What investors should know about oil and geopolitical risk

Recent good news of rising oil prices is a welcome development for investors. Oil rallied in March, with West Texas crude closing the month at $65 per barrel. But how long will the rally last?

“Prices held up far better in the first quarter of 2018 than initially anticipated, and the market is only expected to get tighter going forward, supporting pricing higher over the next 18-24 months,” says Scotiabank economist Rory Johnston in a commodities report.

His only cause for concern is one-sided, bullish market sentiment.

“Speculative short positions as a share of open interest in major oil contracts are at seven-year lows, which leaves few remaining potential buyers and ample downside price risk in the near term as positions are normalized,” he says.

He expects that normalization to cause a drop in prices “before setting the stage for crude’s next step higher on a fundamentally bullish outlook.”

Potential market shock

Geopolitics pose a risk for markets, however.

For example, recent appointments in the Trump administration indicate a potentially hawkish shift in U.S. foreign policy, such as a change in the terms of the Iran nuclear deal and potential sanctions against the Maduro regime in Venezuela.

Says Johnston: “The Trump administration needs to decide whether to extend Iranian sanctions waivers by May 12, and it appears increasingly likely that the White House will begin backing away from the deal.”

If the U.S. deems Iran non-compliant with the deal, “sanctions could be reimposed and disrupt Iranian crude shipments, while markets could even worry about U.S. military action in the region,” says CIBC chief economist Avery Shenfeld, in a weekly economics report. Such action has been publicly advocated by newly appointed U.S. national security advisor John Bolton, he adds.

With Iran being a major oil exporter, any disruption in its crude shipments “would be rocket fuel for global crude prices, particularly with Venezuela—a heavy crude competitor for Canada—already in crisis,” says Shenfeld.

Be reasonable with oil weighting

But potential geopolitical risk doesn’t mean investors should jump the oil tanker, so to speak.

Shenfeld suggests investors keep a “reasonable” weighting in oil-related stocks, given risk in the Middle East. “That’s because, at this stage of the business cycle, a spike in world oil prices could be a significant threat to the rest of their portfolios,” he says.

He explains that central banks likely wouldn’t ease interest rates to counter downward pressure on global economic growth that a sharp climb in oil prices would produce.

“The Bank of Canada would, if anything, be more likely to tighten policy if oil prices reached levels sufficient to spark renewed capital spending growth in Canada’s oil patch, just as a dive in oil prices led to rate cuts in 2014-15,” he says.

He suggests investors hold at least a market weight until there’s more clarity from the White House on the Iran nuclear deal.

Outlook for Canada-U.S. crude differentials

Though Canadian crude producers have enjoyed a recent run-up in prices, “the temporary nature of some of the factors behind that move suggests that somewhat larger discounts to WTI will return,” Shenfeld says.

Canada-U.S. crude differentials have recently fallen to under $17 per barrel, from $22-$27 per barrel in mid-March.

Read: Drill into oil names using these tactics

Like Shenfeld, Johnston doesn’t expect narrower differentials to last: “While we expected discounts to fall as oil-by-rail stepped in to fill the gap [from] overburdened pipelines, the scale and pace of the latest retracement doesn’t seem to square with current takeaway trends.”

For example, getting oil to market will become increasingly challenging with rail capacity stretched and insufficient infrastructure on the horizon.

Says Johnston: “The recent announcement that Kinder Morgan is suspending non-essential spending on the Trans Mountain Expansion (TMX) pipeline until there is more certainty in the investment climate is a serious challenge to future Western Canadian production.”

If TMX and Keystone aren’t completed in the early 2020s, “Canadian crude discounts will expand ever wider to compensate the stranded nature of Canadian crude on global markets,” he says.

For more details, read and full reports from Scotiabank and CIBC.

Also read:

Divest of fossil fuels for better returns: study

Commodities outlook leans bearish

How institutional investors are managing risk and volatility