Drone attacks on Saudi Arabia shake up oil supply and demand

September 30, 2019 MD Financial Management

Last week’s drone attack on Aramco, a Saudi Arabian oil and natural gas producer, shocked markets and investors alike. Luckily it’s been reported that no one was killed in the incident. This act of terror adds to the already heightened geopolitical tensions in the region. The bombing quickly led to a sharp 6% decrease in the global oil supply.

There is still some uncertainty at this time with the country’s oil output cut in half, but Saudi Energy Minister Prince Abdulaziz bin Salman has indicated that capacity may largely be restored by the end of the month and fully restored by November.

Here’s our take on what happened and what it means for oil prices and energy.

The global economy still relies on oil

In the wake of the attack, international oil prices spiked, with Brent crude rising to US$67.50 per barrel — a 12% increase from the previous close. With oil still being a key driver of economic activity (it accounts for approximately a third of global energy demand), the supply disruption has added to global economic concerns.

The ripple effect of a major supply disruption could be substantial. Shortly after the attack, Saudi Arabia says it has been able to quickly recover 41% of its capacity, thereby easing the immediate pressure on global oil supply. At the same time, the International Energy Agency has advised that members hold about 1.55 billion barrels of emergency stock to address any short-term supply crunch and further minimize the impact of the Saudi attacks.

These developments will help reduce oil supply challenges and keep prices stable in the short term.

Oil prices are almost always volatile

In reality, the price spike for oil that followed the attack shouldn’t have come as a surprise — oil prices are notoriously volatile. Over the last decade, volatility in the CBOE/NYMEX Oil Volatility Index has been double that of the stock-based CBOE S&P 500 Volatility Index.1

And, although the attack on Saudi oil fields pushed volatility even higher, prices have since settled back down.

Long-term trends are better for forecasting oil prices

Given the historically volatile nature of oil prices, we don’t find it helpful to try and forecast them in the short term — instead, we look at long-term trends that will drive prices.

One of these is continued innovation in U.S. shale extraction which is bringing prices down along with increased supply in the market. On the other hand, disruption in OPEC countries like Iran and Venezuela as well as with Saudi Arabia’s ongoing efforts to squeeze supply are together contributing to higher oil prices, leading to a more balanced market.

To that end, we find oil futures markets to be a much more meaningful gauge of where oil prices are headed in the longer term, providing a better picture of factors likely to impact energy company shares and cash flows over time.

From an economic standpoint, however, a sustained increase in oil prices will likely drive up inflation and given that energy is central to just about every area of the global economy, any prolonged increase in prices will eventually dampen growth.

MD is mostly underweight energy and not because of the attacks

We have not made any material moves in our portfolios since the incident.

We remain underweight Canadian energy in all active funds and pools by -3% to -4.5%. This is mostly due to the relatively large energy component (16.6%) in the S&P/TSX Composite Index.

We are also underweight energy in our U.S. and international equity fund and pools, just shy of -1% (energy constitutes a much more modest, approximately 5%, weight in the respective benchmark indices).

Lastly, we remain overweight energy by 1.6% in the MDPIM Emerging Markets Equity Pool relative to the MSCI Emerging Markets Index (7.5%).

While the attacks are an unfortunate and horrible act, we do not see a major cause for portfolio adjustments at this time. We will adjust our strategy if necessary as we continue to monitor the situation and global economic conditions. For more information, please contact your MD Advisor*.

 

1 Source: Bloomberg, CBOE

* MD Advisor refers to an MD Management Limited Financial Consultant or Investment Advisor (in Quebec), or an MD Private Investment Counsel Portfolio Manager.

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MD Financial Management

MD Financial Management
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