanwhile, Bernstein is out suggesting that prices could surge to $150/bbl. Here’s Bloomberg, from an article published Friday:

Oil investors may regret urging companies to cough up cash now instead of investing in growth for later as the dearth of exploration is setting the stage for an unprecedented crude price spike, according to Sanford C. Bernstein & Co.

Companies have been compelled to focus on boosting returns and shareholder distributions at the expense of capital expenditures aimed at finding new supplies, analysts including Neil Beveridge wrote in a note Friday. That’s causing reserves at major producers to fall and the industry’s reinvestment ratio to plunge to the lowest in a generation, paving the way for oil prices to surpass records reached last decade, according to Bernstein.

And then on Sunday, there was this from Iran oil ministry news agency SHANA:

Iran’s oil exports surely won’t fall to zero, but a reduction of 500k-1m b/d will affect the market and could drive prices to $100.

You can make of all this what you will, but it certainly seems to suggest that the Trump administration may have to choose between aggressive foreign policy (vis-à-vis Iran and Venezuela) and lower prices at the pump.

Unless of course OPEC members with the capacity to raise output continue to bow down to Trump’s Twitter feed.

I’ll leave you with the following chart which shows the evolution of supply disruptions: