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US war with Iran unlikely, but would devastate oil markets: Fuel for Thought

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US war with Iran unlikely, but would devastate oil markets: Fuel for Thought

May. 20 2019 — Drone attacks on pipelines in Saudi Arabia and the mysterious alleged sabotage of tankers near Fujairah sent pulses racing, but a phony war in the Persian Gulf failed to trigger a feared triple-digit surge in crude prices.

A hot war, however, between the US and Iran could be an entirely different matter.

Tehran has repeatedly threatened to shut down the Strait of Hormuz in the event of an outright conflict with America and its Arab allies. The chokepoint is an obvious target. Over 18 million barrels of oil are shipped daily through the 21-mile-wide channel that separates the Islamic Republic from the Arabian Peninsula.

In 2008, worries that Iran would blockade the strait helped to send oil prices skyrocketing to a record $147/b, a level not achieved since.

“A hot war in the Gulf, especially prolonged closure of Hormuz or severe damage to [the giant oil processing facility of] Abqaiq, would send crude prices well into the triple digits,” said Robert McNally, president of Rapidan Energy Group and former advisor to President George Bush.

“That price spike would slam growth, crush oil demand, and trigger an oil price reversal to the low double digits.”

Abqaiq could be the Achilles’ heel of Saudi Arabia’s oil industry.

Located in the kingdom’s eastern province, the facility filters impurities such as sulfur and gas from around 7 million b/d of crude. This is roughly equal to the country’s entire exports and a volume of readily available crude that is impossible to replace easily.

Destroy it and experts fear an uncontrollable panic would grip oil markets and the global economy.

Saudi Arabia’s enemies also know it. Al Qaeda terrorists went for the jugular in 2006, but were unsuccessful in an attack on the plant.

Since then, the Saudi authorities have beefed up their defenses around Abqaiq to fortress-like proportions with what is effectively a private army guarding the facility. In the wake of the Jihadi attack, state-run Aramco insisted Abqaiq was not critical to its operations, but experts still aren’t convinced.

“If the oil market has a beating heart, it is Abqaiq,” warns McNally.

Oil price reaction muted

Despite the growing risks, a conflict in the Gulf region would probably be brief. Neither the US, nor Iran , wants a war. For President Donald Trump, gasoline prices above $3/gal could be ruinous for his reelection campaign and confronting Iran over its nuclear ambitions looks less urgent than his trade problems with China.

Tehran wants a free hand in the Middle East and the ability to sell its oil without US sanctions, but even its most hardline leaders, such as the feared Revolutionary Guard General Qasem Soleimani, cannot seriously believe they would prevail against the world’s most powerful military.

Gulf Arab oil producers have been acutely aware of the vulnerability of the Strait of Hormuz for decades and have intensified their efforts to create new export routes.

In 2012, the UAE opened a 240-mile long pipeline with capacity to pump 1.5 million b/d of crude across the Hajar mountain range to the port of Fujairah and beyond the reach of Iran. The alleged sabotage of tankers near the port this week – which the US suspects Tehran is behind – challenges this strategy.

Meanwhile, Saudi Arabia has stepped up efforts to increase export capacity from its Red Sea coast via pipeline and the opening of a new terminal last year at Yanbu Port with capacity to ship 3 million b/d of crude. However, the drone attack on its 744-mile East-West Pipeline has once again proved how vulnerable its vital oil infrastructure remains. Combined, these incidents give the impression of a region on the brink of war, a risk oil markets have ignored.

Oil prices rose by little more than 1% after the announcement of the Saudi pipeline attack and traded for most of the week around $72/b. If the intention of these attacks was to frighten oil traders into action, it failed.

“This raises real risk of miscalculation, given a more hawkish Trump administration following the departure of Defense Secretary [Jim] Mattis,” said Paul Sheldon, geopolitical risk advisor at S&P Global Platts Analytics.

Spare capacity at risk

It is assumed Saudi Arabia and its partners in OPEC with the help of Russia will come to the aid of markets in times of extreme stress.

S&P Global Platts Analytics expects the grouping – which is holding a technical meeting in Saudi Arabia this weekend – to compensate for lost Iranian barrels as US sanctions against Tehran begin to tighten after the expiry of waivers. However, this will come at the expense of spare capacity. The group’s supply buffer of last resort could fall dangerously low, to 1 million b/d, according to Platts Analytics.

Of course, industrialized consumer economies also have their own crude reserves to fall back on in case of an emergency in the Gulf. The International Energy Agency calls on its 28 members to maintain reserves equal to 90 days’ worth of the previous year’s net-oil imports.

This might be fine if the Strait of Hormuz was the oil market’s only worry, but it’s not. Russia’s three-week long problem with contaminated Urals crude disrupting exports to Europe forced some consumers to release reserves. Meanwhile, Venezuela remains in a constant state of political convulsion along with Libya, which is key to supplying Europe ’s refiners with high-quality crudes .

For now, traders are betting that cool heads will prevail in the Middle East but the odds of a catastrophic mistake occurring are getting shorter.