U.S. Seen Extending Losses Ahead Of Yellen Speech

 | Mar 27, 2015 07:25AM ET

The oil rally yesterday was driven by the conflict in Yemen as the Saudi’s led an attack – with the support of its Gulf Arab allies – against the Houthi rebel group, which is thought to have Iranian backing. The Shia militia group has seized large parts of Yemen and forced President Abd Rabbu Monsour to flee the capital, which appears to have been the final straw for the countries Sunni neightbours. The attack, which began with air raids, is likely to be followed by a ground invasion as more countries join the effort to defeat the Houthi rebels.

While this is unlikely to have an impact on oil supplies, what we saw yesterday is an additional risk premium being priced in because of the potential for further escalation. More than 3.8 million barrels pass through the Bab el-Mandeb Strait off the coast of Yemen and as long as this conflict continues, there are going to be growing fears that this will be impacted.

Fortunately, the glut in oil supplies at the moment has capped any significant risk premium being added to prices. Oil has been in contango for quite a while now which has led to a record amount of offshore storage, to the point that availability is fast running out. As long as we continue to see such an excess in oil supplies, geopolitical risk premiums should remain fairly low. Only when we see a serious risk to supplies either due to conflict in the middle east or production being cut should we see higher risk premiums being added.

The fact that we’re seeing a small decline in prices today does not mean that traders are no longer concerned about the conflict, it’s simply a correction because yesterday’s rally was a little overdone. Despite being more than 1% down on the day, the fact that Brent crude hasn’t even broken below the mid-point of yesterday’s open and close levels is a technical signal that this is merely a correction. If the conflict continues, we could see further gains next week.