Brent crude futures are on track for their largest weekly decline since the week ending April 24, 2020, during the early COVID-19 pandemic era, on the prospect that a Democratic sweep could end the US-Iran conflict.
UBS energy expert Dominic Ellis wrote in a note earlier that the collapse in crude's war risk premium reflects the prospects for peace and the potential for the Strait of Hormuz to fully reopen. But those hopes are colliding with the harsh reality that replenishing depleted global oil stockpiles could take considerable time.
Brent's $20 plunge over the last several days reflects a massive unwinding of the war risk premium rather than a meaningful improvement in supply and demand, Ellis said. He estimates that another $10 to $15 of premium remains embedded in crude near $95, leaving more room for downside if further diplomatic signals emerge from the Gulf.
Ellis explained:
The more than $20 decline in Brent over the last week reflects bearish sentiment and a rapid unwind of the geopolitical risk premium in the price rather than a change in supply/demand fundamentals. I'd guess there is still $10-15 of risk premium reflected in the current $95 level, and while there is risk of an ongoing unwind if the Iran-US narrative continues to trend towards de-escalation, it is worth reflecting on what has really changed.
Senior figures in the Republican party, including vice president Vance, are openly acknowledging the role that the Middle East conflict played in the Blue sweep on Tuesday, and even President Trump has admitted that the war may have had an impact on the outcome of the elections.
But while Trump has recently downplayed the potential for new strikes on Iran, it isn't yet clear the US is ready either to make the major concessions likely needed to move the diplomatic process forward or to declare "job done" and walk away from the conflict, essentially leaving Iran with a Pyrrhic victory but a victory nonetheless. It is hard to have conviction in opaque political process, but it is clear that the market has over the last 7 months been too eager to price in de-escalation ahead of supporting evidence, and I fear the same thing may be happening now.
However, Ellis pointed out that the conflict has drained nearly 700 million barrels from global inventories, as fundamentals still point to a severe global energy crisis that won't dissipate anytime soon.
He said:
Even in the event that I am wrong and this is the dawn of a new era of diplomatic outreach, a new Iran deal and a clear path back towards the normalization of energy exports, the near 700 mn drawdown in global inventories as a result of the conflict so far and the at least 40-50mb ongoing monthly inventory draw if the conflict continues will drive incremental demand that keeps a floor on oil for the next 18-24 months.
The takeaway is that further peace headlines and a possible resolution could push oil prices lower, but the reality is that stockpiles around the world need to be replenished, which should eventually put a floor under prices.
For instance, US distillate stockpiles fell below 100 million barrels for the first time since 2003.
It's great news that US diesel prices hit two-month lows on Wednesday, but traders will have to reckon with depleted inventories (read here).
Our market technicians at The Market Ear have provided readers with a full breakdown of crude in a note titled "The Oil Massacre" ...