Investors betting that rising political tensions in the Middle East will rescue their energy investments are likely to be disappointed. The main factors preventing a rally in the oil price – North American oversupply and a strengthening U.S. dollar – remain in place and Saudi Arabian leadership is unlikely to jeopardize their already declining global market share by escalating tensions with Iran.
Religion, as usual, lies at the root of political tensions between Sunni-dominated Saudi Arabia and Iran, where Shiite Muslims comprise the leadership. The recent Saudi execution of prominent Shiite cleric Nimr al-Nimr, who had been critical of the country's ruling family, set off a storm of protest in Iran and eventually the expulsion of the Iranian ambassador from Saudi Arabia. The potential for further disruption resulted in West Texas intermediate crude trading more than 3 per cent higher early Monday.
The Saudi government, however, has ample reason to prevent political tensions from escalating. Officials have repeatedly emphasized that the reason the country has not curbed oil production is to maintain its share of global oil sales. Allowing the current diplomatic battle with Iran to intensify to the point where oil exports would be negatively affected – and this fear is what has pushed the crude price higher – would be counter-productive to this strategy. A conflict-driven supply disruption would result in a loss of global market share.
Global political upheaval has historically boosted the value of the U.S. dollar and this pushes the price of oil lower. As the first chart below highlights, the relationship between the oil price and the U.S. trade weighted dollar index (the value of the greenback versus a wide range of its trading partners) has been extremely tight for the past year. As the dollar rises, oil falls. (Note that on the chart, the value of the dollar index is plotted inversely to better show the trend.)
North American oil markets remain oversupplied and this should limit the upside for the oil price in the short term. The second chart shows that U.S. crude inventories continue to climb. At the end of 2015, total stored oil was 26 per cent higher in year over year terms. U.S. oil production growth has slowed markedly, but still remains positive – U.S. oil supply continues to grow despite the sharp drop in the commodity price.
History has shown that predicting the course of politics in the Middle East is among the most pointless exercises ever invented. Nonetheless, and while it's possible that Saudi leadership could lose control of events, the country has little to gain and much to lose from prolonged conflict with Iran. This fact, combined with continued weak supply and demand fundamentals in North American energy markets, implies that investors should remain cautious on the sector despite geopolitical events.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online. Subscribe to Globe Unlimited at globeandmail.com/globeunlimited.