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Why geopolitics still matter to oil

Trump might not bring more war to the Middle East, but as fundamentals tighten the market is ready to trade such risks

Even before the civil war, Syria's oil output was hardly decisive for global markets. Six years on, it is truly a rounding error in terms of world supply balances: production has dropped from more than 400,000 barrels a day to less than 30,000 b/d. Exports have ceased. No, the war in Syria is not, as internet conspiracy theorists think, about pipelines through the country.

So why did oil prices rise sharply after the US fired 59 Tomahawk missiles at an airbase in Syria on 7 April?

After two and a half years of shrugging its shoulders at conflict in Libya, northern Iraq and Yemen, the reaction to the Syria bombing suggests that the oil market is awaking again to geopolitics. It's a long way from the days earlier this century when a surge in violence in Israel and Palestine (crude output, nil) could add a dollar to Brent. But the first signs that the geopolitical-risk premium, as it used to be called, is returning are unmistakable.

This is happening for a few reasons. First, Opec's high compliance with cuts now seems to be tightening balances. Although the first quarter brought a build in stocks (largely in January), the second quarter should bring a sharp reversal. Bernstein, a research firm, reckons inventories will fall by 1m b/d in the second quarter. Petroleum Economist expects Opec to roll over its cuts agreement at the end of May, allowing further stock depletion and putting a tailwind behind a gentle market recovery in the second half of the year.

As supply and demand tighten, geopolitical risks that didn't matter much in a glutted market will gain force among traders. The market is not quite at crunch timeespecially as Opec cuts have increased its spare capacity and tight oil supply is surging. Still, perceptions of a tighter market will make for more volatility. Most oil-price troughs since the 1970s have ended with a supply-side shock-even if, as Bob McNally's recent book points out, the impact on actual supply-demand balances was negligible.

The Trump factor

Another reason is Donald Trump. The unpredictability of an embattled White House that can so blithely flip flop on so many matters (Nato, Syria, the EU, Russia , China, the Federal Reserve and so on) is unprecedented. Geopolitical risk now emanates directly from the White House and Mar-a-Lago. Trump's instincts on US re-engagement in Iraq (where he is understood to have pledged support for Haider al-Abadi's government), on more confrontation or not with Iran, or on deeper involvement in Saudi Arabia's Yemen war may prove soundor not. But instincts they appear to be, and unpredictable they are not.

So any investor or trader must start pricing in these new risks, even if the reality turns out less volatile. The threats include more Iranian sanctions, a deterioration in US-Russia relations (where the expectation was an improvement), American efforts to rid Syria of Bashar al-Assad, a worsening of sectarian conflict in the Middle East, and a confrontation with North Korea. To take one specific example, Secretary of State Rex Tillerson seems to have decided to back Libya's UN-appointed government, not the eastern onea choice that could worsen the conflict, and Libyan oil-output prospects, as easily as help resolve it.

These new risks, in sum, look strong enough to see off bearish macro-economic worries about Trump's economic protectionism, US interest-rate rises and emerging-market weakness. The International Energy Agency on 13 April trimmed its demand outlook for 2017 again. But that story doesn't fit the market's mood right now. The prospect of more war in the Middle East looks a more tradeable short-term risk than a blip in Indian consumption growth, let alone the more speculative rise of electric cars and super-batteries.

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