As the world is grappling with global economic slowdown potentially on the verge of a recession, as judged by the sub 50 global PMIs seen across the board over the past few months, an oil attack on the world's largest oil processing plant in Saudi Arabia on Saturday could not have come at a worse time. There were several drone attacks that struck the Abqaiq plant and nearby Khurais plant, that has taken out about half of Saudi Arabia's oil output -- about 5.7 million barrels per day (mbpd). This plant operated by Saudi Aramco reportedly claims to restore about a third of its output, or 2 mbpd, by Monday. Brent oil jumped as high as 19% to $71.95/bbl but as of the European open, Brent is now up 10% -- closer to $65.5/bbl.
Geopolitics aside, as the world continues to play the blame game as to who is responsible for the attacks. Houthi rebels in Yemen have claimed responsibility for the attack but U.S. Secretary of State Mike Pompeo has blamed Iran as the culprit for the attacks. There was no official evidence, other than satellite imagery provided to CNN showing the oil facilities were struck from northwest, suggesting an attack from Iran and Iraq.
President Trump was quick to tweet that they were "locked and loaded" waiting for official confirmation. A worrying thought in itself. Iran has officially denied that they were responsible for the attacks, but it seems the U.S. is less inclined to believe them. Rather than figure out who or why, a feat slightly above my pay grade, let's focus on what really matters to oil markets: Is the world short of oil supply now?
The Kingdom produces about 10% of total global supply of 100 mbpd. And 5.7 mln bpd is about 5% of global oil supply. OPEC produces about 32 mbpd of oil, so this is about 18% of OPEC supply. Saudi Aramco has about 35-40 days of supply to meet its contractual obligations, according to a source close to the matter. If 2 mbpd is restored by Monday, we are talking about 3.7 mbpd of oil being out of the market.
To put things in perspective, the world has been awash with an excess of oil for the past 18 months and OPEC plus Russia have an agreement in place to take about 1.2-1.5 mbpd out of the market since 2017 to be in effect until March 2020. So this "excess" inventory that was choking OPEC previously can easily be brought back on the market to cap any price increase. The market can still be short of about 2.2 mbpd of oil in the near term, as it is uncertain how long it will take the Kingdom to restore entire production lost.
The United States Strategic Petroleum Reserve (SPR), the world's largest backup of oil inventory support, contains about 645 million barrels. It has been drawn on three times in the past, namely in 2011 during civil unrest in Libya, in 2005 during Hurricane Katrina, and in 1991 during Operation Desert Storm in Iraq. So if one were to assume this to be out for a few weeks, the U.S. SPR can easily offset the lack of supply by releasing barrels as it has done in the past.
One thing is certain, the last thing the U.S. and President Trump needs is a shooting higher oil price, one that moves up aggressively on oil supply disruption, not on the back of higher demand. These sort of aggressive price rallies will certainly hurt consumer demand, which is already on the verge of slowing down in the U.S. and in rest of the world. Needless to say, oil price spikes can cause a recession a lot quicker.
Let's look at demand now. On Sunday night, China released its August Industrial Output data, showing an increase of +4.4% year over year vs. estimates of 5.2%. August retail sales were up 7.5% y-o-y vs. 7.9% and Fixed Asset Investment was lower as well, at +5.5% y-o-y vs. 5.7% expected -- so they are slowing down. There is no doubt that global consumer oil demand has been weak this past year, as the IEA and other governmental organizations downgraded their forecasts recently on the back of lower demand from the U.S., China and India, etc.
The problem with the oil market is not one of supply, it is one of demand -- plus, where the U.S./China trade talks are headed and what U.S. central bank policy will be as Fed Powell sits with the FOMC on September 17 to announce their interest rate policy and Quantitative Easing measures going forward. As the S&P 500 has retraced back all the way to its all-time highs and there has been more amiable talk between the U.S. and China recently (one can only hope!), the market has been less worried about the trade war: They expect the Fed to put a floor under the market by cutting interest rates by 25 if not 50 basis points.
It seems a bit premature, given markets have recovered a lot since the Fed presided over the FOMC the last time around. It seems the risk is that Powell stays patient and continues to monitor the data, especially ahead of Oct. 1 talks between the U.S. and China. Cutting now would be totally premature and risk stoking inflation which has shown signs of ticking higher.
Now with U.S. consumers facing an even higher gas price at the pump after this weekend's attacks, this risk is even greater. If the Fed decides to do nothing, make no mistake, the dollar will rally aggressively and markets will be disappointed as everyone assumes the Fed keeps printing money forever and rates to move down to 0; a strange world in and of itself.
The global economy had been slowing down since the start of 2018. Trade wars just accelerated that move lower. Trump cannot afford to lose votes and popularity closer to November 2020, so it is possible a fake deal, even, is agreed with China prior to the election to get the markets higher, then Trump is back full guns blazing against China once re-elected. China is too wise to trust Trump as they are happy to wait it out. One thing is certain, they will not cave into Trump by changing domestic policy, they may just buy more U.S. agricultural goods, as they have always maintained. This trade war has done nothing other than make traders happy as markets violently moved up and down 10% this past year.
The fate of oil rests on U.S. Fed Powell and what happens to the dollar, as a higher dollar will hurt commodities -- including oil, copper and other base metals. The energy sector has been one of the worst performing sectors over the past year and funds have been massively underweight the sector.
Last week, as bond yields rose sharply, this caused a massive rotation out of technology and cyclicals into energy, as funds capitulated on rotation taking their risk down. This was not a fundamental move. This was a 6 sigma move that hurt funds last week.
Today's short squeeze in oil has seen the sector open up 5%. Investors would be wise to question why they are up and not chase them blindly. Oil price higher on geopolitical risks and potential war is not positive for equities, it is usually negative. Oil stocks, especially the majors like British Petroleum (BP) , Totalfina, Royal Dutch Shell (RDS.A) , and Equinor, etc. continue to be great shorts in a portfolio; now more so given they are about 10%-20% off their lows.