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Is The Specter Of High Oil Prices Of $100 Back? – Analysis

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The loss of output is the single, worst and most sudden of disruptions to oil market so far.

By Manish Vaid

Oil prices breaching a $100/barrel mark, depends on how the situation evolves in the Gulf, following the additional sanctions imposed on Iran by the US. The fallout of these sanctions could trigger a sharp response from Iran, in lieu of its hobbling economy, which may now extend to the Strait of Hormuz. The recent discussions on oil prices projected to touch a ‘three figure mark’ triggered in 2018, when President Trump announced the imposition of sanctions on Iran.

HSBC , which is one of Europe’s largest banks, was quick to predict oil prices touching this mark during that period. Here it cited difficulties to be faced by oil markets in successfully replacing heavier Iranian crude oil and extra-heavy Venezuelan crude oil, due to limited spare capacities available with other oil producers including Saudi Arabia. Soon the market too responded to Trump’s announcement of sanctions, wherein it started looking upward, and both West Texas Intermediate (WTI) and Brent extended a longest quarterly rally in a decade recording at $73.46/barrel and $83.32/barrel, respectively. Within a few days, this triggered a further push of oil prices, wherein WTI and Brent crossed $76/barrel and $86/barrel respectively, highest in almost four years, prompting the International Energy Agency (IEA) to call on producers to pump in more oil to stabilise the market.

However, this time around with Iranian and Venezuelan crude already disappearing, a series of unprecedented drone attacks on Abqaiq and Khurais in Saudi Arabia triggered quite a response from oil markets. Recouping from an immediate loss of 5.7 million barrels of daily crude production (mbpd) remains a herculean task for Saudi Arabia and a greater challenge for other oil producers.

This loss of output is the single, worst and most sudden of disruptions to oil market so far, surpassing the previous high loss in oil output of 5.6 mbpd during the Iranian Revolution of 1978-79. The loss took away half of the kingdom’s oil output and impacted 5% of the global supplies, and has virtually eliminated the world’s spare capacity.

With all eyes glued to the ever-tensed Strait of Hormuz, drone attacks on Saudi oil installations came as a surprise to the oil markets. This prompted an all-time high jump in almost 30 years wherein Brent surged by almost 20%, falling just short of $72/barrel, before closing nearly 15%, which was still at four-months high. Any extension of tensions that may include a strike by Iran in the Strait of Hormuz, has the potential to pull the prices up to even make it cross the $100/barrel bar; this is because of high dependency on this strait by oil traders. According to the US Energy Information Administration, this strait, which is the world’s largest chokepoint, witnesses a movement of a third of the world’s liquefied natural gas (LNG) and around 20% of the world’s oil.

Under an environment of mistrust that continues to intensify between Iran and the US as also Saudi Arabia, has so far diminished the chances of any reconciliation whatsoever with Iran, thereby possibly escalating the confrontation in the Gulf region to a level which may lead to a war-like scenario.

Even as hydrocarbon importers like India are diversifying their oil imports away from the Middle East by strengthening their energy relationship with both the US and Russia, the relevance of the Strait of Hormuz remains, until the time this region remains the key exporter of crude oil to Asian markets. The newer challenge of now replacing lost Saudi Arabian Arab Extra Light and Arab Light crude, which was been produced in Abqaiq and Khurais, in addition to the lost Iranian crude, has emerged for several oil importers. As rightly pointed out by Bob Tippee, editor of Oil & Gas Journal ‒

If the light crude that’s been disrupted cannot be replaced with light crude of similar grade and similar quality immediately, which it probably cannot, there will be some problems in the market.

Besides, the possibility of oil prices reaching the three figure mark ever since 2008 has become greater than ever before, as both Saudi Arabia and the US have undermined the risks of drone attacks on the world’s biggest oil installations by ignoring the recent attacks on Saudi Arabia, particularly after the US sanctions on Iran. Drone attacks of such a nature would now put this region on its toes, and will prompt them to be prepared for unconventional threats. This paves a way for Asian insurance companies to cover ships carrying oil from the Persian Gulf to put an additional premium, the burden of which would be borne by oil importers as a new normal.

In an environment of escalated tensions in the region, one more attack of such a nature could cripple the global energy system, which is yet to embrace clean energy in a big way and is not yet shying away from fossil fuel use, as also observed by the BP Energy Outlook 2019.

The problem gets heightened when the US, viewed as a new ‘swing producer’, has failed to compensate the lost oil in the market, especially to export facilities. The failure is due to pipeline bottlenecks, and so far the US has only offered its strategic petroleum reserve as a stopgap arrangement, which would release oil, but the quantity of which is yet to be finalised. These limitations have put shale oil companies in a dock, resulting in getting about $15/barrel less for their Permian oil compared to the WTI benchmark. Moreover, the understanding of expediting the approval process of the oil pipelines came only after the drone struck on Saudi oil installations.

Crude oil production by the OPEC countries however, remains an important factor which influences global oil prices by adjusting their available spare capacities. A limited spare capacity exerts upward influence on oil prices, as has been the case since the ‘Declaration of Cooperation’, where OPEC members agreed to implement production adjustment of 1.2 mbpd to rebalance the oil prices under the prevailing oversupplied oil market. OPEC has so far extended the production cut and were about to meet to analyse the oil market, but with the attack on the oil installation, they will now have to rethink this strategy.

Saudi Arabia, the largest oil producer within the OPEC, had the greatest spare capacity in the range of 1.5-2 mbpd, in comparison to the total spare capacity of the OPEC, which recorded at only 2.15 mbpd as of the 2nd quarter of 2019. This leaves very few spare capacities for the rest of the OPEC member countries held by Kuwait, United Arab Emirates, Iraq and Angola, which is surely not enough to meet the production gap. Therefore, with almost no spare capacity left, the world oil market cannot afford to have another supply disruption.

However, there is a silver lining in a dark cloud amidst the ever rising tensions around the gulf region. Recently, Houthis has announced the halting of missile and drone attacks at Saudi Arabia and this should be received well by the US, and could encourage the Saudis to join them in the talks initiated by the US with Yemen’s Houthi rebels even before the attacks. The commencement of this dialogue, though a difficult one, can go a long way in way in de-escalating tensions with Iran, which could otherwise be devastating, both for the regional peace and the global oil markets. It might even accelerate the switch to electric vehicles, and the render the OPEC irrelevant and obsolete.

Observer Research Foundation

Observer Research Foundation

ORF was established on 5 September 1990 as a private, not for profit, ’think tank’ to influence public policy formulation. The Foundation brought together, for the first time, leading Indian economists and policymakers to present An Agenda for Economic Reforms in India. The idea was to help develop a consensus in favour of economic reforms.

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