September 24, 2019

Recapping the Attack on Saudi Oil

by Tajinder Dhillon.

On Sept. 14, Saudi Arabia’s crown jewel was under attack.  Eighteen drones and seven cruise missiles were on path to target prized locations including the world’s largest oil processing facility in Abqaiq and the second largest oilfield at Khuaris.  Both locations are owned by Saudi Aramco (state-owned as of now), which is the world’s most profitable company.

The result was devastating.  Key infrastructure was deeply damaged, and reports indicated that production of up to 5.7 million barrels of oil per day were impacted.  To put this in perspective, this is equivalent to 5% of global oil production and 50% of Saudi Arabia’s production.

As the attacks occurred on the weekend, the market was eagerly anticipating how oil prices would move on Monday.  The question was not if oil prices would rise, but by how much.  When the dust settled, Brent Crude jumped $7.48 per barrel from $60.34 to $67.82, marking the largest dollar increase in over a decade and the sixth-largest increase since 1970, as seen in Exhibit 1 (note: Brent reached an intraday high of $71.95, which is the largest intra-day advance in history).

Exhibit 1 – Brent Crude Largest Single-Day Gains

Shape of the Brent futures curve

Heightened uncertainty around the stability of oil production led to expectations that global crude inventories would tighten, which caused a steepening of the futures oil curve.  The shape of the curve can be categorized as either “contango” or “backwardation.”  This is important as it gives insight on market sentiment and expectations.  Backwardation occurs when the spot price for oil is greater than prices trading in the futures market.  In other words, consumers are willing to pay a premium to receive oil today than wait for oil to be received in the future.  This behavior exists if markets believe oil is ‘tight’.  Indicators of a tight market include low or falling inventories and lower production.

OPEC+ has been aggressively cutting output since the beginning of the year to help balance the markets and continue to do so until March 2020. The attack on Saudi Arabia only amplifies cutting efforts further, as Saudi Arabia plans to call on its oil reserves to supply the market in the interim.  According to Joint Organizations Data Initiative (JODI), Saudi Arabia has a reserve of approximately 188 million barrels located across strategic locations. If we assume this reserve is used to supply the potential 5-million-barrel shortfall in its entirety, it would take 38 days for it to be completely depleted (this is unlikely to occur as Saudi Arabia subsequently surprised markets by announcing they would restore most of the lost production by end of September).

Exhibit 2 highlights backwardation in effect.  We can see how prices today are more expensive than prices into the future.  The curve dramatically steepened on Sept 16 as oil prices rallied.

Exhibit 2: Brent Crude Futures Curve

Source: Eikon by Refinitiv

Looking ahead

Whether the spike in oil prices will persist, there will be immediate impacts on many industries including airlines who use jet fuel, or air freight and logistics companies such as FedEx and UPS.  One group of companies who should benefit from a higher oil price are companies who extract oil from the ground and in turn sell it to customers.

When looking at select S&P 500 exploration and production companies, we note the negative sentiment coming from sell side analysts.  As shown in Exhibit 3, 19Q3 EPS and Revenue estimates have been downgraded substantially over the last year according to I/B/E/S data from Refinitiv.  EPS estimates have been slashed by 40% on average, while revenue estimates have declined by 5% (if Occidental Petroleum is excluded, this drops to 12%).

Exhibit 3: Estimate Revisions for S&P 500 Exploration & Production Companies

As of now, all five companies above are expected to miss earnings expectations in 19EQ3 when looking at the StarMine Predicted Surprise. If analysts begin to raise their estimates given the spike in oil, investors could benefit from a possible positive surprise when companies being reporting earnings.

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