By Bhamy V Shenoy
When the world learnt about the loss of 5.7 million barrels per day (mmbd) of Saudi Arabian oil on September 14, old oil professionals who have lived through similar disruptions (see graph) would have expected that within days oil prices will jump to three digits. In the event, even after one week, these went up by a mere 7%, an increase often experienced on rumours or minor dispersions. Thus, this outage, though historic, may turn into a non-event.
What is even more surprising is that just about every news media has published that the impact of oil outage has resulted in historic price increase never seen since 2008. No one has questioned why the oil market has not reacted the way most oil pundits (including the author) used to pontificate if for whatever reason Saudi oil production is disrupted. Every one used to predict that such a dramatic development will result in skyrocketing of the oil price.
Oil price skyrocketed by 350% after the first oil shock in 1973, resulting from the Yom Kippur war and Arab oil embargo. The second oil shock in 1978-79 was caused by the Iranian revolution resulting in a price increase of 250%. The third oil shock was caused when the Saudis abandoned the swing role resulting in oil price falling below single digits.
There have been other minor oil disruptions as a result of Iraq attacking Kuwait in 1990 (prices did increase by 270%, but did not last even for a year), Libyan revolution, civil war in Venezuela, and civil unrest in the Nigerian Delta. None of these affect oil prices in the long term as the first two oil shocks. As discussed earlier, the Saudi outage of 5.7 mmbd is unprecedented and if one were to apply the lessons of the first two oil shocks, prices would have easily gone above $100 per barrel. But they have not. Why?
Just like the first two oil shocks, this non-event fourth oil shock was totally unexpected, though the possibility of it was dreaded by oil experts. The September 14 drone attack on Abqaiq, the largest oil installation in the world, and on Saudi Arabia's second largest oil field Khurais, reduced the world oil production by 5.7 mmbd.
But for this critical information on the amount of production loss, the world did not have reliable information on who was behind the attack, how long will it take to restore production, what is the spare capacity to fill the void, oil inventories held by Saudis and other OPEC+ members to meet the demand, the impact of the US releasing its Strategic Petroleum Reserve (SPR), etc. Though there were many unknowns, oil pundits and government officials were ready to give predictions. Only a few readily agreed that their crystal ball is cloudy.
Although Iran-supported Houthi rebels, who are fighting the Saudi-supported government in Yemen since 2015, claimed they were behind the attack, not many believed them. The US and many countries blamed Iran for the attack.
Before the attack, the US Energy Information Administration (EIA) estimated the spare capacity at 2.3 mmbd (see graph) and most of it in Saudi Arabia. With the loss of 5.7 mmbd, the current world spare capacity is now negative. Even the US, with the often discussed flexibility of shale oil production to react to price changes, may not be able to increase oil production significantly. Other countries like Russia, Kuwait, the UAE and Iraq have some spare capacity, but their contribution is unlikely to be more than a few hundreds of thousands of barrels per day.
A day after the attack, Aramco declared oil production will be restored by the end of the month. It was contradicted by former Aramco officials that it may take many months since specialised equipment had been destroyed and cannot be manufactured and installed quickly.
But for oil inventories held by the Saudis in four export terminals at Ras Tanura, Sidi Kerir (Egypt), Rotterdam and Okinawa (Japan), no information for other OPEC+ was available. The Saudis had about 180 million barrels (just 40 million barrels above the level in 2002) and a large part of it should be considered as working storage and not to meet exigencies.
It was felt the world will not suffer any shortage immediately since oil demand can be met by drawing on existing inventory, and as time progresses and inventory levels start coming down, there will be competition for limited supplies. But it is difficult to estimate when that critical time will come. The longer the processing facilities in Saudi Arabia remain disrupted, the larger the impact on future oil supplies, which are already tight.
The accompanying graph shows how the historic sudden drop in world oil supply had insignificant impact on oil price. The first day of trading after the drone attack saw 14% increase in oil price, but 11 days later the oil price was slightly higher than what it was the previous week.
There could be many reasons for the market not to reflect the potential unprecedented supply/demand imbalance in the months to come. During the first two oil shocks, the oil industry did not have access to supply/demand information. Today, we have much better, though not perfect, information. Studies had shown very low short-term price supply and demand elasticity. During the previous shocks, the market overestimated the loss shortage and prices skyrocketed.
In the early 1970s, the US did not have SPR. Some OECD countries though had some mandatory reserves, these weren't adequate. The International Energy Agency was established soon after the first oil shock and today it is in a much better position to deal with this kind of disruption.
Despite all these positive factors, if Aramco is unable to repair oil infrastructure as announced (despite all claims to the contrary), then there is bound to be unmanageable shortage, resulting in higher oil prices.
There is another big unknown. Since there is credible proof to show that Iran was behind the attack, there is some chance-not insignificant-of a regional war erupting in the Persian Gulf. Iran has already given the ultimatum that, if attacked, there will be an 'all-out war'. In such an eventuality, we will definitely experience world oil supply being reduced significantly to create a large imbalance. Such a possibility should have resulted in the market reflecting a large security premium. But it has not. This again shows that the market is putting a low probability on such an event.
During earlier shocks, oil demand showed every indication of increasing at a rapid rate and oil supplies not being able to keep up (there was the fear of the end of oil era because of decreasing oil reserves). However, now we face an entirely different scenario. Peak oil is replaced by peak demand. With global warming on the world agenda, and every chance of oil reserves being stranded like coal reserves, there is no need for oil price to go higher to incentivise oil exploration. This may be the reason for oil prices not to skyrocket as expected.
Still, if the Saudis fail to restore oil production quickly as claimed by Aramco, and the oil market gets tight, low price elasticity is likely to come into play, and we may see oil prices skyrocketing to three digits. Therefore, the world cannot afford to be complacent about the fourth oil shock being a non-event. Also, for some time because of this outage, security premium may become a permanent component of oil pricing in the future.