There has been limited market reaction to the drone attacks on Saudi energy assets as investors focus on interest rates and weak growth. But the unprecedented scale of the strikes, and the threat of more, underline the risky ‘new normal’ for the global economy.
SINGAPORE (Sept 23): On the edge of war and peace” — that is how The New York Times has described US President Donald Trump’s vacillation between hardline and conciliatory decisions on Iran. Both US and Saudi Arabian officials have accused Iran of being behind the attacks on Saudi Arabian oil and gas assets that put roughly 50% of the kingdom’s oil production, or about 5% of global supply, out of action.
On Sept 16, Trump tweeted that the US was “locked and loaded”, in response to the strikes. Not long after that alarming declaration, however, Trump said at the White House that he would “certainly like to avoid” war. “I know they want to make a deal,” he was reported to have said of Iranian officials. Yet, a couple of days later, Trump announces that he has ordered new sanctions to be imposed on Iran, even as he says he is open to meeting President Hassan Rouhani. The Trump administration had, last November, imposed almost-full economic sanctions on Iran that had been lifted or waived under a deal struck in 2015. Rouhani has said Iran would not agree to a meeting until the economic sanctions were lifted.
Meanwhile, US Secretary of State Mike Pompeo’s assertion that the strikes on the oil and gas infrastructure amounted to an “act of war” by Iran is only going to escalate tensions. “We may be entering a new phase of heightened instability and conflict in the Gulf,” says Philip Andrews-Speed, senior principal fellow at the National University of Singapore’s Energy Studies Institute. “If the risks continue or escalate, the impact on the global economy can only be negative, adding additional downward pressure on economic growth to the existing trade war.”
Still, investors’ reaction to these geopolitical events have seemed relatively muted. When markets reopened after the weekend’s strikes, prices of crude oil spiked as much as 20%, as traders scrambled to buy oil contracts amid fears of a prolonged disruption to oil supply. News headlines were also proclaiming that the attacks have effectively “detonated” state-owned oil group Saudi Aramco’s plans for a hundred-billion-dollar IPO.
Crude prices soon moderated, however, falling back to close to the levels they were trading at before the attacks. Even as investigators are examining evidence, including satellite images as well as missile and drone parts recovered from the Abqaiq processing facility and Khurais oil field, Saudi officials said the kingdom’s oil output would be back to full production by month-end. Aramco is going ahead with its IPO plans, which reportedly could happen as early as November, with management back to talking to its bankers on the offering.
Yet, as Yaw Yan Chong, director of Thomson Reuters Oil Research & Forecast in Asia, notes in a report put out by Refinitiv, Aramco has been actively seeking to buy refined products, particularly diesel
and jet fuel, from the spot market. He says this is “signalling that all might not be quite as well as the Saudi government would have the market believe”.
He adds: “Price levels for potential replacement crude grades similar to the ones affected by the drone attacks — the Arab Light and Arab Extra Light grades — have jumped in their latest spot tenders for November-lifting cargoes, signalling that the market remains cautious.”
Indeed, the market does seem to be taking extra risk into account. Even after coming off the temporary peak, benchmark crude prices are still US$4 to US$5 per barrel higher than pre-attack levels. “Upward pressure on prices will continue, owing to the perceived risk of continuing or escalating conflict in the Middle East,” says NUS’s Andrews-Speed. “We are already seeing Chinese companies (for example, Unipec) buying more oil from the US.”
How should investors react? What are the wider implications of the still-unfolding events?
Cracking supplies
The 17 points of impact at Abqaiq, Aramco’s largest oil processing facility, showed up on satellite images released by the US government as large holes on the side of storage tanks and smoking chimneys.
As Yaw’s report notes, the strikes on Abqaiq — the world’s largest crude-processing plant, with a capacity of seven million barrels per day — will affect the global refined products market, mainly middle distillates, and petrochemicals market. It will also severely affect Saudi Arabia’s own petrochemicals production, as Abqaiq also supplies gas to the kingdom’s own crackers, and its refineries run on lower levels of crude feedstock.
Saudi Arabia is the largest supplier of crude to Asia, accounting for about a quarter of supplies so far this year. According to Refinitiv, the kingdom is the largest supplier to China, having expanded its market share on the mainland to account for about 18% of imports, overtaking Russia, or about 6.5 million tonnes a month. The kingdom is also the largest supplier to Japan and South Korea, with a 40% and 36% market share respectively. Its main customers include China’s Sinopec, as well as India’s Reliance Industries, Taiwan’s Formosa Petrochemical Corp and Japanese refiners.
Yaw expects that the Saudis will draw on their storage reserves to keep their supply commitments. Apart from storage in the kingdom itself, Saudi Arabia has a capacity of about 10.1 million bbls stored in Okinawa, Japan as well as storage in Rotterdam, the Netherlands and Sidi Kerir in Egypt.
Whatever the case, the damage and disruption, and the resulting spike in the price of oil, only demonstrate how vulnerable the global economy, and a critical component of it, is to conflict and instability in the Middle East.
“This incident should result in a higher geopolitical risk premium, given the apparent ease with which a significant chunk of productive capacity was put out of action,” notes the research team at Oversea-Chinese Banking Corp. “There is also the risk of more attacks later.”
Anthony H Cordesman, Arleigh A Burke Chair in Strategy at the Centre for Strategic and International Studies in Washington, DC, writes in a commentary: “At a minimum, the strikes show that the strategic threat from relatively inexpensive conventionally armed weapons can be as serious as, or more serious than, massive uses of strategic airpower were in World War II and Vietnam.”
Risk on
So, what should investors be looking out for? Analysts note that the markets have been focused more on growth worries than on geopolitical tensions. The attacks in Saudi Arabia only momentarily overshadowed the meeting of US policymakers at the rate-setting Federal Open Market Committee, where they cut another 25 basis points to US interest rates.
Indeed, “the market cannot afford any significant shocks at this stage — be it an escalation in trade tensions, a no-deal Brexit or an oil price shock. Oil price shock may be the most dangerous, as it could be very damaging on the all-important consumer”, warns Seema Shah, chief strategist at Principal Global Investors, in an emailed note. “Without that support, we could be facing a reasonable chance of recession next year — particularly when you consider that the [US] Federal Reserve is running out of ammunition.”
Still, heightened tensions in the Middle East would certainly push oil prices higher, which would in turn drive up valuations of oil and gas exploration and production, and drilling companies. OCBC Research recommends sticking to the oil majors — BP, Total, Royal Dutch Shell — “when the dust settles”.
Maybank Kim Eng analysts see opportunity in the upstream players in this region, as well as oil storage players such as Dialog. They note that each International Energy Agency country has an obligation to hold emergency oil stocks equivalent to at least 90 days of net oil imports.
NUS’s Andrews-Speed says: “If oil prices rise and stay high for a few years, renewable energy sources will get a strong boost as will modes of transport (vehicles, ships, planes) that use alternative fuels.”
For now, Saudi Arabia’s assurances have taken the edge off the market, analysts note. At the same time, there is the acknowledgement that Trump will think twice about starting a conflict that will push up oil prices at home, ahead of the election next year.
“While there are no shortages of alternative supplies in the world, [the] events have highlighted the potential for serious short-term disruption and, arguably, therefore, that the reinstatement of a higher geopolitical risk premium is long overdue,” writes Neil Mellor, senior currency strategist at BNY Mellon.
Mellor points out that price trends in oil tended to be inversely related to the performance of the US dollar because the commodity is priced in the currency, and the US has been a major net importer of crude for much of its history. Now, however, the correlation “belies a shift in pricing dynamics”: that the US has become the third-largest producer of crude oil, after Saudi Arabia and Russia, and is set to become a net exporter of the commodity instead. As such, “in view of shifting dynamics, the US dollar — in its role as safe haven — could feasibly become a net beneficiary of the geopolitical uncertainty that caused them”.
Ultimately, conditions in the global political economy are fragile. “The last thing one needs right now is an oil crisis, given the ongoing US-China trade conflict,” says Mustafa Izzuddin, fellow with ISEAS-Yusof Ishak Institute. “Both would have global ramifications, with disastrous consequences, particularly for smaller countries, including those in Southeast Asia.
“There is a geopolitical imperative that is likely to be more perilous than the economic ramifications [of conflict]. If a regional war erupts, it could drag in the external powers and cause the Middle East to be inflamed with significant fatalities.”
