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Drone Attacks Test Saudi Aramco, Deliver Wake Up Call To Global Markets

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Last week’s drone attacks on Saudi oil infrastructure, which slashed the kingdom’s oil production by 5.7 million barrels a day, should finally jolt global investors awake to the mounting geopolitical risks in the Middle East. 

I’ve warned of this before, but the impact on global oil markets of Saturday’s attacks cannot be understated. The attacks knocked offline roughly 6 percent of global oil production and more than half of Saudi Arabia’s output.

There is a real risk of a full-blown war in the oil-rich Middle East now, with Saudi Arabia and its allies -- including the United States on one side -- and Iran and its regional proxies on the other. 

There’s tough talk out of both Riyadh and Washington blaming Iran for the attacks on Saudi oil installations

Iran has denied accusations that it’s backing the Houthi rebels in Yemen who claimed credit for the attack, but Iran has little credibility in the eyes of either the Saudis or the United States. 

The Houthis have been fighting a bitter war against a Saudi-led coalition, which has the backing of the United States, since 2015. 

Iran also has little to lose -- the United States has already reduced its lifeline oil exports to next to nothing as part of a “maximum pressure” sanctions campaign to get Tehran to renegotiate a more favorable nuclear deal. Anyone expecting Iran-backed attacks on Saudi Arabia or its Gulf allies to end in the near-term is delusional. 

Indeed, the long, bitter rivalry between the Middle East’s two powerhouses -- Sunni Saudi Arabia and Shiite Iran -- may have finally reached its breaking point. 

An outright war would be the worst-case scenario. But even if a war does not materialize, this past weekend's attacks show that the outlook for global energy security has drastically deteriorated. 

It is difficult to imagine a scenario where oil traders are not now rethinking their perspective on global oil markets, considering the damage 10 cheap drones inflicted on the world’s most important oil producer. 

I would expect the floor on oil prices, which has been rooted at around $60 a barrel for months despite a host of recent assaults on Middle East oil infrastructure and tanker seizures in the critical Strait of Hormuz, to rise substantially. How much will ultimately depend on the size and duration of the Saudi outage. But prices could increase as much as $15 a barrel. Even if reports prove correct and the kingdom can bring back substantial lost volumes in a matter of days, expect prices to rise several dollars a barrel.

The international benchmark Brent price for crude oil opened Monday at $72 a barrel, a 20 percent increase from Friday's $60 a barrel close. As I am writing this, prices have settled somewhat to $65 a barrel, an 8 percent increase over Friday. 

Whatever the amount ends up being, a new floor will be set by traders. That’s because Saudi Arabia holds more than two-thirds of global spare oil production capacity of about 3.2 million barrels a day, according to the International Energy Agency. That spare capacity is output that can be produced on short notice and represents a world's only true cushion against supply disruptions.  

Yes, there are significant crude oil volumes in strategic storage around the world, including in the United States, which holds some 600 million barrels squirreled away in salt caverns. Saudi Arabia also has about 180 million barrels in facilities inside and outside the kingdom. Refiners will still get their existing crude orders despite the attacks. 

President Trump does not want to see retail gasoline prices rise as the 2020 re-election campaign gathers pace, which is why he has authorized a release of crude from the Strategic Petroleum Reserve should it become necessary to calm a jittery market. 

But that’s the point. The bigger, more important picture is that Saudi Arabia’s spare capacity should no longer be considered safe. Indeed, the bulk of Saudi spare capacity comes from supergiant fields that must flow through and be processed by the very plants that were damaged by the weekend drone strikes.

Riyadh’s plan to list shares of state oil giant Aramco before year-end now seem in doubt. Already delayed once in 2018 due to unfavorable market conditions following the Khashoggi killing, a public offering now seems reckless. 

Saudi Arabia must prove it can defend its oil assets before it should expect a successful IPO, never mind one that delivers the kind of $2-trillion valuation that Crown Prince Mohammed bin Salman is seeking.

Global oil markets will look elsewhere for help, but no other producing country can step in and fill the swing-producer role of Saudi Arabia. 

America cannot do it. Shale producers need months to increase their production. They are also focused on improving their capital efficiency and delivering higher returns to shareholders, not on adding additional barrels. What that means is that U.S. producers will likely use any increased revenues that result from higher oil prices to pay down debt or make investors happy through dividends or share buybacks. 

The bottom line is that Middle Eastern oil infrastructure and shipping are extremely vulnerable to multiple threats today that didn’t exist a few years ago, particularly from an opponent as skilled in asymmetrical, guerilla-warfare techniques as Iran. 

Drones are a game-changing technology that can threaten energy installations in remote areas previously thought to be relatively secure due to their location. Saudi Arabia has been subjected to roughly a dozen drone attacks in recent months and has been incapable of defending against them with 100-percent certainty. Before Saturday's attacks, the Houthis targeted Saudi Arabia’s 1 million barrel a day Shaybah oil field in late August.  

Even with heightened security, it’s difficult for a defense system to intercept multiple drones, which can fly at low altitudes and go undetected by radar. High-tech sensors and jamming technology have also failed to stop drone attacks in Saudi Arabia, which is disadvantaged by the vast oil infrastructure it must defend. Guarding thousands of gathering and processing facilities, gas separation plants, export terminals and pipelines is no easy task. 

Saudi Arabia has traditional anti-missile technologies like the U.S.-made Patriot system, but they haven’t gotten the job done against drones. More effective anti-drone defenses are under development but aren't yet perfected.

Iran also has the ability to choose from multiple targets in Saudi Arabia, making it challenging to focus defense efforts. It can hit ports, seize tankers in the Strait of Hormuz, and use drones through the Houthis to disable oil production deep in the Saudi oil heartland, hundreds of miles from the conflict in Yemen. Iran also has cyber warfare capabilities, which could be the next front in its asymmetrical campaign. 

The other members of OPEC regularly suffer serious production disruptions due to conflicts. Libya and Nigeria have swayed oil markets to some extent in recent years. But these episodes are relatively minor in the grand scheme of the 100-million-barrels-a-day global oil market. 

If Saudi Arabia continues to be an easy target, the effect on global oil markets, not to mention the global economy, could be profound.