Oil prices have sold off aggressively following the US-Iran Memorandum of Understanding. While we believe the move is overdone, we look at some of the reasons behind the strong pullback in prices
The Oil Market Prices in a Quick Recovery of Persian Gulf Supplies
The Memorandum of Understanding (MoU) between the US and Iran has led to a significant sell-off in the oil market – far more aggressive than most analysts were expecting, including us.
The sell-off has been driven firstly by the premature expectation of a normalisation in oil supply from the Persian Gulf, and secondly, clear weakness in the physical market. However, we believe that the market is being too optimistic over the speed of the supply recovery as well as its sustainability. Furthermore, we have seen a significant tightening in global oil inventories since the start of the conflict, which leaves the market more vulnerable relative to the pre-war environment.
The price action in recent weeks reflects a market that is treating this temporary ceasefire between the US and Iran as a permanent deal. This is clearly not the case, and as we have seen over the last four months, the situation can change very quickly. It took long enough to agree on a temporary ceasefire. Reaching a permanent deal which tackles the nuclear issue within 60 days would be very optimistic. Of course, there is always the potential for the ceasefire to be extended, which would effectively be kicking the can down the road.
Fundamentally, while a reopening of the Strait of Hormuz is seeing oil and LNG flows pick up, they remain well below pre-war levels. Our balance sheet continues to show that the oil market will be tight through the third quarter, and this follows the significant inventory drawdowns since March. We believe the market has overshot to the downside. However, our assumption is that flows will only get close to pre-war levels towards the end of the third quarter, while current price levels imply a return to normal by the end of July.
At close to $70/bbl, the oil market currently has close to zero geopolitical risk premium priced in. ICE to average $85/bbl in 4Q26. Clearly, more bearish sentiment combined with a quicker supply recovery poses a risk to this view.
In this note, we look at some of the key reasons why the market has sold off so aggressively.
Persian Gulf Oil Flows Are Resuming
Oil flows through the Strait of Hormuz are picking up, vessel tracking data shows an increase in crossings, although for now they clearly remain well below pre-war levels. Over the last week, it is estimated that oil flows have averaged around 7m b/d vs pre-war flows of 20m b/d. However, we do not need to see Strait of Hormuz oil flows return to 20m b/d in order for Persian Gulf oil supply to fully recover. Given that some Saudi and UAE oil is bypassing the strait with the help of pipeline diversions, we only need to see flows through the strait return to around 14m b/d to get back to pre-war levels.
However, the key uncertainty is whether these flows can be sustained. A lot of these vessel movements are essentially vessels which have been trapped for months in the Persian Gulf finally moving out. Inbound vessel movements are more modest, which suggests flows could pull back once previously stranded ships have left the Persian Gulf.
Strait of Hormuz Oil Tanker Crossings Rise but Dominated by Outbound Movements (Number Of Tankers)
Note: Vessels which turn off their AIS will not be reflected in this data
Source: LSEG, ING Research
Iran Sanction Waiver
A condition of the MoU was that, in addition to the US lifting its blockade on Iranian ports, sanctions would be eased on Iranian oil exports. The US has kept to this promise with the blockade lifted and a temporary 60-day waiver on sanctions. The lifting of the US blockade is more important when it comes to seeing a recovery in Iranian oil exports. The easing in sanctions does open the door for further potential buyers of Iranian oil (rather than almost exclusively China), which suggests that discounts on Iranian crude oil could narrow, rather than lead to a dramatic increase in Iranian supply. In order to see Iranian oil output increase, we would need to see a more permanent easing in sanctions, which would then potentially see Iran managing to increase output by about 500k b/d from pre-war levels.
The Physical Oil Market Is Weak
A key factor behind the weakness is that ultimately, the physical oil market is weak at the moment. Buyers have been deferring purchases in anticipation of lower prices, and so are happy to draw down inventory instead. The weakness in the physical market is highlighted by the widening discounts for a number of crude grades. Dated Brent is trading at a discount to Brent futures and there have been reports of China reselling West African cargoes.
However, restocking will need to happen at some stage, as the continued drawing down of inventory is not sustainable. The forward curve still does not provide the biggest incentive to restock, so possibly we may have to see the forward curve flatten and possibly even move into contango for more meaningful restocking to occur.
And while there will be a lot of attention on when and if we see a recovery in China’s crude oil imports, it is unlikely that we see significant restocking from China given that while imports have fallen drastically following the war, inventory drawdowns have been much more modest. The restocking demand we expect will come from elsewhere.
Dated Brent vs Front-LINE Brent Futures- DFL (US$/bbl)
Source: LSEG, ING Research
Return of Gulf Flows Coincides With Continued SPR Releases
The pickup in oil flows from the Persian Gulf is also coinciding with the continued release of oil from government strategic reserves. IEA member countries early on in the conflict agreed to a coordinated release of 412m barrels – the largest on record. These volumes continue to come onto the market, and if we look at just the US, releases from the Strategic Petroleum Reserve have averaged more than 1.2m b/d since May.
Demand Destruction Has Been More Aggressive Than Expected
Expectations had been that demand destruction in the second quarter of the year was anywhere between 2-3m b/d, with most of this coming from the petrochemical sector and aviation. However, more recent estimates from the IEA suggest that the demand hit has been far more aggressive than expected. The IEA estimates that 2Q26 demand fell around 5m b/d YoY, compared to a previous estimate of a 2.45m b/d year-on-year decline over the quarter. Demand appears to have been much more reactive beyond the sectors and fuels initially expected. More aggressive demand destruction would also mean that the degree to which the market has had to rely on inventories is somewhat less. Looking forward, the key question is how quickly demand recovers. The IEA expects that global oil demand will only return to YoY growth in the final quarter of this year.
Growing Surplus Expectations for 2027
There is a growing expectation that the global oil market will be well supplied through 2027, assuming obviously that the return of Persian Gulf supply continues. While the 2027 supply/demand balance means little for current fundamentals, markets are forward-looking, and so this will not be helping sentiment.
The higher prices seen through March and much of the second quarter mean that there has been an increase in US drilling activity. As a result, US crude oil production is expected to grow in the region of 500k b/d YoY in 2027.
In addition, the UAE’s exit from OPEC leaves room for stronger supply from the Middle East. The UAE had been producing around 3.5m b/d pre-war, and with current capacity of almost 4.3m b/d and plans to increase this to 5m b/d in 2027, there is sizeable upside to supply next year.
Furthermore, Iran is another potential source of additional supply. However, this will largely depend on whether there is a more permanent easing in US sanctions on Iran. If this were the case, we could see Iran increase output by around 500k b/d from pre-war levels to around 3.8m b/d.
Some may argue that if we move to significant oversupply in 2027, we will see OPEC+ manage supply in an attempt to rebalance the market. However, this may be more difficult to put into practice. Gulf countries have suffered in recent months due to the war and the blockade of the Strait of Hormuz, so there will likely be pushback if producers are asked to rein in supply. Iraq has already made it clear that it wants a higher production quota following the war. And with the recent exit of the UAE and threats from Iraq, the group will want to be careful about pushing members too much.
A Significant Speculative Short Has Built Up in the Oil Market
Through the war, there was a reluctance amongst market participants to hold too much risk in the market, given the headline-driven nature of the market and how one tweet could lead to wild swings in prices. However, since the temporary peace deal, we have seen a sizeable amount of fresh selling coming into the oil market. In fact, the speculative gross short in ICE Brent is near record highs, and while this highlights the bearish sentiment in the market, it also suggests that the speculative short is somewhat stretched, which may limit the appetite for significant further fresh selling.
The Managed Money Gross Short in ICE Brent Is Near Record Levels (000 Lots)
Source: ICE, ING Research
Consumers Are Not Jumping Into The Market To Hedge
Tying in with buyers deferring purchases in the physical market, in the futures market, consumers are also holding back from hedging, possibly in anticipation of lower prices. While recent Commitment of Traders data does show that ICE Brent consumer longs have edged higher recently, they are still well below pre-war levels.
ICE Brent Commercial Gross Long (000 Lots)
Source: ICE, ING Research
Disclaimer: This publication has been prepared by ING solely for information purposes irrespective of a particular user’s means, financial situation or investment objectives. The information does not constitute investment recommendation, and nor is it investment, legal or tax advice or an offer or solicitation to purchase or sell any financial instrument. Read more
