Tehran and an improving global outlook are providing a floor for oil prices

Earlier in the year, Iran threatened to close the Strait of Hormuz if the West stopped the country from selling crude. If Tehran carried through with this threat it would close the world's main conduit for oil, would have severe supply implications and cause oil prices to shoot through the roof. But we think the fear in the marketplace may be overdone. Firstly, the West would never allow this to happen. Secondly, it would almost certainly result in war for Iran, in which Iran would likely come off second best, and Tehran would be acutely aware of this.

Saudi Arabia clearly thinks the threat to oil prices coming from a possible disruption in the Strait of Hormuz is overdone; Saudi Arabia oil minister Naimi stated "if you believe Hormuz will close, I will sell you the Egyptian pyramids". Naimi also added the current disruptions were minuscule in the grand scheme of things. Nevertheless, Iranian sanctions are out of the influence of Saudi policy, so there is not much Naimi can do about that.

However, Saudi Arabia and other nations have the capacity to cover a significant short-fall in supply. Despite threats from Tehran, Saudi Arabia has stated it can increase production by as much as 25%. Furthermore, France has announced that industrialized nations are considering releasing strategic crude stockpiles to counter the rising prices. Yet, it seems these possible supply-bolstering factors are proving somewhat of a ceiling for oil prices, rather than bringing oil prices down significantly over the long-term.

Moreover, when we look at the supply of oil we see the market is awash with crude, thus simple maths can't explain why oil prices are so high. But this is not the only part of the equation. We also have to look where this oil resides, i.e. what stockpile levels are? It is almost impossible to get these figures, but the information available suggests inventories are building.

Overall, the widening gap between Brent crude and WTI suggests that investors are still nervous about the future of oil prices (the spread is around 17, up from 6.2 during December 2011), and the improving global outlook is combining with the fears of increasing tension in Iran to create a floor for oil prices.

Moving into the rest of the year, whilst demand stemming from Europe is expected to remain fairly stagnant we are expecting the pace of China's slowdown to cool-off later in the year with the help of policy easing measures from Beijing, which should provide some support for oil price. But a resolution of the situation surrounding Iran would likely cause a revaluation to pre-Iranian tension levels. Likewise, if Saudi Arabia and other oil producing nations continue to increase production then we should see this reflected by a cooling in the price of oil.