Get Ready for Oil’s Next Leg up: Supply Constraints and Geopolitical Risks Abound

Supply constraints will trigger oil’s next leg up, which will be a boon for attractively valued Vermilion Energy Corp. (TSX:VET)(NYSE:VET).

Matt Smith

Former investment manager and market junkie, Matt has 20 years of experience. He hails from Sydney Australia where he earned a Master of Business Law from the University of Sydney and Master of Arts in International Relations from the University of New South Wales. He has been helping investors achieve their goals for over a decade. When not studying the markets, he can be found relaxing with his dogs and practising Spanish.

Published July 7, 2018 10:00 am EDT

Oil is whipsawing wildly, as markets react strongly to every piece of good or bad news regarding its outlook. The latest developments concerning supply constraints and geopolitical risks indicate that crude could soon be due for its next leg up.

Tehran is taking a hard line since Trump pulled out of the Iran nuclear deal, which — along with threats of a trade war — is ratcheting up geopolitical risk. There are signs that OPEC is incapable of delivering on its commitment to boost output by one million barrels. This is threatening global supply at a time when shale oil growth has slowed, and there is rising demand for crude as the global economy improves.

Now what?

In response to Trump’s threats to choke off Iran’s oil exports to zero, Iranian president Hassan Rouhani threatened to block the straits of Hormuz, a crucial oil shipping route, in retaliation for hostile U.S. action against Iran. The threat this poses to global supplies is tremendous, because it is estimated that 20% of the world’s crude is shipped through the straits. The latest threats are reminiscent of 1988 when Iran and the U.S. engaged in a showdown in the straits, as Washington moved to ensure that they remained open and shipping traffic was unimpeded.

While the likelihood of Tehran effectively blocking the straits is slim, Rouhani’s threats indicate that the level of geopolitical tensions in the Middle East could become a full-blown crisis.

You see, Trump’s plans to cut off all Iranian oil exports by November 2018 threatens Tehran’s ability to revitalize an economy shattered by years of international sanctions. That has the potential to trigger significant domestic dissent, indicating that Washington could very well be tightening the screws in an effort to cause the current Iranian regime to collapse. For this reason, there is the potential for up to 2.6 million barrels daily to be removed from global supplies should Trump’s plans be successful.

That would certainly cause prices to rise sharply and eclipse the additional one million barrels that OPEC and Russia plan to add back to energy markets. Needless to say, any response by Iran, which included a move to block the straits of Hormuz, through which passes around 17 million barrels of crude daily, would cause oil to spike sharply well into triple figures, according to some analysts.

According to a number of industry analysts, OPEC and Russia are incapable of delivering the one million barrels promised. Production outages in Libya caused by renewed fighting, the implosion of Venezuela’s oil industry, and conflict in Iraq are all diminishing the cartel’s oil output and ability to boost production.

Let’s not forget that the pressures Trump is placing on Iran have also sharply escalated the conflict between Saudi Arabia and Iran, which could have unintended consequences for OPEC’s oil production.

Pipeline, drilling, and other infrastructure bottlenecks are also weighing on the U.S. shale industry’s ability to keep expanding at a rapid clip — notably in the Permian, which has the largest spare capacity of any U.S. shale oil basin. That makes unlikely that, in the short term, the shale industry could fill the gap left by emerging supply constraints in the Middle East.

So what?

This is good news for Canada’s energy patch and, in particular, globally diversified upstream oil producer Vermilion Energy Inc. (TSX: VET)(NYSE:VTE). The driller’s stock has remained flat for the year to date compared to West Texas Intermediate’s (WTI) 20% gain. Vermilion is one energy company that maintained its dividend, despite the collapse in oil prices, and it is well positioned to benefit from higher prices.

It has also been steadily expanding production with first quarter 2018 oil output rising by 9% year over year to 70,167 barrels daily. That trend will continue, since Vermilion completed the $1.4 billion acquisition of Spartan Energy Corp., which is forecast to add up to 23,000 barrels daily, which is 91% oil weighted, to the driller’s total production. These developments — along with higher oil — will give Vermilion’s earnings a solid boost, which, in turn, will lift its market value.