The oil markets overlooked the major threat to global demand from the U.S.-China trade war this week, instead shifting focus to the Middle East where tensions are rapidly escalating.
A series of apparent attacks on oil infrastructure in the Arabian Peninsula thrusted geopolitical risk to the forefront of market concerns. Against a backdrop of an already tightening supply-demand balance, the possibility of a serious supply outage poses a major risk to market stability.
Attacks on infrastructure
Over the weekend, Saudi Arabia said that two of its oil tankers were hit by explosions off the coast of the UAE, and officials called it an act of sabotage. Two other Norwegian tankers also suffered damage.
There were no reports of a supply outage or an oil spill, but the incidents heightened perceived risk to oil supply in a vital part of the world. More importantly, the incidents fed into a narrative of a cycle of escalating tension between the U.S. and Iran, despite the lack of hard evidence pointing to Iran’s role in the attacks, at least at the time of this writing. An unnamed U.S. official told the Wall Street Journal that the administration doubted Iran was the culprit in the tanker attacks. “It would be very clumsy from the Iranians,” the U.S. official said. Iran, for its part, denied any involvement.
Separate reports suggested that the administration suspected Iran was behind the attacks, but Tehran is accusing Washington of a setup. Iran denounced the tanker attacks and called for an investigation into the incident.
A report from the New York Times said that top national security aides in the Trump administration were briefed on potential war plans against Iran, including one that involved 120,000 troops. The request for the plan came from national security adviser John Bolton, a well-documented hardliner on Iran. President Trump denied the report.
The latest attacks come roughly a week after the Trump administration said that threats from Iran were rising, although they declined to offer evidence. Taken together, however, there is a palpable sense that the two countries are on a collision course as a tit-for-tat cycle of tension becomes increasingly hard to control.
On Tuesday, Saudi Aramco said that two pumping stations were struck by attacks from drones. The pumping stations are connected to a major oil pipeline that runs from Saudi Arabia’s eastern oil fields to the Red Sea. Aramco said that the damage was minor, but it temporarily shut down the line as a precaution. While any involvement of Iran on the tanker attacks is unclear, Houthi rebels claimed responsibility for the drone incident. If the Houthis were behind the attack, Iran was likely involved, some analysts believe.
While details remain murky, the common thread between the string of incidents is that they involve oil transit points that are alternatives to the Strait of Hormuz. The Saudi tankers were destined for the Fujairah oil export terminal on the eastern coast of the UAE, which lies outside the Persian Gulf. The UAE is trying to build up this site, adding storage capacity, in order for oil flowing through the Gulf to have an alternative to the narrow strait. Meanwhile, the drone attacks hit a pipeline that carries oil west from the eastern oil fields in Saudi Arabia to the Red Sea, also bypassing the Persian Gulf.
At just 21 miles in width at its narrowest point, the Strait of Hormuz is often cited as the most critical chokepoint for oil and gas in the world. Roughly 18.5 million barrels per day passed through the Strait in 2016, or about 30 percent of total global seaborne oil and other liquids that year, according to the EIA. About 80 percent of that went to Asia. About 30 percent of the global LNG trade also passes through the narrow waterway.
“Iran has repeatedly threatened to ‘block’ the strait as a ‘weapon’, but due to the importance of the waterway for the global economy and the price of oil, the strait is also protected by the US Navy’s Fifth Fleet and other allies,” Bjørnar Tonhaugen, Head of Oil Market Research at Rystad Energy, said in a statement. “Needless to say, if the strait was to be blocked or disrupted, even only for a short period of time, oil prices would react violently upwards.”
But because the effects would be so catastrophic, “the threats being expressed lately are probably of the rhetorical kind, with less likelihood of the ‘oil weapon’ actually being set in motion,” Bjørnar Tonhaugen added.
Geopolitical risk in a tight market
Still, the oil markets took note, with Brent rising more than 1 percent on Tuesday. The price increase is certainly muted because of the gloom surrounding the escalating U.S.-China trade war. But that makes the jump in prices all the more notable.
Supply disruptions can easily add a few dollars per barrel to the price of oil. But even perceived risk can push prices higher. Historically, major price movements tend to occur when markets are tight, while the risk premium becomes much smaller if there is plenty of oil sloshing around. In the years following the oil market collapse in 2014, geopolitical unrest melted away as a major driver in price swings.
However, the OPEC+ production cuts have tightened up the market. Meanwhile, production is rapidly declining in Venezuela and Iran, and another significant outage is possible in Libya. Russian oil contamination has interrupted oil flows to Europe. Any further supply risk could spook the market and send prices much higher. And because oil is a fungible commodity, and the market is truly global, even a small outages in far-flung places can lead to painful price spikes everywhere.