Green is the new black

September 20, 2019

Over the week, markets have sought to extract the essential meaning from the recent attack on Saudi oil production facilities. Is this a short-term disruption or the starting gun on a recession? What is certain is that the events have underlined the vulnerability of the world’s energy infrastructure. This should hopefully encourage an acceleration towards viable carbon alternatives.

Before the sun rose over the Kingdom of Saudi Arabia last Saturday morning, two of its major oil facilities were attacked by drones.  Consequently,  50% of the country’s oil production has been halted, wiping out more than 5% of the global crude supply (5.7 million barrels per day (mbd)). The Khurais and Abquiq sites were targeted, the latter being the heart of Saudi’s oil industry, where two-thirds of its total supply is refined and cleaned of impurities like sand and sulphur. Both are the property of Saudi Aramco, often referred to as Saudi Arabia’s crown jewel. The state-owned oil firm is the biggest in the world and is set to be publicly listed soon:  The company has said that the attacks do not hinder its IPO intentions.

The oil supply collapse was bigger than the one resulting from Iraq’s invasion of Kuwait in 1990 (4mbd) as well as the loss of Iranian production in 1979 – both of these oil shocks were followed by a recession. The subsequent price rally was intense – the biggest jump in 30 years – with crude prices rising almost 20% intraday, before President Trump said that Strategic Petroleum Reserves could be released if required.

Oil price changes tend to cast a long shadow

Already fears are rising about a global growth slowdown. Higher oil prices (if consistent) could indeed be another (or final) log on the fire. When oil prices rise, transport costs and the price of petroleum-based products inflate and the disposable income of consumers starts evaporating. According to High Frequency Economics, consumer energy products have a weight between 3% and 4% of GDP in most advanced economies.

A silver lining?

  On Tuesday, the Saudi Arabian Energy minister said the kingdom had restored half of the lost production and would fully restore output by the end of September. But what we have to remember is that crude oil is not as fungible as economists would have us believe. Every producer produces a different grade of oil. The most widely variable characteristics are viscosity and sulphur content. Refineries are finely tuned to process one specific type of crude and can operate only a narrow range of the chemistry it was designed to process.

Aramco has already informed India’s top refiner, IOC that the grade of the crude it receives will be different (Arabian Heavy instead of Arabian mix). This means that reserves are not a panacea.

The question now is to gauge how fragile the geopolitical situation is when it has been underlined how vulnerable global crude supply is to cheap and easy-to-deploy disruptive attacks.

Yemen’s Houthi rebels claimed responsibility for the attacks. US Secretary of State Mike Pompeo quickly accused Iran of being behind  them. Iran denied any involvement in the attack and the Iranian President, Hassan Rouhani, called the attack a reciprocal act by the “Yemeni people” in response to assaults on their country. Saudi Arabia has meanwhile promised to “confront and deal” with this terrorist aggression”. In response to a Saudi request, France is sending experts to take part in an investigation aimed at revealing the origin and modalities of the assaults.

 Whilst the oil price shock should  be short lived, the risk of further escalation in the Middle East is real. With the US Administration pointing the finger at Iran, geopolitical risks will remain at the forefront. Above everything it means that a substantial risk premium will be attached to the oil price. Some may find consolation in the fact that the most hawkish member of the Trump Administration, James Bolton,  is no longer in the picture at this heated moment.

Green is the new black

The most concerning takeaway from all of this, is the vulnerability of the world’s energy infrastructure. A facility of such importance should have been better protected – the fact it is not, opens the door to more uncertainty. To conclude with a positive perspective, all this highlights why energy transition is essential and hopefully an acceleration towards viable carbon substitutes has been catalysed.

Source: Bloomberg, BIL

Author: Group Investment Office