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Direct confrontation between US, Iran returns risk premium to oil markets

Mounting tensions after the U.S. killed a top Iranian military commander Jan. 2 have reintroduced a recently absent supply-side risk premium to the oil market, analysts said.

Height Securities LLC analysts wrote Jan. 3 that they viewed the killing of Qassem Soleimani, a general who headed the Islamic Revolutionary Guard Corps' elite Quds Force, "not as another one-off military action that will fade from the news cycle, but as a significant event in the U.S.-Iranian relationship that will alter the Middle East substantially. … The impact for investors should trend toward increasing risk premiums for oil and greater overhanging risk in broader markets."

Although the airstrike that killed Soleimani and Iran's subsequent response — a direct Iranian attack targeting two U.S. bases in Iraq with ballistic missiles — sent oil prices immediately higher, neither event posed a direct threat to global oil supplies.

"The U.S. assassination of a top Iranian general marks the most serious escalation in U.S.-Iran relations since the Trump administration's withdrawal from the nuclear agreement in May 2018," Raymond James analysts wrote Jan. 3. "It is also the most headline-grabbing geopolitical crisis vis-à-vis oil prices since the drone attack in Saudi Arabia in September 2019."

That Sept. 14, 2019, attack on Saudi Arabian Oil Co.'s Abqaiq and Khurais oil processing plants disrupted about 5.5 million barrels per day, or roughly 5% of global oil supply, sending Brent crude oil prices 14.6% higher on the day to $69.02 per barrel Sept. 16, 2019. But oil prices quickly retreated as the market learned that Saudi production would be restored within weeks.

At the moment, Iraq finds itself in the middle of the tit-for-tat between the U.S. and Iran as the tensions between those two countries have manifested on its soil. Meanwhile, there is rising confusion about the continued U.S. presence in Iraq. On Jan. 5, the Iraqi Parliament urged the government to expel U.S. troops that have been in the country fighting ISIS. A Jan. 6 letter from the head of the U.S. military's task force in Iraq to Iraq's joint operation's command said the U.S. would be moving its forces out of the country. On Jan. 7, U.S. Secretary of Defense Mark Esper walked that letter back.

"Although any U.S. withdrawal — if it occurs — would likely be gradual, [its] potential … has cast further uncertainty on the region," Fitch Solutions analysts wrote Jan. 8. "The oil market appears attuned to these threats and we see the ebb and flow of geopolitical risks in the Middle East fueling sporadic premia in Brent over Q1."

Mizuho analyst Paul Sankey pegged Iraqi oil production at over 4.68 million bbl/d in recent months, well above the 130,000 bbl/d Iraq produced at the time of the 2003 U.S. invasion. "Right now, we forecast an overbalanced 1H 2020 and a tighter market in the second half of the new decade. However, any significant issues in Iraq could quickly change balances to tight," Sankey wrote Jan. 2.

Amid rising tensions, Raymond James analysts wrote "there is no way to quantify the probability" that Iran would move to disrupt oil production in Saudi Arabia or other U.S.-allied states in the region, "suffice it to say that our baseline oil price forecast … does not assume any incremental supply disruptions."

Tudor Pickering Holt & Co. analysts on Jan. 7 cited the region's escalating tensions in increasing its West Texas Intermediate crude oil price forecast by $3.50/bbl to $61/bbl and that of Brent crude oil by $4/bbl to $65/bbl. Fitch Solutions raised its 2020 Brent crude oil process outlook by $3/bbl to $65/bbl, while Raymond James pegged its Brent crude oil price outlook at $70/bbl, assuming no supply disruptions.