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Saudi Arabia’s spat with Iran … what does it mean for oil prices?

Saudi Arabia’s spat with Iran … what does it mean for oil prices?

Things are hotting up in the Gulf.

Last Sunday, 3 January, the world’s largest oil exporter, Saudi Arabia cut diplomatic ties with Iran after protesters stormed its embassy in Tehran following Riyadh’s execution of a prominent Shi’ite cleric on Saturday.

On Monday, 4 January, fellow Gulf oil producer, Bahrain said that it would also cut ties with Iran and the UAE “downgraded” its diplomatic relationship, recalling its ambassador from Tehran.

Both Saudi Arabia and Iran are major players in international trade, as well as in various conflicts playing out throughout the Middle East, and outright hostility between the two countries could bleed over in many ways, especially because Iran, which holds some of the largest proven oil and reserves, hopes to ramp up exports following the expected removal of sanctions against it, in February.

So what is this latest crisis between two regional powers likely to mean for oil prices?

In the very short term, the news that Saudi Arabia had broken off diplomatic ties with Iran sent oil and gold prices higher. On Monday, benchmark futures surged by 4 percent to a three-week high. However, the rally was short-lived quickly fizzled and oil prices had fallen back by the end of the day. Overall, oil prices have barely budged from their recent lows.

As Time Magazine’s Rana Foroohar wrote earlier this week,

“this is a truly bizarre data point. Oil is typically amongst the most fear-driven commodities. Supply and demand are supposed to rule markets, but every time there’s a big conflict in the oil-rich Middle East, from the Iranian revolution to the Gulf War, prices go up about 30% higher than they should be, regardless of the facts on the ground. Even when supply isn’t interrupted, even when there’s plenty of oil to fuel world markets, the price of crude is typically driven by fear rather than reality.”

However, things seems to be a little different this time. While Saudi Arabia’s execution of a Shi’a cleric, followed by the torching of the Saudi embassy in Tehran definitely counts as a crisis, oil markets are being depressed by a variety of long-term factors.

Not too much demand…

Key amongst these is China’s economic slowdown. The country is struggling with a debt crisis that has produced turmoil for both domestic and international markets, even halting trading on the Shanghai stock exchange, following ten consecutive months of weak manufacturing data. Meantime, the United States’ manufacturing sector is also staring down the barrel of a recession, and manufacturing activity in India, which the International Energy Agency believes will lead growth in oil demand this year, contracted for the first time in two years.

In short, global demand for oil is weaker now than it has been for some time and this exerts downward pressure on oil prices.

Too much oil…

At the same time as demand for oil has dropped, the supply of it has increased. More than 18 months into the crude-price rout, oil production remains high around the world and the U.S. Energy Information Administration recently said that domestic oil production was higher than previously reported in each of the first nine months of 2015.

This is partially because of the increase in production in North American shale oil, which has continued to climb, despite more than a year of falling prices.  HIgh production levels from the Gulf states are another key contributor. According to the International Energy Agency, Saudi Arabia produced 10.2 million barrels a day of crude oil in November, or about 11% of global output of crude and related liquids, while Iran produced 2.9 million barrels a day of crude in the same month.

If international sanctions against it are lifted, Iran is expected to increase its output by hundreds of thousands of barrels a day this year , and Saudi Arabia already has expressed its unwillingness to cut production to make room for the Iranian barrels. Analysts believe that the heightened tensions with Saudi Arabia could encourage Iran to accelerate its production increases.

So where to now?

Essentially, uncertainty in the oil market is rising. Tensions between Iran and Saudia Arabia could send oil prices spiking again. On the other hand, escalating political tensions in the Gulf, weak demand and the possibility of increased supply from Iran’s huge oil reserves, as sanctions lift could mean even more oil on the world market and another year of low prices—or  No one’s sure which way it will go. Watch this space…


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