The insight below was written by Hedgeye Energy Policy analyst Joe McMonigle.
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.
President Trump’s speech Tuesday at the United Nations included tough talk on Iran but because he did not beat the war drums, the market will view the Iran conflict as diffused. But we heard nothing that changes our view and forecasts.
We continue to believe the current 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
The Saudis put their best foot forward at the September 17 press conference.
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.
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.
UN General Assembly & More Sanctions
For now 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.
The Administration is also making an attempt to get new or re-imposed European Union sanctions on Iran. To this end, the US will likely soon release proof of Iran’s responsibility for the attacks in the days head. The pressure on Iran is increasing as today the U.K., France and Germany said they also believed Iran was responsible for the Saudi oil facility attack.
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 at this time.
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.
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.
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.
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Joseph McMonigle serves as Senior Energy Policy Analyst at Hedgeye Potomac Research and is president and co-founder of The Abraham Group LLC, an international strategic consulting firm focused on the energy sector and based in Washington, D.C.
Mr. McMonigle is the former Vice Chairman of the Paris-based International Energy Agency, an international organization of oil consuming countries, whose core mission is to work for stable energy markets and respond with joint measures to meet oil supply emergencies. He also served concurrently as U.S. Representative to the IEA (2003-2005). In addition, Mr. McMonigle served as Chief of Staff at the U.S. Department of Energy, a cabinet department with a $23 billion budget and over 100,000 federal and contractor employees (2001-2005). Mr. McMonigle also served as the American co-chair of the U.S.-China Energy Cooperation Working Group and led DOE’s bilateral activities and engagement with China.
Before joining the Bush Administration, Mr. McMonigle was the administrative assistant and general counsel to a United States Senator. He is also an attorney and member of the Energy Bar Association as well as the Pennsylvania and District of Columbia bars.