A damaged refining tower stands during repair at Saudi Aramco’s Abqaiq crude oil processing plant… [+]
Saudi Arabia is moving quickly to restore the 5.7 million barrels a day of oil production knocked out in the September 14 drone and missile attacks on its Abqaiq processing facility. But even if the kingdom can return output of the full 12 million barrels a day by November, American oil producers are in a strong position to benefit from the Saudi’s setback.
The “risk premium” built into oil prices has waned dramatically since the attacks. U.S. benchmark West Texas Intermediate (WTI) closed at just under $54 a barrel on September 13th and now trades around $56.
It’s hard to imagine a risk premium of just $2 a barrel considering how easy it was for Iran to knock out more than half of Saudi production in one quick strike, wiping out two-thirds of the world’s spare capacity in the process. Moreover, Saudi oil infrastructure now looks extremely vulnerable to future attacks. It’s also likely that an increasingly desperate Iran will escalate the conflict further based on its behavior in recent months, including seizing tankers in the Strait of Hormuz and hitting a critical oil port in the United Arab Emirates.
Markets are once again focusing on trade issues, U.S. political turmoil and a possible recession that would cut into oil demand. But traders betting on lower oil prices are underestimating the geopolitical risks in the Middle East. The risk premium should be several dollars higher.
Even with the pullback in oil prices, U.S. producers have benefited and will continue to do so from the attacks. Even a $2 bump in WTI helps shale producers who have been operating near breakeven levels recently. Plus, there should also be greater demand for U.S. exports as major consuming nations seek to diversify away from Saudi and Mideast suppliers – who are looking less reliable these days.
Higher revenues today are only half the story for American producers, though. WTI future prices initially spiked much higher – as high as 20 percent to over $63 a barrel – on September 16 on the initial market opening following the weekend attack. The price spike spurred a race among producers to lock in higher prices for their future production.
Solid data on hedging activity is difficult to obtain but U.S. producers are believed to have had only about 20 percent of their 2020 planned production futures sold before the attacks. That number has jumped significantly in post-attack trading sessions, setting a new floor for U.S. oil prices.
The U.S. oil sector has delivered record production growth in recent years – America is now the world’s largest oil producer – but financial performance has lagged. Investors have tired of the sector’s reliance on debt to maintain production growth.
U.S. exploration and production (E&P) stocks are trading near historic lows and credit is becoming difficult to find for smaller producers. News of the Saudi production loss delivered a much-needed boost of confidence to investors with E&P shares rallying anywhere from 5 percent to 20 percent in the immediate aftermath of the attacks, although stocks have pulled back in more recently along with oil prices.
The news even invigorated bonds for companies with sub-investment grade or “junk” ratings, easing some default concerns of investors.
The timing of these events is crucial. U.S. producers are in the process of setting their 2020 capital budgets and the opportunity to hedge future sales at a higher price due to the increased risk premium provides a big boost of confidence for executives worried about debt levels and a weakening demand outlook.
The oil industry typically sets capital budgets under the assumption that U.S. oil prices will be in the neighborhood of $50 to $55 a barrel. With prices trending below those levels before the attack, executives had been concerned. But no more. U.S. producers have a lot more confidence now that oil prices will remain above that level.
The windfall will most likely be used to pay down debt and reward Wall Street, though, not seek additional production growth. Domestic oil production from shale is already slowing – up less than 1 percent in the first half of the year compared with roughly 7% growth over the same period of last year.
The Energy Department recently revised its growth forecast for this year downward by 100,000 barrels a day to 12.2 million barrels a day.
Higher prices will likely protect current E&P plans but don’t expect them to prompt a reexamination of production targets. The oil sector would need to see WTI prices of $75 a barrel or higher to cause such a change in strategy.
Even without higher output targets, American producers will find greater demand abroad for their product.
The markets remain skeptical of assurances by Saudi Arabia that production will be back online so soon. The attacks targeted Saudi production of two key crude grades for export – Arab Light and Arab Extra Light – that is uniquely well matched with American shale’s light sweet variety of oil.
The light sweet crude that U.S. shale producers export is a natural replacement for the missing Saudi supplies. The new export market should remain open to U.S. producers at least for the next few months until final repairs to the Saudi facilities are complete.
Rystad Energy warns that repairs could take much longer than expected, with the potential for an estimated 1.6 million barrels a day of Arab Light, and 350,000 barrels a day of Arab Extra Light, to remain offline through October.
U.S. refiners should see opportunities, too. Saudi Arabia appears to be prioritizing crude exports over refined product flows and is lowering throughputs at its domestic refineries. In all, that could mean a drop of 770,000 barrels a day in refinery throughputs in both Saudi Arabia and neighboring Bahrain, which is no longer receiving Saudi crude after the attacks.
That should open profitable export opportunities for U.S. refiners to Saudi-dominated markets in Europe, particularly for diesel. During the first half of 2019, the U.S. exported about 650,000 barrels a day of refined products to Europe, with diesel the top export by volume
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a trend that should accelerate now.
