Provocation And Response: A Gulf War In The Making?

Drone strikes September 14 on Saudi Arabian oil facilities have disrupted 5.7 million b/d of the country's crude oil and gas production, representing more than 5% of global oil supplies, causing a huge jump in oil prices. The strikes caused fires at Abqaiq and Khurais in the east of the country.

The Abqaiq oil complex is the starting point of the East West Petroline, the Abqaiq IPSA natural gas line, which has been converted to crude oil transport, and the Abqaiq-Yanbu Natural Gas Condensate pipeline. In addition to serving east-west oil transport, which bypasses the Strait of Hormuz, Abqaiq is Saudi Arabia's main crude processing and desulphurization facility and therefore crucial to maintaining crude flows and quality. Khurais is a complex of oil fields with a capacity of 1.5 million b/d. How long it will take to repair the damage is still being assessed.

Who is to blame?

Houthi rebels in Yemen claimed responsibility for the attacks, which would be by far their most successful attempt to disrupt Saudi oil infrastructure. They have previously attacked remote Petroline pumping stations, airports and populated areas in western Saudi Arabia.

Houthi drone strikes earlier in the year appeared coordinated with attacks on tankers off the UAE port of Fujairah, signaling Iran and its allies' capacity to impact Gulf oil production beyond the threat to tanker traffic through the Strait of Hormuz.

US Secretary of State Mike Pompeo claimed that Iran was directly behind the September 13 drone strikes and that they emanated from southern Iraq, where Iran wields considerable influence. Iran has denied involvement, while Iraq has said the drones were not launched from its territory.

US President Donald Trump later moderated the US response to say that it appeared Iran was behind the attacks.

The strikes caused Brent crude oil prices to jump sharply from about $60/barrel September 13 to $68.25/b September 15 before falling back to just under $66/b. Brent then spiked again September 16 close to $70/b, exceeding that level in intraday trade.

Policy impact

The significance of the attacks lies as much in the impact on US policy on Iran than on the temporary loss of as much as 5 million b/d of Saudi crude production.

The departure of John Bolton as Trump's national security advisor came almost immediately before the strikes. Market watchers interpreted Bolton's departure as signaling a less hawkish US policy on Iran, moderating the 'maximum pressure' approach attributed to him.

Bolton's departure was preceded by Trump's comments on the last day of the G7 summit in France when he said he would be prepared to meet Iranian President Hassan Rouhani if the circumstances were right. There was speculation that Trump and Rouhani could meet at the UN General Assembly in New York later this month, a possibility now ruled out by Tehran.

A second significant personnel change preceding the drone attacks on Saudi oil facilities was the replacement of Khalid al-Falih with Prince Abdulaziz bin Salman as Saudi Arabia's oil minister. This has been interpreted by market watchers as signaling a more consensual policy approach by Riyadh within OPEC and possibly less reliance on Russia.

Multi-tasking

The Abqaiq and Khurais attacks are the most serious provocation yet in the US-Iran Gulf stand-off and put both apparent changes in policy emphasis on the back foot. Yet retaliation risks a dangerous cycle of escalation just as it did earlier in the year following the tanker attacks.

The lack of a US military response then, combined with statements from both sides that they wished to avoid war, caused the market to downplay the potential of Gulf tensions to disrupt the oil market.

This allowed attention to focus on the bearish global economic outlook and impending increases in non-OPEC crude supply. That attention has been rudely snapped back to the Gulf. The drone strikes highlight not just the vulnerability of Saudi crude supplies, but Iran and its allies' willingness to up the ante based on the assumption that Riyadh and Washington will not risk regional conflict.

Supply relief

Saudi Arabia provides the majority of output cuts under current OPEC+ policy, over-complying with its actual quota by 540,000 b/d in August. However, OPEC+'s efforts to reign in oil supply would be largely ineffective without US sanctions on Iran and the collapse of Venezuelan oil production over a number of years.

Pressure is still building on OPEC as a result of the slowdown in the world economy and the impact of the US-China trade war. US production may look peaky, but it remains at record levels. Non-OPEC supply received significant support from the very large jump in Brazilian output in August - just over 400,000 b/d - as the country's pipeline of Floating Production Storage and Offloading (FPSO) vessels, built to serve its giant pre-salt oil fields, come onstream.

Norway's state oil company Equinor announced in August that Norway's Johan Sverdrup field may start up one month earlier than expected in October. The field is expected to produce 440,000 b/d once it reaches plateau production by the summer of 2020. These supply gains will be added to by Guyana and smaller gains from other countries such as Canada. The 120,000 b/d FPSO Liza Destiny arrived offshore Guyana at the end of August. First oil is expected in early 2020.

The direction of oil prices hinges on the extent of the damage to Saudi oil facilities and the length of time it will take to restore crude supplies, as well as on any US/Saudi response and its potential to turn a cold war hot. A moderate response and return to 'normality' will eventually see the underlying changes in the demand/supply balance reassert themselves as the dominant factor influencing oil prices.