Early Saturday morning, 14 September 2019, Saudi Arabia's oil infrastructure in the Northeast provinces came under attack, taking six million barrels of oil per day (bpd) offline. A catastrophic halt of this magnitude - half of Saudi's processing volume and 6% of global supply - is unprecedented in modern history, potentially even more impactful than closing the Strait of Hormuz.
The drone strikes targeted the Abqaiq oil processing plant, one of the largest in the world, and Khurais, the country's second-largest oilfield. Houthi rebels in Yemen have claimed responsibility, though the attack's precision appears beyond their known capabilities and US secretary of state Mike Pompeo has placed the blame squarely on Iran.
Although damage assessment is still underway, Saudi Aramco has stated the country may remain short of full production capacity for weeks. Quantifying the long-term effect on energy markets will depend on the extent of the damage, Saudi retaliation and potential US involvement.
Here is how we are assessing the range of outcomes going forward:
Worst case: If the entire 6m bpd stays offline for a prolonged period, we think the price of Brent crude could breach triple digits by early 2020. In this scenario, we would expect large amounts of strategic reserves to be released, US crude production to ramp significantly, and the fragile, trade war-challenged global economy to slip into recession under the weight of extremely high prices for crude oil and crude products, such as gasoline, diesel and jet fuel.
Base case: Saudi loses about 1-2m bpd temporarily, partially offset by spare capacity from Russia, the US and other oil producers, and drawing down stockpiles. In this scenario, we would expect Brent crude to drift higher through year end, as reduced spare production capacity and lower stockpiles would likely keep spot prices elevated.
In our view, the base-case scenario would not be enough on its own to tip the global economy into recession, but it would make Europe's situation more challenging and could keep global interest rates low for the foreseeable future. As long as oil stays below $100 per barrel, we think the US is in a stronger position; the rise of shale has made it a swing oil producer, meaning positive effects from higher energy investment could provide some cushion to the negative effects of lower consumption.
Either way, we believe this is a huge deal for oil markets:
- Tension in the Middle East is at its highest point since Iraq invaded Kuwait in 1990, when oil prices jumped 160% over four months.
- This is a new type of drone warfare, exposing the extreme vulnerability of any oil field or processing unit in the world. Consider that Saudi Arabia has the third-largest military budget, yet the unmanned drones - which typically have no heat signature and are made of composite materials - went completely undetected, flying below the Saudi's ‘iron dome' defence system. This permanently changes the risk of oil production, forcing Saudi - and everyone else, for that matter - to alter how it protects assets.
- Saudi is likely to retaliate after it stabilises oil production, with potential for significant escalation depending on the target and whether the US or others become involved.
- Any chance of de-escalation between the US and Iran is now off the table.
Regardless of whether Saudi's capacity is restored in a week or a month, we believe a geopolitical risk premium the likes of which has not been seen in recent history is back in the oil markets and should continue to be reflected in oil prices. We expect this to support higher prices throughout the energy value chain.
In particular, we believe the disruption will shift increasing focus to opportunities in North American midstream energy and E&P companies:
- It highlights the strategic importance of US shale for diversifying energy supplies.
- Higher energy prices tend to result in stronger counterparties and higher throughput volumes.
- Concerns that slower global demand could push crude oil to $40 per barrel have been largely removed.
- President Trump has indicated he may seek to fast-track remaining pipeline permits.
The situation remains highly fluid and our investment teams are following developments closely.
Tyler Rosenlicht is head of midstream energy and MLPs at Cohen & Steers