Oil’s slippery slope

A recent attack on Saudi Arabia’s oil production, temporarily halving production (around one-twentieth of global output) overnight, has highlighted the vulnerabilities of the Kingdom’s infrastructure. While rebels in Yemen claimed responsibility for the attack, the US and Saudi Arabia consider that impossible without Iran’s support.

The Middle East conflict is proving to be a proxy for the tensions between the US (and its allies including Saudi Arabia), against Iran, China and Russia.

“This was an Iranian attack” said US Secretary of State Mike Pompeo, and an “act of war.” The US responded by preparing new sanctions on Iran and President Donald Trump has repeatedly said that his administration is studying options and toned down calls for military retaliation. But, he said last week, “there’s plenty of time to do some dastardly things.” 

Iran’s Foreign Minister, Javed Zarif, denied involvement and said that the US’s “maximum pressure” policy on his country was turning into “max deceit,” repeating calls to restart talks on resolving their differences on Iran’s nuclear programme.

In May 2018, the US unilaterally withdrew from its commitments with European governments to limit Iran’s nuclear ambitions, and re-imposed sanctions on the country. That left Iran with few negotiating options and dwindling oil production.

The attack also illustrates the weaknesses of conventional military defences faced with cheap, difficult-to-detect drone strikes. As Saudi Arabia restores oil supply, the US has approved the release of strategic reserves.

Price spike

The immediate impact of the September 14 attack affected 5.7 million barrels per day (mpd), the equivalent of around 5% of the world’s output, pushing crude oil prices up almost 15%. Once Saudi Arabia reassured markets with repair estimates, prices fell back. National oil company Saudi Aramco has already restored 2 mpd of production (see chart), and plans to return to August’s 9.8 mpd output by the end of this month, it said last week. Along with promises to release inventory, oil prices fell back on the news (see chart). The Kingdom also cut production to meet its OPEC+ commitments last year, meaning there is potential additional capacity.

Still, the danger is that any additional drag on the global economy, already coping with US/China trade disruptions (including China buying less US oil) and the uncertainties of the UK’s Brexit efforts, would translate into lower consumer demand and a broad slowdown.

In the meantime, trade in oil is adapting to US/China frictions. China, the world’s biggest crude importer, historically sources its oil from Russia, Saudi Arabia and Iran. In the wake of the first US tariffs on Chinese products, China’s imports of American oil fell ten-fold, and reliance on Saudi oil increased further still as US/Iran tensions increased.

On the brink?

Politically, everyone is running out of options. Saudi’s military could choose to retaliate, but any escalation would be logistically and diplomatically dependent on US support. In any case, the Kingdom knows that new strikes on its installations would be technically relatively easy to carry out. Saudi anti-missile defences were facing Yemen when the drones struck on 14 September, and did not detect the threat. While Saudi Arabia’s military infrastructure can cope with conventional attacks, defending against cheap, undetectable drones able to strike precise targets could be much harder.

Iran may also have calculated that the US will not respond. Trump called off a strike in June in retaliation for attacks on tankers in the Strait of Hormuz, and Tehran may have decided they have little to lose. And could still choose to disrupt oil moving through the Strait, which channels one-fifth of the world’s traded oil.

The US is also running short on options and Mr Trump promised three years ago not to drag the country into foreign conflicts, while ruling nothing out.

Asset allocation implications 

The outlook for earnings is already depressed as global trade adapts to disruptions. Any sign of falling US consumption would risk triggering an earnings recession, and equity indices suffer from rising risk aversion. While some stocks, such as oil producers, would of course gain, emerging markets would be hardest hit given their exposure to the global economy. 

In such circumstances, rising oil prices and a deteriorating global economy should see the US dollar appreciate against cyclically sensitive currencies, especially the Indian rupee and the Turkish lira. Any wider deterioration would also see gold attract safe haven flows, especially in the context of low yields for traditional haven assets.

This said, we do not believe that there is a high risk of long-term oil shock, as Saudi Arabian inventory and repairs along with the release of US reserves, will cover commitments. In addition, global supply and reserves have shifted so significantly in the last three decades that we do not believe the impact of the attack will last long, nor trigger a 1970’s style oil crisis.

In our view, the only trigger for a deep and longer-lasting crisis (and higher oil prices) would be prolonged conflict around the Strait of Hormuz. One thing is clear; the unintended consequences of US trade and nuclear diplomacy are playing out in the Middle East over oil.  

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