The weekend attack on a major oil processing facility in Saudi Arabia knocked out around 5.7 million barrels per day of supply, driving up crude prices by nearly 15%. What are the implications for investors?
What actually happened and why?
It appears that Iran launched a major cruise missile attack from Iran directly at the largest Saudi oil facility. Most likely, it seems Iran is feeling tremendous pressure from U.S. economic sanctions and is finding its current predicament increasingly unmanageable, so it is lashing out in an effort to force the U.S. to drop the sanctions. The Iranian economy is in decline, inflation is worsening, while government funding is increasingly scarce for social programs and terrorist activity due to sharply reduced oil revenues. The Europeans tried to offer Iran a $15 billion lifeline, but was unable to implement even a temporary deal. Iran seems to be hemmed in financially.
So it seems the Iranians are initiating attacks, which it formally denies, to create as much pressure as possible on the U.S. and the Europeans to withdraw the sanctions and to accept Iran as it is. There is also a clear pattern. Initially, Iran attacked one oil tanker in the Strait of Hormuz, then 4 tankers and then they captured a U.K-flagged tanker after the U.K. seized one Iranian ship, all of which elicited little response from Western powers. Although Iran kept escalating its aggressive behavior, no concessions were made. So with the economy performing badly, Iran’s leadership keeps ratcheting up the assaults to force a U.S. policy change. This is likely to continue until someone, most likely Saudi Arabia, responds to these attacks.
What happens to the oil market?
It is very fortunate that the global oil market is suffering from an excess of supply. While prices initially spiked about 15%, this was driven more by psychology than oil shortages, which is likely why prices have retreated. U.S. inventories are quite high, the Saudis hold considerable inventory that can fill in for its own reduced production shortfalls, and other members of OPEC may take the opportunity to increase output to benefit from lost supply coming from the Saudis. At more than 12 million barrels per day, the U.S. is already the world’s largest oil producer and we can produce more fairly quickly. The price rise in crude implies roughly a 20 cent per gallon increase in gasoline prices at the pump, which may not be sustained. It is doubtful that oil prices will rise much from current levels unless there are additional strikes on Saudi oil operations, which open the door to significant reprisals and a potentially broader conflict.
What are the broader economic effects? Could the rise in prices cause a recession?
The surge in oil prices is highly unlikely to cause a significant slowdown in global or U.S. economic growth. First, the rise in crude prices seen so far doesn’t even bring prices back to 2018 levels. Second, the upside for oil prices is severely constrained by high levels of inventory and the ability of producers to bring more oil to market, as the rise in prices will encourage them to do. So the broad economic effects are very likely to be minor.
How does the current crisis play out?
It is hard to know how the geopolitical conflict will end. The Saudis may choose to respond militarily to send a message to Iran that two can play the game. More than 50% of all of Iran’s oil and energy product exports are processed from Kharg Island, which is highly vulnerable to attack from the air. In fact, it was largely knocked out of service by Iraqi jets in 1986 and it took Iran many years to rebuild. Iraq has never been an air power. And Iran doesn’t have an air force that can defend its facilities from the Saudi air force. So Iran’s cruise missile attack was a very risky gambit and reveals the desperation of the Mullahs in Tehran.
There has been so far no response to Iran’s escalating provocations. It is doubtful the U.S. would attack Iran in the near term, even though we blame Iran for the attack on the Saudi oil facilities, primarily because President Trump has been a long-time advocate of staying out of military conflict in the Middle East, arguing that those countries should provide for their own defense. Unless an ally is under attack, U.S. involvement is likely to remain limited. But don’t be surprised if new weapons sales, especially defensive missile weapons, are made to the Saudis.
If neither the U.S. nor the Saudis respond militarily, it seems likely that the Iranians step up or continue their attacks. Such a major provocation simply cannot be ignored, certainly not by the Saudis. If the current financial situation is intolerable to the Mullahs in Tehran, they may well continue to act out until either they suffer a military response in kind or until Western countries sit down to negotiate a change in Iranian behavior. It is clear that Iran wants an end to economic sanctions, but it is hard to imagine Iran giving up its effort to develop nuclear weapons or its support for terrorists around the world in exchange, so the situation seems likely to devolve into a more serious conflict before long. This could happen quickly if the Saudis respond militarily. Iran may also call on its regional allies, Hezbollah in Lebanon, Shia militias in Iraq, and the Houthis in Yemen to widen the conflict even further.
We have been aware of the potential for conflict in the Middle East for some time, which is why we have favored domestically sourced energy producers and maintained exposure to defense contractors. Sales of these domestically sourced products should perform well.