Mix of economics, politics leading to new high in crude prices

Sometime back I was part of a discussion about how Middle Eastern geopolitics doesn’t hold as much relevance in influencing the oil prices anymore like how it used to be a decade ago when the economy of the region was the center of the universe. Someone asked me, “What should happen in the Middle East for oil prices to break the range and surge again, to which I replied, “Either some big military action across the Strait of Hormuz so that it gets blocked or a bomb blast at Aramco.”

While the first possibility had remained largely in the realms of sabre rattling ever since US President Donald Trump had announced economic sanctions on Iran on May 2018, the second, however improbable it may have seemed when I said it, actually did happen last weekend.

On September 15, 2019, a Saturday morning, the world woke up to the news of a drone attack on Aramco, the world’s largest oil company that produces 10% of the world’s total output of about 100 million barrels of oil and other equivalents per day.

About 10 aerial automated combat drones were involved in the coordinated attack on Aramco’s Abqaiq plant in Buqyaq and the Khurais Oil field. Abqaiq is described by Aramco as the largest crude stabilisation plant in the world and Khurais is the second largest oil field after Ghawar.

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In an immediate impact, nearly 50% of the production at about 5.7 million barrels a day (amounting to about 5% of the world oil production) was cut, and even if the production resumes in some weeks it is estimated that about three million barrels a day shortage in supply should last for longer period of time, maybe some months.

On Monday morning, as expected, the Brent shot up to about 8% and now is hovering around $66/bbl, almost a 10% hike over the weekend closing price, the sharpest and the largest increase ever since the great slide happened in Oil prices five years ago.

After the fateful OPEC meeting of November 2014 ended without any conclusion in output cut, crude oil prices that had started to slide from the peak of $100/bbl until a few months before, took the deep plunge from around $80/bbl, marking the onset of a new structural disintegration of oil economy. OPEC itself had never seen anything like this ever since oil became the single largest commodity that determines every other economic indicator during the 1980s.

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While the earlier ups and downs in the prices were considered largely cyclical, and the spikes mostly were due to geopolitical reasons, like Iran-Iraq war of 1980s, the Gulf war of 1990s, the Afghan/Iraq attacks in 2001 and 2003, and the Arab Spring of 2011. But in the new scenario, there was no recovery in sight, so much so that there are talks of “End of Oil” and the definition of “Peak Oil” changing from peak supply concept during 2006-07 to peak in demand now.

A combination of factors such as increasing tight oil production or what is popularly known as shale gas in the prairies of Dakota, disunity in OPEC, and lowered demand in world economies due to recession or low growth have resulted in oil prices hovering around $50/bbl for most of the last five years. Shale gas production has taken US oil output from five million barrels a day about seven years ago to more than 12 million barrels per day now.

The OPEC fell apart with Iran getting isolated initially and now even Qatar is going its way after it fell off with the UAE and Saudi Arabia in 2017.

Besides, a number of micro economic factors like the advent of more fuel efficient automobiles, and transportation in general, better infrastructure and growth in alternate sources of energy like solar have resulted in continued lower oil prices. This is despite Venezuela, the country having the largest oil reserves, going to dogs in terms of their economy and output and practically zero exports from Iran. Today, instead of the OPEC, it is the three specific powers, the US, Russia and Saudi Arabia, who control the market.

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Saudi Arabia, after not agreeing to an output cut during November 2014 OPEC meeting, stepped up its production to about 11 million barrels per day in the hope of defending the market share and crushing the smaller players in shale gas. But to its horror, the industry itself had changed and adjusted to the new lows. The break-even price for shale output had come down to $40/bbl from $60/bbl in 2014.

The young Saudi crown prince, Mohammed bin Salman, who on one hand was battling with his own family trying to assert his influence, found himself on the other hand caught in a vicious cycle of more output leading to more deficit. He drew up funds from rainy day reserves, considered divestment of Aramco and changed his Oil Minister.

The new appointee Khalid Al-Falih took a different approach and held informal talks with Russian President Vladmir Putin. He initiated what was first termed as “output freeze”. This was followed by output cuts that helped prices rally to some extent in 2018. The production was ramped back to 11 million barrels a day and then subsequently it was brought back to about less than 10 million barrels a day when the drones struck.

While the Houthi rebels of Yemen were quick to claim responsibility for the attacks, the US Secretary of State, Mike Pompeo, blamed Iran for the attack considering that it happened from the north and northeast where the Houthi rebels are located. President Donald Trump followed it with his tweet of “locked and loaded”, ready to strike back.

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Iran was quick to denounce this and said they have nothing to do with this, and so do many other experts who feel that it isn’t as simple as that going by the satellite imagery of the path of the attacks. Houthi rebels have support of other Shiaite group support like Hezbollah and other splinter groups in Iraq and Syria. The attack could have been engineered by a more complicated network of syndicate than what meets the eye.

Besides, the Shia minority in Saudi is largely concentrated in the eastern region where Aramco is located. Any further escalation would mean Iran closing down the Strait of Hormuz resulting in spiralling oil prices. It is the only outlet for the remaining output from Saudi Arabia and other countries to reach rest of the world.

Iranian export of oil too has come down in seven years from about 1.5 million barrels a day to a paltry 100,000 barrels a day this July. So, obviously, any price rise due to this is not going to make any difference to them. It would however invite a larger risk of a combined attack from GCC nations along with the US if their role in the attack is proved. It is no surprise who would be the major beneficiaries of this price rise – Russia and the US — and the remaining members of the OPEC. So it is anybody’s guess if one were go by various conspiracy theories!

The attack also coincides with a change of Ministry of Oil in Saudi Arabia. Only a week ago, Khalid Al-Falih was removed by a royal decree and replaced by Abdul Aziz bin Salman bin Abdulaziz Al Saud, another member of the royal family.

The new minister literally has had a “baptism by fire” and faces the biggest challenge at the beginning of his career. He has to restore normalcy in production at the earliest. A bigger question is though Saudi Arabia is the third largest defence spender in the world with a defence budget of $68 billion, it couldn’t defend its most prized asset!

(Kishore V Ramasubramonian is a oil and gas professional and works for a leading offshore drilling company)

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