Oil prices – five signs the tide is turning in Q3

• US/EU sanctions against Iran take effect on 28June/1 July
• Seasonal demand pick-up in Q3
• Iran/West negotiation on the verge of collapse
• OPEC reserve capacity still disturbingly low
• Euro area – small steps in the right direction will gradually improve risk appetite>

Oil price plunged in Q2 

Oil prices have plunged by 30% since the end of March. But we see several signs suggesting a new recovery in prices in Q3.

Several events have triggered the sharp oil price decline. In March Iran and the West decided to resume the discussions on Iran’s nuclear programme after the negotiations collapsed in January last year. This eliminated the political risk premium that had lifted oil prices by around USD 10/barrel in Q1.

In Q2 the crisis in Europe was the overwhelmingly dominant factor driving developments in most markets, and the oil market was no exception. Fears over what a break-up of the euro might mean triggered a massive flight among financial investors from risky asset classes such as oil into safe havens like the US dollar. This helped to accelerate the oil price decline.

Adding to the growing worries over the Euro zone, the US and China, the world’s two largest oil consumers, have shown signs of weakening economic growth. In this environment market participants have recently scaled down their oil demand growth forecasts for 2012 significantly. At the same time Saudi Arabia, the world’s largest oil exporter, has pumped record-high volumes of oil into the market. This contributed to a significantly softer supply/demand balance for Q2.

Source: Reuters Ecowin

Signs the tide is turning in Q3

Nonetheless, we see several drivers that could lift oil prices back above USD 100/barrel in Q3. In seasonal terms Q3 is the peak period of the year for oil demand, pushed up by the US driving season and increased energy consumption to keep air conditioning systems running in warmer regions. In addition, the US and China have introduced new measures to stimulate growth; these measures are expected to have a positive impact on oil demand.

Obviously there is a high risk that the euro may collapse, in turn pushing the world economy into a new decline. Such a scenario could trigger a new plunge in oil prices.

Despite this, we expect a last-minute solution for the crisis-hit countries that will gradually calm the market, boost risk appetite and attract investors back to the oil market.

The negotiations between Iran and the West are on the verge of collapse. A new collapse could lift risk premiums sharply, as many fear that Israel will resort to military action against the nuclear facilities in Iran. As the talks have so far not produced any results, the US sanctions and the EU embargo against imports of Iranian oil/insurance ban on vessels carrying Iranian oil will take effect on 28 June and 1 July respectively. This could cut Iranian oil sales by over 1m barrels/day in Q3.

Despite a ramp-up of oil production in North America (shale oil, oil sands and offshore production in the Gulf of Mexico) over the past year, the market has limited options for replacing additional losses of production. As a result of Saudi Arabia’s sharp production increase, the world’s safety buffer – OPEC’s reserve capacity – has dropped to very low levels. A protracted strike in the North Sea could further erode this buffer.

We may thus see a rapid recovery in oil prices when worries over the euro crisis gradually abate and the oil market refocuses on the supply side.

Source: Bloomberg, CFTC data

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