Saudi attack, geopolitics and oil markets

Perhaps a false sense of security had crept in. Plentiful oil supply, carefully stewarded in 2019 by OPEC+ to get the market closer to balance, and moderate prices. Rising geopolitical tension,even around Iran, seemed a nebulous threat. The events of last Saturday shattered any complacency.

So what does the attack on Saudi Arabia’s infrastructure mean for oil market dynamics? I mulled over the question with Ann-Louise Hittle, Head of Macro Oils.

The vulnerability of the oil supply chain

Much of the global economy – food, medicine, energy – relies on just-in-time global supply chains. For oil, the supply chain from producer, through pipelines, storage, processing, refining, shipping and on to consumer markets is not quite just-in-time. It’s bolstered by sizeable inventories, both national strategic reserves and commercial stocks. Even so, the supply chain, moving 100 million b/d, has held together by and large with few outages for nigh on 40 years – even through the Gulf War. 

The emergence of a plethora of new producing countries since the 1970s helped to diversify and de-risk supply – up to a point. There are dozens of non-OPEC countries which collectively produce 70% of global supply today.

Yet there is no escaping that the Middle East is still home to one-third of global capacity. Concentration risk is extremely high. The Achilles heel has always been the open waters of the Strait of Hormuz through which 20% of the world’s supply traverses daily. Saudi Arabia’s onshore Abqaiq processing plant – with its 5.7 million b/d throughput – may be back up and running within a few weeks. But the attack shows that other critical elements of the supply chain are more easily disrupted than we imagined.

Geopolitics – be careful what you wish for

The growth of tight oil has reduced US import dependence, emboldening US foreign policy since the 2016 election. The result is a ramping up of the risks to global oil supply. Outages caused by infrastructure and political unrest ran at less than 1 million b/d, or 1%, of global demand 10 years ago – meaningful, but more ‘background noise’.

Just prior to Abqaiq, however, outages exceeded 5 million b/d, or 5%, of global demand. Half of that, 2.7 million b/d, was due to US sanctions on exports from Iran and Venezuela imposed within the last three years. This reduction in available spare capacity primed the market for an incident like Saturday’s.

The limitations of US tight oil as an instrument of power

‘Short cycle’ tight oil has been the main driver behind US production rising from 7 million b/d in the early years of this century to 17 million b/d in 2019. We forecast US volumes to exceed 20 million b/d in the early 2020s, almost double that of Russia or Saudi Arabia.

But, as Ann-Louise likes to point out, short-cycle does not mean instant response. Tight oil can’t be cranked up or down swiftly in response to price signals – it’s not spare productive capacity the way OPEC holds it. It might take 9 to 12 months for new wells to be drilled, completed and brought to market. Nor will higher prices triggered by the attack lead to new drilling. The independent E&Ps, which account for 80% of Permian production, have been reined in by shareholders to focus on generating cash flow and dividends rather than spending for growth.

The world is awash with supply – if it can get to market

Once Saudi capacity is restored, there will be plenty of supply. OPEC+ has successfully kept in balance a market that could have been heavily oversupplied in 2019. Discipline in constraining output by 1.1 million b/d has held Brent above US$60/bbl. Next year, the oversupply could worsen, assuming Saudi capacity returns to normal. More production is due on stream from the US, Canada, Brazil, Norway and Canada, among others. We expect OPEC+ will need to cut supply further in 2020.

What next?

It’s far from clear. The US doesn’t want conflict to erupt with an election only a year away; Iran still less. With this attack on crucial oil infrastructure, we’ve taken a few steps further down a very dark corridor. We can’t see what’s at the end. But there’s a sense of foreboding that what lurks there might be pretty scary.