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Commodities

Iran, Saudi Arabia and Oil Prices

By Elliott H. Gue, on Jan. 6, 2016

Editor’s Note: Elliott Gue and Roger Conrad will make their annual appearance at The MoneyShow Orlando to share their outlook and top picks for 2016. Don’t miss out on this opportunity to meet the Capitalist Times team in person. This year’s conference will take place March 2 – 5 at Disney’s Contemporary Resort. Register for free today to secure your place at this must-attend event.

US crude-oil inventories remain more than 125 million barrels above the average for this time of year, with the hub in Cushing, Oklahoma, storing a record 62.993 million barrels during a period of seasonally weak demand when stockpiles tend to increase.

This dynamic creates a situation where the price of West Texas Intermediate could tumble to between $20 and $25 per barrel, a dramatic move that would increase the appeal of storing crude in offshore tankers and prompt producers to shut in wells.

The financial infotainment industry continues to focus on largely irrelevant geopolitical factors. A classic example is the ongoing diplomatic conflict between Saudi Arabia and Iran that earlier this week resulted in a short-lived pop in oil prices that quickly fizzled.

Given the uninformed opinions bandied about in the press, here’s a quick rundown of the historical roots of the tension between Iran and Saudi Arabia and what it means for the global oil market right now.

History Lesson

As with Christianity, Islam encompasses a number of different sects. After the prophet Muhammad’s death in 632 AD, a rift emerged about whether his successor should be a blood relative or someone selected on his own merit.

Shiites preferred Ali ibn Abi Talib, who was assassinated around 660 AD, and then followed a separate group of leaders hailing from Muhammad’s bloodline.

The rift between the Sunnis and Shiites deepened in 680 AD, when the army of the Sunni religious leader killed Ali ibn Abi Talib’s cousin, Hussein.

Today, about 85 percent of the world’s Muslims are Sunni, though Shiites form the majority in Iran and Iraq. Saudi Arabia and other Sunni-dominated countries have significant minority Shiite populations.

Present Day

The most recent flare-up in this centuries-old conflict stems from Saudi Arabia’s execution of a prominent Shiite cleric, Nimr-al-Nimr, who criticized the government and its treatment of the country’s Shiite minority (about 15 percent of its population). Nimr-al-Nimr’s animosity toward the Saudi royal family prompted him to threaten to lead Shiites in a bid to secede from the rest of the country in 2009.

This rhetoric didn’t sit well with the Saudi rulers, nor did violent clash’s betweejn state security forces and al-Nimr’s followers in 2012. Nimr-al-Nimr was sentenced to death in 2014.

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These sectarian tensions are exacerbated by the fact that most of Saudi Arabia’s Shiite minority lives in close proximity to the nation’s largest oil fields—the last place security forces would brook any unrest.

Nimr-al-Nimr’s pending execution prompted protesters to attack the Saudi Arabian embassy in Tehran and set part of the building on fire. On Sunday, Supreme Leader Ayatollah Ali Khamenei denounced Al-Nimr’s treatment and stated that Saudi Arabia would face “the divine hand of revenge.”

These events prompted Saudi Arabia and some of its regional allies to sever diplomatic ties with Iran. Most analysts agree it’s the worst breakdown in relations between the two rivals since the late 1980s.

Implications

Although the rising tension between Saudi Arabia and Iran has important implications for the proxy wars underway in Syria and Yemen, these developments shouldn’t be misconstrued as bullish for global oil prices.

Neither Syria nor Yemen produces significant volumes of crude oil. The conflict in Syria has spilled into northern Iraq, but most of that country’s major oil fields are located in the south, far from the fighting.

Saudi Arabia has made no secret of its distaste for recent agreements with the West to remove or reduce sanctions on Iranian oil exports. Ramping up Iranian crude-oil output beyond 500,000 to 1 million barrels per day will require significant investment from Western oil companies, a challenging proposition with prices at less than $40 per barrel.

Don’t expect Saudi Arabia to reduce its output to accommodate crude-oil exports from Iran. And don’t expect Iran to change its development and export plans after four years of sanctions.

Saudi Arabia has the financial power—US$642 billion in foreign reserves—to maintain production and depress prices further to hurt Iran and other producers.

Meanwhile, Iran’s economy has much more diversity, making the country less dependent on exporting crude oil to fund its deficit; even at prevailing prices, an uptick in international oil shipments would make a positive contribution to the nation’s budget.

In other words, we doubt Iran will seek to improve relations with Saudi Arabia or pursue a unified strategy to support oil prices.

As always, the infotainment industry has barraged investors with sensationalist headlines about the geopolitical risk premium bolstering oil prices. The resultant short-lived rallies give us an opportunity to add to our hedge positions as long as supply and demand fundamentals—namely, excess global inventories and resilient non-OPEC production—remain bearish.

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