What the Saudi Oil Attack Means for Energy Stocks

After an attack on Sept. 14, Saudi Arabia has lost about 5.7 million barrels per day of oil production capacity. This is more than half of its capacity and about 6% of world capacity. Two major oil facilities--Abqaiq, an oil processing complex with a capacity of 7 mmb/d, and processing trains with a capacity of 1.2 mmb/d in the Khurais field--have been damaged. Houthi rebels have claimed responsibility for the drone strikes. But the United States--specifically the secretary of state, among others--has cast doubt on that and says the attacks were directly from Iran. The Saudis have been predictably optimistic about being able to partially restore production within days. However, a more realistic scenario is weeks and potentially months, given the complexity of the equipment and testing required, the release of U.S. satellite imagery showing extensive damage, and the lack of even a preliminary assessment of the damage from the Saudis. The potential impact of the attack hinges on how quickly operations can be fully restored, and on whether the kingdom or its allies--including the U.S.--choose to retaliate.

Saudi inventories are not officially reported, but the Joint Organisations Data Initiative estimates the kingdom has 188 mmb held in reserve, which means it can theoretically maintain domestic consumption and exports at the prior level for about 37 days before shortages take hold. So if capacity is restored within that time frame, the availability of supply should not be threatened and the maximum impact on annual supply would be capped at roughly 0.5 mmb/d. The implied drain on global inventories translates to roughly two days of forward supply, or 4% of the current OECD stockpile. In that scenario, we would expect prices to slightly exceed what’s in our current valuation models for one to two years, but our long-term outlook would not change as the West Texas Intermediate threshold to encourage the appropriate level of U.S. shale activity would still be $55 a barrel. As a result, our fair value estimates would not dramatically increase for most of our energy coverage. The degree of any change would depend on a company’s financial and operating leverage.

However, there are reasons to be more pessimistic. For starters, there could be a quality mismatch, with a shortage of lighter grades. Reuters reported that buyers of Saudi crude are already being asked to take Arab heavy instead of Arab light. And according to CBS News, citing the Center for Strategic International Studies, a Washington think tank, the satellite imagery released by the U.S. government shows that the Abqaiq damage limits Saudi Arabia’s ability to process high-sulfur crude into more desirable sweet crude. This could have profound ramifications, given that the IMO 2020 regulations preventing global maritime operators from using high-sulfur fuel take effect in January 2020.

If the capacity of the facility cannot be restored before Saudi inventories are exhausted, we can expect persistent worldwide shortages. There is very little spare capacity for crude production globally, which means that a reduction in Saudi exports cannot be easily replaced. Among OPEC producers, only Saudi Arabia, Iran, and Venezuela are operating below capacity. The Abqaiq outage certainly prevents Saudi Arabia from responding in this case, and the latter pair have limited access to international markets anyway due to U.S. sanctions. Iran has the technical ability to ramp its exports quickly, but as the likely instigator of the Abqaiq attacks, according to U.S. officials, there is no chance that the U.S. and Saudi Arabia will allow it to be the primary beneficiary by easing sanctions. A rapid turnaround in Venezuela is impossible, given that output there has collapsed in the last few years as a result of chronic mismanagement of the oil industry coupled with the wider economic malaise.

The U.S. does have the ability to eventually increase production to a degree, if producers--primarily shale companies--expect sustainably higher crude prices that would justify reversing the 15% decline in drilling activity that we have observed since the beginning of 2019. However, even though shale volumes are considered short-cycle supply, there are still large lags between pricing shifts, changes in activity levels in the field, and any associated production response. Therefore, it would take at least 6-12 months for shale producers to start compensating for global shortages, and even with a large increase in drilling activity, we would expect output to increase only by 1-2 mmb/d at the most--much less than what Saudi Arabia has taken offline after this attack.

Instead, for a quick reaction the U.S. could choose to tap its Strategic Petroleum Reserve, which contains 645 mmb and could be released into the marketplace within two weeks. That could offset the current Saudi shortage for up to 113 days, theoretically. But there is a huge catch: The U.S. ability to export crude is already close to full utilization, following the rapid expansion of the shale industry in the last few years. Therefore, the U.S. could use the SPR to offset the 630 mb/d of current Arab light imports from Saudi Arabia, but that would only account for 11% of the capacity loss at Abqaiq. Any attempt to further stabilize the market with U.S. reserves would probably just create a domestic surplus while leaving the rest of the world undersupplied, merely widening spreads between domestic and international benchmarks.

As the rest of the world cannot fully compensate for a supply shortage of this magnitude, it is vital for Saudi Arabia to restore production volumes quickly to avoid a significant global oil shock. Early commentary and media speculation suggest that this is possible, but satellite imagery reveals extensive damage and it is not unrealistic to expect full repairs to drag on for months. Saudi inventories could provide some insulation initially, and its exports to U.S. and Europe could be redirected elsewhere as storage levels in those regions are currently substantial. But global inventories cannot mitigate the impact of a 5 mmb/d loss of supply indefinitely, and the consequence of this level of shock has not yet been priced in by the oil markets. Energy investors should therefore be cognizant that a further spike in prices is plausible, pending further detail from Saudi Arabia on the extent of the damage and the time frame for recovery. Dave Meats, CFA

Our long-term outlook for midstream oil and gas companies is unchanged, but we could change our fair value estimates depending on whether new and material investment projects are sanctioned in response. We think midstream companies that could benefit from higher demand for export infrastructure and related pipelines, wider differentials, and higher demand for liquefied natural gas, given oil-linked contracts, include Enterprise Products Partners EPD, Magellan Midstream Partners MMP, and Cheniere Energy CQP/LNG. Other companies that could benefit include Plains PAA/PAGP and Targa Resources TRGP.

We see the increase in oil prices since the attack as a modest response for a disruption of this magnitude, suggesting that the market expects a quick resolution. We think the situation remains fluid and sensitive, with heightened tensions in the Middle East and potential reprisals from Saudi Arabia as well as the U.S. (President Donald Trump has tweeted that the U.S. is “locked and loaded”) under its “maximum pressure” policy against Iran.

As the rest of the world cannot fully compensate for a supply shortage of this magnitude, it is vital for Saudi Arabia to restore production volumes quickly to avoid a significant global oil shock. Early commentary and media speculation suggest this is possible, but satellite imagery reveals extensive damage, and it is not unrealistic to expect full repairs to drag on for months. Saudi inventories could provide some insulation initially, and its exports to U.S. and Europe could be redirected elsewhere as storage levels in those regions are currently substantial. But global inventories cannot mitigate the impact of a 5 mmb/d loss of supply indefinitely, given only 37 days of Saudi inventories, and the consequence of this level of shock has not yet been priced in by the oil markets. Energy investors should therefore be cognizant that a further spike in prices is plausible, pending further detail from Saudi Arabia on the extent of the damage and the time frame for recovery.

From a midstream perspective, we think there are several takeaways.

First, U.S. oil export infrastructure has a limited ability to respond in the short term, with recent export levels at 3.2 mmb/d in June compared with effective capacity in the 4.2-4.5 mmb/d range. Trump has suggested that the Strategic Petroleum Reserve can be used if needed, but any releases are more likely to be useful to offset any reductions in the 630,000 barrels a day of Saudi Arabian light crude being imported currently, which would be a fairly modest offset. This means that even if U.S. supply can respond appropriately to price signals (which will take 6-12 months), it will be constrained by infrastructure, creating the opportunity for wider differentials in the short run, given the greater U.S. surplus. Material export infrastructure additions are in process, mostly in the permitting stage, and are not likely to be available until 2021 and 2022. Broadly, for the companies already in the lead on adding export infrastructure, we see this as positive for Enterprise Products Partners and Magellan Midstream Partners. U.S. exports now have the potential to be perceived as more reliable going forward, increasing demand.

Second, Trump suggested that permit approvals for Texas pipelines and other pipelines should be accelerated. This is useful to the extent that it could accelerate the ability of U.S. supply to move to the Gulf Coast for export, as Texas pipelines might only need a few months for permit approvals. However, export infrastructure permits could take up to 18 months, meaning there would need to be a substantial change in the pace of the regulatory agencies, which Trump may be suggesting. The acceleration in Texas permits, primarily Permian-related, would be beneficial primarily for the owners (Plains, MPLX MPLX, ExxonMobil XOM, and others) of the Wink-to-Webster pipeline, currently due online in early 2021. Companies with large positions in the Permian, such as Enterprise Products Partners, Plains, and Targa, would also indirectly benefit because of the potential to extract larger marketing profits via higher differentials.

Third, the sharp increase in the price of oil makes U.S. LNG more attractive, given the still extensive usage of oil-linked contracts for LNG. We think this suggests a more favorable environment for Cheniere Energy to land European partners for new contracts while it continues to pursue additional Chinese partners amid U.S.-China trade tensions. Stephen Ellis

Concerns about the disruption of Saudi oil supplies have increased oil prices, but with the likelihood that supply should normalize in about four weeks as reserves enter the market, we see a limited impact on our fair value estimates for the Chinese oil companies we cover. We think the event could lift geopolitical risk premiums in oil prices, especially with the potential for further attacks, and this may keep crude oil prices slightly elevated for longer. However, our long-term view remains that crude oil prices will be constrained by excess supplies. We are keeping our midcycle forecasts for West Texas Intermediate and Brent oil at $55 and $60 per barrel, respectively.

Our preferred stock pick of the three Chinese oil companies remains CNOOC CEO. Despite its recent share price rise, we think CNOOC is currently undervalued with long-term weakness in oil prices largely priced in, while the company’s dividend yield of over 5% is attractive. The company has been effective at managing costs, and the weakening yuan actually benefits CNOOC because its output is priced in U.S. dollars while costs are partly yuan-based. Also, we would not rule out a further rise in oil prices once information on the extent of damages to Saudi supplies is revealed.

PetroChina PTR and Sinopec SNP are unlikely to benefit much from the higher crude oil prices because of their downstream operations. Sinopec may find it difficult to pass on the sharply higher input costs to its refined petrol products, especially in the current competitive environment. We have already factored in a normalization of refining margins from previously high levels, but the prospect of this additional lag puts more pressure on margins. For PetroChina, given its more evenly distributed activities, where it is self-reliant on its oil input needs, we anticipate a marginal benefit.

Industry sources have indicated that they expect Saudi supplies to normalize in about four weeks, but we think most of this comes from tapping reserves while inventories provide an added buffer for some customers. Much of the bottleneck will be due to a lack of oil tankers to get the supplies to clients. We anticipate a greater logistics challenge for Asia because of this shipping constraint. Lorraine Tan, CFA