Up Next: Beat up Iran at UNGA; Make run at new EU Iran sanctions; Retaliatory military strike of Iran energy asset. Iran escalation.
One week after Iran’s brazen attack on the world’s largest oil processing facility in Saudi Arabia, oil prices now have pre-maturely softened to about $3-4 higher than pre-attack levels. However, geopolitical risk levels remain sky-high with low global spare production capacity while the Saudi facility is repaired as well as a looming military response and further Iranian escalation.
We continue to believe the geopolitical risk premium is between the $5-10 range we outlined after the attack but probably closer to $10 that prices neared on September 16. However, other potential catalysts could provoke an even higher risk premium.
Saudi Recovery Overly Optimistic
The Saudis put their best foot forward at the September 17 press conference resulting in somewhat calmer markets by the end of the week with Brent and WTI up only about $3 and $4 respectively from the Friday before the attacks.
But markets are more convinced by the Saudi press conference than we are. As we explained on the September 13 Hedgeye Macro Show with Keith McCullough, we believe the damage is much greater than what is being generally conveyed. Moreover, we also think the Saudis are also rightly concerned about disclosing too much information especially to their adversary Iran. (The Wall Street Journal published a Sunday article estimating the repairs will take at least 8 months to resume normal operations.)
If anyone can repair the facility as quickly as possible, it is Aramco. Our only skepticism is regarding the time until repairs are completed and believe the current timetable is overly optimistic. In our view, Saudi full production capacity of 12.5 million barrels per day (b/d) and more importantly, the corresponding spare production capacity, will likely not be restored until the end of the year at the earliest. The Saudis will be spending a great deal of money to get back up and running as soon as possible. The picture should be clearer by mid-October but markets should not rely on the timetable outlined last week.
New Period of Low Global Spare Capacity
Certainly, Saudi Arabia will be able to maintain their current production levels of 9.8 million b/d under the current OPEC+ agreement through the rest of the year by a combination of using other facilities and strategic stocks. The problem, however, is that until they are back at 12.5 million b/d capacity, we will be in a period of low global spare capacity - maybe 500,000 b/d.
In the meantime, another attack or supply disruption would likely see a much sharper spike in prices until the Saudis get back to 12.5 million b/d. Iraq, UAE and maybe Russia could add some production but Saudi Arabia is the world’s real spare capacity provider. The IEA would almost certainly have to do a coordinated release of strategic stocks if another attack or disruption happened during this interregnum.
US/Saudi Responses: UN, Sanctions & Military Action
Our sources tell us the US is considering several options for a military response with Saudi Arabia but a decision has not yet been made. We may be out of consensus here but we give a greater than 50 percent chance for a military strike against Iran.
We also believe Iran will escalate with additional action, and US officials are preparing for such a scenario. As a result, the US is taking some time to fortify military assets in the region to counter any further Iranian attacks. The Department of Defense announced Friday that it will send additional US military personnel and equipment to Saudi Arabia.
Since last Saturday, Trump has turned to further sanctions on Iran and downplaying military action. We would agree that Trump does not want military confrontation with Iran but won’t back away from it if necessary. The Iranians are making it close to necessary by design. There is also a point where restraint becomes a political liability going into an election year.
We believe any military response will be a calibrated with a potential target of an Iranian natural gas asset or infrastructure (but probably not oil assets). The map above shows key natural gas assets in Iran that may be soon on US/Saudi target lists. Such a target could possibly be more harmful to Iran than going after military or oil assets, and it could also be argued that it may be a more effective deterrent to future escalation. At the same time Trump made the restraint comments, he also suggested that the US has at least 15 targets in Iran.
But first, the US plan is to generate international condemnation of Iran’s attack. Look for this to be the big storyline at this week’s United Nations General Assembly in New York, at least from the US and Gulf allies.
Trump’s recent announcements of additional sanctions may not move the needle much as a deterrent or punishment of Iran. However, we are hearing that the White House is also making an attempt to get new or reimposed European Union sanctions on Iran. To this end, the US will soon make public additional proof of Iran’s responsibility for the attacks in the days head. EU sanctions definitely would have a major impact on Iran and are probably not what Iran anticipated after the attack. However, we are skeptical the Europeans will go along with new sanctions.
Maximum Chaos: Market Misjudges Iran & Iran Misjudges Trump
We outlined in an early June client note that Iran would escalate activities to increase geopolitical risk and oil prices. The tanker attacks and capture of vessels were the first acts of the Iranian strategy we called “maximum chaos” to counter the US plan of “maximum pressure.”
Iran sees “maximum chaos” as the only way out of US sanctions that are crippling their economy and revenue. Iran refuses to negotiate with Trump until sanctions are eased. Therefore, Iran is calculating that Trump will avoid military confrontation at all costs, and their plan is to continue to escalate attacks until Trump eases oil sanctions. Iran also believes higher oil prices hurt Trump politically so in their view attacks on oil assets are the perfect anecdote to Trump’s oil sanctions. All of this adds up to enormous risk for oil markets.
We think Iran is misjudging Trump on military action. We agree he prefers not to get into a situation that leads to another Middle East war. But not at all costs and not if Iran makes it necessary.
Last Friday in press events with the Australian Prime Minister, Trump talked about showing strength through restraint, and it certainly has value if combined with active diplomacy and cooperation from both sides. But if restraint is met by another Iranian attack, the calculation changes not just on a policy front but also as a potential political liability for a President going into an election year.
We think Iran continues its maximum chaos strategy with further attacks. This is why we strongly believe the odds of a military response have gone up significantly and is almost inevitable. The market thinks that if Trump/Saudis do not respond with a military strike, the geopolitical risk is diffused. But Iran thinks Trump will blink and only feels emboldened.
Geopolitical risk is sky high. If the US/Saudis respond, geopolitical risk spikes. If Iran continues attacks or escalates, geopolitical risk spikes. There is currently no scenario that reduces the geopolitical risk present in markets today.
There is also concern that Iran could launch another attack like Abqaiq after exposing the vulnerabilities of the Saudi security and air defenses. However, since Friday, we suspect US intelligence and spy satellites are watching Iran closely for any signs of preparation for future attacks and will take action to thwart it.
On Sunday, the Wall Street Journal published an article reporting that some Houthi leaders, uncomfortable with the Iran alliance, said Iran is planning future attacks and tried to enlist their assistance.
Geopolitical Risk Premium in Oil Markets
It is difficult to attribute a geopolitical risk premium since there are several possible scenarios that would have different risk profiles. In our view, we think the risk premium is still in that $5-10 range, even though the market has softened its view of the supply risk. Accordingly, a US/Saudi response would push prices back up closer to $10. If Iran responds and escalates, prices have the potential to spike $15 to $20, especially if an oil asset is attacked.
Even before the attacks, we believed oil supply/demand fundamentals were tightening with declining crude stocks and would tighten further in the fall, especially with IMO rules going into effect next year. Our estimation is that prices were already discounted by about $10 on fundamentals alone, but markets were focused almost exclusively on US China trade and macro economic narratives.
Until now, there was no geopolitical risk priced into markets but even now the risk premium is not fully represented. The situation is very fluid, and we think it’s at the beginning stages, not the end. The wild card is Iran, not Trump.
