How the shock of the Saudi attack will linger over the oil market
The drone strike on Saudi oil facilities proves that the global oil supply chain is vulnerable to attack. Markets must start to price a bigger risk premium into oil.
The attack on Saudi Arabia's oil facilities was "the big one", says Spencer Jakab in The Wall Street Journal. The drone strikes on the world's largest oil processing plant at Abqaiq has forced Saudi Arabia to cut output of of crude oil by 5.7 million barrels per day (mbpd), roughly 60% of its output and as much as 6% of global supply. World oil production is around 100 mbpd. Even if supplies are restored quickly, as Saudi Arabia has reportedly indicated they will be, the "technological sophistication and audacity" of this strike against critical infrastructure, for which Iran-backed Houthi fighters in Yemen have claimed responsibility, "will linger over the energy market".
Saudi attack is a game-changer
The attack prompted the biggest one-day rise in Brent crude prices in at least 30 years. The benchmark rose by as much as 20% to over $70 a barrel before falling back; major equity indices slipped by between 0.5% and 1%. The 5.7 mbpd taken offline is the biggest disruption to global supplies on record, topping even the outages caused by the 1979 Iranian revolution and the 1990 Gulf War.
The strike could prove a "significant game-changer", says Stephen Innes of AxiTrader. It suggests that crucial nodes in the global oil supply chain are "extremely vulnerable to terrorist attacks". So markets must start to price a bigger risk premium into oil. The slump in crude prices this year in the face of growing Iranian belligerence now looks complacent, agrees Jim Armitage in The Evening Standard. The "sub-$60 trend we've seen over the summer seems out of touch with reality".
Oil is an oversupplied market
Nevertheless, oil is still trading significantly below the $86.70 a barrel high it hit last October. That is due to weak global demand. The International Energy Agency thinks that worldwide appetite for Opec oil in the first half of 2020 could be 1.4 mbpd lower than current output. "We are massively oversupplied," Christyan Malek of JP Morgan told Reuters, noting that "it would take five months of a five mbpd outage to take global crude supply levels back to a 40-year normal average". The main reason is booming US shale oil production. American oil output doubled in the decade after 2008 to overtake Saudi Arabia as the world's biggest oil producer. That makes the kingdom's reserves less crucial. The fact that Opec, the oil exporters' cartel, has been voluntarily restricting supply in recent years in a bid to support prices also suggests that they have the spare capacity to cover any Saudishortfall.
The attack itself is "unlikely to be a disaster for the global economy", writes Jennifer McKeown of Capital Economics. The biggest risk comes not from supply disruption, but rather the fact that the incident raises the odds of a "full-blown US-Iran conflict". That worst-case scenario could push oil up to $150 per barrel and drive inflation in developed countries as much as 3% higher (see below).
Saudi Arabia's uncertain future
For Saudi Arabia, the "stakes couldn't be any higher", says Andy Critchlow in The Daily Telegraph. The International Monetary Fund estimates that Riyadh needs oil prices around $85 per barrel if it is to balance its budget. If it can't do that then one of the Middle East's more stable countries could face an uncertain future.The local Tadawul stockmarket opened down 2.3% on the first day of trading after the strike on Abqaiq. The index has fallen by 16% since May.
Weaning the country off oil
The nation remains overwhelmingly dependent on oil, which accounts for about 80% of exports and more than 40% of GDP, says Abeer Abu Omar on Bloomberg. Yet even that understates petroleum's real significance: "non-oil activity is heavily dependent on state outlays financed by oil revenue".
The Saudi budget has suffered from the protracted slump in oil prices, which caused the economy to shrink in 2017 for the first time in a decade. Yet Riyadh has done little to cut back on a generous welfare system that provides many citizens with cushy government jobs. Indeed, last year the government launched a lavish new "cost-of-living allowance" reports Natasha Turak on CNBC. The measure costs more than $13bn and is "intended to stimulate sluggish growth and shore up support" for the regime. That is vital in a country where the unemployment rate is more than 12% and more than half the population is younger than 30.
The budget deficit is set to hit an "eye-watering" 6.5% of GDP this year, says Tom Rees in The Daily Telegraph. On current projections the kingdom will "burn through its foreign currency reserves and government debt would climb to 70% of GDP by 2023". Annual oil revenue is worth $11,000 per Saudi at current prices, notes Critchlow, but it won't last forever.
Crown Prince Mohammed bin Salman's "Vision 2030" initiative aims to prepare Saudi Arabia for a future without oil by diversifying into sectors such as tourism and technology. The recent move to allow women to drive was part of the broader economic reform strategy. Yet as Lauren Silva Laughlin points out in The Wall Street Journal, ambitious plans to build a futuristic city called "Neom" will "cost $500bn".
To fund his projects, MBS' flagship initiative is to float 5% of Saudi Aramco, the state oil company. The flotation would be the biggest listing in stockmarket history. Yet it has been repeatedly delayed and the Abqaiq incident is another blow, says Nils Pratley in The Guardian. A higher oil price would normally be a boon for Aramco. But "a drone attack on a key refinery" is no longer a mere hypothetical and investors will be wary. To press ahead with the flotation for the end of this year as originally planned "would look desperate".
Is this the pin that pricks the bond bubble?
Markets had neglected the scope for oil to spike, says Louis Gave of Gavekal Research. The theory was that "with so much excess supply around the world, no lasting energy shock is possible". Attention focused instead on the potential for deflationary shocks from a "Chinese devaluation" or "eurozone implosion". That has helped create a record bond bubble.
Yet this week's oil price spike and talk of war in the Middle East are a reminder that "the next shock... could actually be inflationary". Inflation has already been "creeping higher, despite a strong US dollar and a weak oil price". It wouldn't be the first time an inflation shock snuffed out an equity upswing. The 1973/74 oil price spike "put the Nifty Fifty bull market to the sword".
Indeed, the 1970s oil shock "tipped the world into recession and sparked off a bout of inflation that took nearly eight years to tame", as Russ Mould of AJ Bell points out. "On six of the last eight occasions when oil prices have risen by more than 100% year-on-year", the global economy has slowed or even shrunk. Oil spikes are inflationary, then deflationary: the jump in inflation acts as a tax on people and businesses, slowing consumption, investment and growth. Bond markets are foolish to think that low inflation will continue indefinitely. Still, for now oil remains a fifth lower than it was a year ago.
Western economies are also less dependent on oil these days thanks to greater energy efficiency. "Energy only absorbs 2.5% of US household consumption," says Robin Pagnamenta in The Daily Telegraph. In the 1970s that figure was 8%. It is the "oil-thirsty economies of Asia" that are most exposed to supply disruption. Asia, which lacks its own reserves, has grown "addicted to imports... three quarters of Saudi Aramco's oil goes to Asia".
Will there be another Gulf war?
US Secretary of State Mike Pompeo was quick to point the finger at Iran for Saturday's Abqaiq attack despite Tehran's denials. Donald Trump tweeted that America was "locked and loaded" and pledged support for his Saudi allies.
The standoff between Saudi Arabia and Iran has deep religious and political roots and is "in many ways a regional equivalent of the Cold War", says Jonathan Marcus on the BBC. The two sides are engaged in proxy conflicts, notably in Yemen where Riyadh has been conducting an unsuccessful war against Iran-backed Houthi rebels for the past four years. Neither side is prepared for a direct confrontation, but Saudi Arabia has been emboldened by the White House's support and the Abqaiq incident "could upset the apple cart". All sides have reasons to resist conflict, writes Gideon Rachman in the Financial Times. Iran would find itself outgunned by its well-armed Gulf neighbours in an all-out war. The Saudis know that crucial infrastructure notably the kingdom's water supply could be vulnerable to future drone attacks. Donald Trump won't want to start a war that could drive petrol prices higher before the 2020 election.
The problem is that leaders in all three capitals have "shown themselves to be erratic, emotional and prone to miscalculation". So there is significant potential for dangerous escalation on the ground and "further mayhem on the markets".