Oil market doing what comes naturally

For all the headlines over the threat to oil shipments from Iran as Western sanctions ramp up, it seems the crude market is doing what it does best: getting on with business. That is to say both buyers and sellers are adapting to the new realities and seeking to maximise their advantage while ensuring that everybody gets the oil they need. Take the Chinese for example. They are the top buyers of Iranian crude, usually taking about 20 per cent of the Islamic republic's exports, or some 550,000 barrels a day. But this was cut by 285,000 barrels a day in January and February, and according to sources the Chinese will extend the reductions for a third month in March. At the same time China's refiners appear to be putting the knife into Iran, presumably as they seek better terms, the nation's political leaders are saying the West should back off from Iran and that putting sanctions on the oil trade isn't the solution to the nuclear problem. What this shows is that China is seeking to maximise its own position in the situation. It cannot stop Europe and the US from trying to end Iran's nuclear programme, but China can benefit from the process. And it would be wrong to think the Chinese are alone in this: virtually everybody in the physical oil markets is also trying to work out how best to profit. Record amounts of West African crudes will be shipped to Asia in the first quarter, with estimates reaching 1.82 million barrels a day, up from 2011's average of 1.57 million. Russia, the world's top oil producer, is also eyeing selling more oil in Asia, adding to its existing market for its Eastern Siberian Pacific Ocean (ESPO) crude. Indian refiners, the second-largest buyer of Iranian oil last year at 341,000 barrels a day, are apparently happy to keep buying, but at the same time making it clear the Iranians will have to keep their prices low in order to get the business. It's also likely that Saudi Arabia is seeking to maximise its position as the world's top exporter. What this tells you that behind the drama of the news headlines, the oil market is getting on with the job. The main impact of the headlines seems to be in the paper market, where oil futures have been rallying, with front-month Brent up 12 per cent since mid-December to trade near its highest level in six months. What's driving the oil price higher doesn't appear to be extra demand, with expectations that the International Energy Agency will this week trim its demand growth forecast for 2012 to as little as 300,000 barrels a day. With Europe staring at recession, if not already there, a slow recovery in the US and an easing of growth in Asia, it's hard to be bullish on the oil price in the short term based on fundamentals. It's also not hard to see the Iran premium remaining in the oil price for months to come. The West seems determined to hurt Iran economically with sanctions that make it difficult to pay for oil, while equally, the authorities in Tehran seem determined to maintain their nuclear programme is for electricity only, while vowing to continue its development. If you look at the history of similar conflicts, there are a variety of ways that the Iranian situation can reach end game. The real problem for the oil market would be if tensions erupted into full-scale war, with the Western powers and Israel attacking Iran, and Iran doing its best to shut down the Strait of Hormuz, through which 20 per cent of the world's oil passes. The more likely scenario, for the time being, is that matters escalate until the pain becomes too much for somebody to bear. In practical terms, this could be the West backing down if Iran manages to withhold its oil for long enough to cause economic agony in what is, after all, an election year in the US and France. Alternatively, the sanctions and economic hardship in Iran could result in its own internal conflicts coming to the fore in the form of some sort of regime change, followed by a compromise with the West. In all but the all-out war scenario, the physical oil market will be able to fairly quickly adjust, in fact, there may even be too much crude floating around as the Iranians will no doubt try to continue selling.