Why didn’t oil price go up?

September 14, 2019 will be long remembered in the history of world oil. On that day, Saudi oil installations in Abqaiq and Khurais were attacked and the world lost 5.7 million barrels per day (mmbd) of oil production. There has never been such a large loss of oil in the past.

Learning from similar incidents in the past, most oil pundits would have expected that oil price would skyrocket to three digits. However, no such increase took place. By any measure, this was a ‘Black Swan’ event. No one had expected such an attack though many were certain of its massive impact on oil price and the world economy if it were to take place. The fact that it largely turned out to be a non-event, in terms of oil price, is a puzzle.

Currently, most oil pundits predict that Brent price will be around $60 per barrel for the next few months. No one likes to admit that their predictions are based on the current prevailing oil price and not any great insight. The past history of oil price forecasts, most of which were erroneous, clearly supports that inconvenient truth.

There are some outliers who give different oil price scenarios, ranging from a low of $20/b to a high of $100/b and above. While it is easy to give different price scenarios, it is impossible to predict with any degree of confidence which scenario will prevail.

When the first two oil shocks took place in 1973 and 1978/79, prices jumped up by 350% and 250% respectively. There were even well-researched forecasts that the oil era may end soon. At that time, there were no reliable monthly world oil supply/demand estimates to know the severity of the crisis. As a result, one did not have an idea of actual supply/demand imbalance. But today, we have reasonably reliable data on world oil supply and demand.

Before the attack, the International Energy Agency (IEA) had estimated OPEC (Organisation of Petroleum Exporting Countries) spare capacity to be only 2.3 mmbd and most of it was in Saudi Arabia. Thus, when the world lost 5.7 mmbd, the supply/demand imbalance was around 3.4 mmbd and there should have been intense competition between countries to ensure continuous oil supply. However, there was no such pressure.

The Organisation for Economic Cooperation and Development (OECD) countries had built up strategic petroleum reserves (SPR) in a formal way after the formation of the IEA in 1974. Thus, most of them must have realized that they can draw from their SPR, if needed. In fact, soon after the attack, President Trump announced that the US will release oil from its SPR.

Oil price went up by only 15% the first day market closed soon after the Saudi attack. But then, it fell over the next two days. At the end of the week, it was marginally higher than what it was before the attack. This might have been mostly because of the assurance given by Saudis that they would restore production before the end of the month. It was contradicted by some who were predicting that it would take months to manufacture specialized equipment destroyed by drones and missiles. However, such predictions have turned out to be erroneous so far. Aramco has claimed to have restored production within two weeks.

It was also generally felt that because of the global economic slowdown and the continuing US-China trade war, oil demand will remain weak. Such weakness may reduce demand by as much as 0.5 mmbd, which may not make much difference. Still, it is often given as an important factor to describe the softness in oil prices.

Despite OPEC+ (OPEC and other oil-producing countries) oil cuts of 1.2 mmbd, studies by the IEA, the US Energy Information Administration (EIA) and the OPEC itself showed oil supplies to be adequate. In this background, it is not a surprise that the market did not give any security premium and oil prices are now back to the pre-attack level of $53/b for WIT and $60/b for Brent.

As the oil market was digesting the Saudi attack, there were missile attacks on Iranian oil tankers close to the Saudi port city of Jeddah in the Red Sea. The oil price increase was relatively insignificant considering the geopolitical implications. This again showed that the oil market is not prepared to bring back the security premium.

There are some compelling factors to argue that the security premium might be less than or close to zero in the future. Earlier, there was the fear of ‘peak oil’. Now, we have every possibility of ‘peak demand’ and oil reserves being stranded just like coal reserves. Also, the world has built up reasonable amounts of commercial and strategic petroleum reserves.

In the oil sector, we have reasonably reliable information on some of the known knowns which influence the oil price. One such known is demand. However, there is considerable uncertainty in the case of oil supply, because of the doubts about the optimistic production capacity (is it really as much as 12 mmbd?) of Aramco, possible violations of production quota by most members of OPEC+, the ability of Iran to overcome US sanctions, the usual oil disruption in Nigeria, the civil war-torn countries of Venezuela and Libya, etc. Finally, we have an unknown unknown of geopolitical events which can never be predicted.

In the current environment of delicate supply/demand balance, market perception and market reality can change at any time because of a geopolitical event. A geopolitical event of even a smaller magnitude could result in skyrocketing of the oil price. Recently, Saudi Arabia’s crown prince Mohammed bin Salman warned that oil could reach “unimaginably high numbers” when such events take place. Therefore, India cannot afford to remain complacent since its flexibility to handle such a price increase is limited.

(The writer is a former oil industry professional)