September 17, 2019

The long held perception that Saudi Arabia’s oil infrastructure was well hardened against any major attack was shattered over the weekend when explosive laden drones struck the Kingdom’s largest crude processing facility and second largest oil field. Oil markets responded by pushing Brent oil prices up by as much as 19.5% when trading opened on Sunday night (Figure 1).

Approximately  50% of Saudi Arabia’s crude production runs through the Abqaiq crude stabilization facility, which makes the raw product suitable for export to world markets. In the wake of this attack Abqaiq has been crippled and 5.7M barrels per day of Saudi oil and 700,000 barrels per day of natural gas liquids effectively shut in. Oil traders are now left to ponder how this event will impact the future oil supply and demand balance. Important considerations include: duration of the outage, commercial and government inventory levels, available spare capacity, and heightened geopolitical risk.

 

Saudi officials originally indicated that production from Abqaiq could be restored in short order. Videos of fires burning across the facility and satellite images released by the U.S. Government suggested a much direr situation. The Saudis may indeed be able to get a portion of the facility back up and running in the near term, but a more fulsome recovery is likely measured in months rather than days. Saudi Aramco has committed to maintaining supply to its customers and will meet their needs by turning to oil inventories. The Kingdom exports ~7M barrels of oil per day and holds inventories of 187.9M barrels. This implies that there is only enough oil in storage to supply customers for one to two months.

The International Energy Agency (IEA) was created by the Organization of Economic Co-operation and Development (OECD) in the early 1970s with the objective of protecting member countries from oil supply shocks. The IEA’s 30 member nations are each required to hold a minimum of 90 days of oil reserves and could potentially act in a coordinated manner to release those reserves in the event of an extended Saudi outage. The United States Government holds ~660M barrels of oil in its Strategic Petroleum Reserve (SPR), and President Trump has said he would authorize an inventory release if needed. The possibility of a release of strategic reserves held by IEA member countries will act as a regulator on price appreciation.

Another potential source of back up oil supply traders have historically looked to is spare production capacity. These barrels are the would-be by-product of oil producers opening the taps a bit more. In recent years oil prices have been burdened by too much supply. In an effort to reduce commercial oil inventories a coalition of 21 member countries, affectionately known as OPEC+, has curtailed oil production to the tune of +1.2M b/d. This in theory means that OPEC+ should have sizeable spare capacity, but the brunt of efforts to realign inventories has been borne by Saudi Arabia. Outside of Russia and the United Arab Emirates, OPEC+ members have little to no spare capacity available. Unfortunately, Saudi Arabia holds the vast majority of that security blanket.

While Houthi leaders from Yemen have claimed responsibility for the attack, U.S. Secretary of State Mike Pompeo has squarely laid blame on Iran. President Trump followed up with a tweet which stated that the United States is “locked and loaded” to respond if Iran is verified to be the culprit. From both a geographic and technological standpoint Iran is indeed the most likely candidate behind the attacks. Last week President Trump dismissed Iran hawk John Bolton from his role as National Security Advisor, pushed for a meeting with Iran’s President Rouhani, and suggested he would be open to allowing Iran to export oil for food and medicine. This week the odds of any sort of deal with Iran seem much less likely. The collapse of the Iranian nuclear accord has bolstered the standing of far right-wing politicians and Revolutionary Guard in Iran at the expense of moderates. This political shift and a perception that President Trump does not want a war may have emboldened the Iranian’s to launch this attack. The big question now is what if any military response will we see from Saudi Arabia and the United States. Any strike against Iran could lead to the break out of a wider conflict, and is exactly the type of geopolitical “tail risk” we have been discussing since the resumption of U.S. sanctions.

The attack launched against Saudi Arabia has effectively removed ~6% of global oil supply. The duration of the outage is currently unknown, but the longer it goes on the more likely it becomes that oil prices will drift higher. Commercial and government oil inventories are available to help cover for the outage, and tapping into commercial storage could help OPEC+ bring global oil inventories back down to the five year average levels (or below). This would also be supportive for oil prices in the longer term. Further, Saudi Arabia’s oil infrastructure has now been shown as vulnerable and the odds of a military conflict have increased. As a result, a new geopolitical risk premium will likely be attached to oil prices. Traders have focused attention on the effects of trade wars and weak global economic data points for global oil demand but these attacks on Saudi Arabia have, at least for a time, shifted the narrative back to concerns over oil supply availability. Put it all together and the post attack move to higher oil prices seems justified. The sustainability of higher prices will depend on duration of the outage, availability of alternative sources, and ensuing geopolitical actions. Sustained higher oil prices are positive for producers and energy service companies, but also negative for consumers and airlines. As to the overall economic impact, at this point it is likely to be minimal, but should prices increase materially from here, it could become a more significant impediment to consumer sentiment and spending. Stay tuned.

 

 

 

 

 

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