NEWS / Foreign Exchange

Oil: Fundamentals and Middle-East tensions to support oil prices further

Geopolitical tensions are again affecting the oil market after Iran seized 15 British navy and marine personnel who had allegedly entered Iranian waters illegally. The British prime minister, Tony Blair, rejected the notion of trespassing and said that the seizure was a very serious situation.

Whether or not the Royal Navy entered Iranian waters is, however, not really the issue - the real issue is that the Iranians dared to step-up the conflict with the West. The seizure of the 15 British servicemen is definitely being seen as a serious provocation by both Downing Street and the White House, and the episode underlines the high stakes Iran is willing to wager in the ongoing dispute with the world community over its nuclear programme. Should Iran fail to release the detained Britons, the world community will be left with few options other than to stiffen its rhetoric against Iran, meaning an escalation of the situation and the possible use of military force cannot be ruled out.

The seizure of the British military personnel came just one day before the UN Security Council on Saturday unanimously approved further sanctions against Iran. The new measures follow a resolution on December 23 last year that explicitly prohibited the trade of nuclear and ballistic materials with Iran. The December resolution froze the assets of individuals involved in the Iranian nuclear programme. The new measures widen the freezing of assets to include more people, and banks and nations are now barred from giving new loans to Iran. The Iranians are, unsurprisingly, opposed to the new sanctions. President Ahmadinajad this morning warned that other nations ???seeking to impose sanctions against Iran will suffer a greater damage themselves???.

We would argue that the seizure of the 15 British navy personnel marks a serious stepping up of tensions between Iran and the world community, and that a further escalation certainly cannot be ruled out. The oil market is used to harsh rhetoric from Iran, but seizing foreign military personnel is a clear escalation.

Furthermore, the stand-off comes at a time when oil market fundamentals are getting tighter by the day. The weakness in the oil market seen in December and January has served as a wake-up call for OPEC, and the oil cartel has certainly cut back on production in the past two months. According to the latest figures, OPEC10 (Angola and Iraq do not have quotas) produced 26.5 mb/d in February, just 0.6 mb/d above the current target. OPEC10 production has not been this low since 2004.

Lower OPEC oil production is starting to show up in the statistics. According to the International Energy Agency, total OECD stocks have fallen by 65.7 million barrels - or an average of 1.2 mb/d in the first two months of 2007.

Looking forward, demand appears to be very healthy. US refinery run is now expected to recover from a very low level of refinery utilisation in the first three months of the year. Last week, US refineries were operating at 86.3 percent of capacity - the highest level since the week that ended February 9. The low refinery run and strong demand mean gasoline stocks have fallen by more than 7% in the last six weeks. The draw in gasoline stocks is the reason the crack spread is at the current elevated level of more than USD 20 a barrel. The crack spread has not been this high since summer last year, when the market feared new hurricanes.

Hence, given the falling gasoline stocks and strong demand for gasoline ahead of the driving season, we expect healthy demand for crude oil going forward. The market might well, as the IEA warned in their latest monthly oil report, tighten further in the coming months if OPEC does not step up production going forward - we doubt OPEC will step up production, though.

Tight fundamentals combined with the heightened tensions in the Middle East mean that we see an upside risk to current oil prices during April. We would not be surprised to see prices rise above USD 65 a barrel this week (NYMEX 1.pos) and go even higher in April.