U.S Frac Spread Count Update + China + Exports

By Mark Rossano

The energy market closed out the year with a big drop in the frac spread count, which carried forward into the second week of January with a move down to 275. The drop was driven by the Permian, which has seen a big decline over the course of 2019. The Permian activity now resembles something closer to 2017 but will rebound back soon as activity accelerates with new spending in Q1. This should support rig activity as DUCs need to be replenished as some of the quoted drilled but uncompleted wells will maintain that “status” due to many issues making them useless at this price deck. Some of the wells were drilled for the “parent-child” which has yielded poor results, had a poor landing (fell out of zone), or is drilled in an area that isn’t economic at this strip. This will keep rigs relatively flat after the substantial decline of about 100 rigs over the last year.

The frac spread fell below 300 for the first time since 2017 as activity slowed down well ahead of normal seasonal adjustments. Typically, completion crews slow down into the holiday season, so a down move is expected- but the scale and pace were a bit surprising. The pendulum always swings too far in both directions, so there will be some support for activity as completions crews start to come back from holiday. There may be one more down move towards 270, but this should be the low (for now) as activity picks back up with new CAPEX programs. The CEO of Patterson was on CNBC talking about how the rig count bottomed in Dec, which is likely as some work picks back up in Q1’2020. It is hard to see too much growth as E&Ps look to manage portfolios as hedges increased throughout Q4 taking advantage of the rise in crude pricing. The backwardation of the curve steepened as companies looked to buy protection even as the front month ran- so the average hedging price probably averaged around $56-$58. Things have reversed considerably following the recent events with Iran (more on that below), as the fundamentals in oil play out to the downside.

There remains a large amount of marketed spreads (about 500) with many of them sitting idle as only 364 are currently active. Companies such as Patterson (Universal), Keane, BJ Services, Halliburton have a lot of capacity on the sidelines that could get redeployed to a new basin with reduced pricing (hard given current costs) to compete for work, or get scrapped or idled indefinitely. Halliburton has already talked about shifting equipment and manpower down to the Permian, so some of those assets could come back- but some capacity will be retired given the age of some fleets and increase wear and tear due to the rise in proppant and pressure reducing the useful life of assets. This will help keep a lid on U.S. production as exit 2020 falls below exit 2019, but activity will recover enough to keep total 2020 oil production for the year above 2019 oil production of about 12.4M barrels a day. The problem will remain realized prices as the world the demand for heavier crude rises around the world. API Gravity is a term everyone should get more comfortable with as “heavier” crude finds more favor- especially oil that is on the heavy/sweet end of the spectrum. API Gravity is a measure of how heavy or light a petroleum liquid is in comparison to water. China has brought online massive facilities, but many of them are complex requiring a heavier blend of crudes to operate. This has created tightness in some of the global spreads, but as the refined product market struggles under cyclical demand declines and structural oversupply- oil demand faces many headwinds as economic run cuts and extended turnarounds limit refining capacity. Oil pricing was inflated by the geo-political uncertainty (which is fluid but ebbing lower) as Iran faces growing local opposition (bearish crude) and Libyan factions discuss a ceasefire.

Even with some properly timed hedges for U.S. E&Ps, oil growth will face significant headwinds as Russia considers “life after the OPEC+ deal.” E&P companies had an opportunity to hedge some production in the first 6 months of the year at prices ranging between $56-$58 as the backwardation steepened considerably driven by the OPEC meeting and geo-political uncertainty. The above chart highlights where WTI prices went quickly allowing for some “decent” priced hedging in the first half of 2020. Russia has come out saying they are considering life after cuts as you “can’t cut forever,” which is interesting as they actively increase their condensate production. Many will point out that OPEC countries don’t include condensate production in their totals (which is true), so it makes sense for Russia to exclude those figures. On the flip side, it also frees Russia to increase their condensate production considerable as ESPO is expanded and gas is pumped into the Power of Siberia. The additional condensate can be blended into Urals as well to reduce total sulfur content, and increase flow as Ural demand has fallen due to IMO 2020 requirements. It also opens up the opportunity to “classify” something as condensate that doesn’t actually meet the API gravity standards. (We have never seen OPEC+ nations lie… I know!) Typically, Russia consumes all the condensate it produces, but with new wells coming online- Russia is facing a surge in condensate production, and the new OPEC+ quotas allow for expansion away from the eyes of the market. I will discuss in greater detail below on the geo-political situation.

The oversupply in the market will worsen now that China has increased runs across their new state-owned facilities and started pushing more refined product. China tightened the physical oil market as oil flowed in to bring new equipment online. It is important to note that China has also been slowing down the ramp of some facilities, and even at this reduced pace- continue to export a record amount of refined products. In the below chart, it is clear where the new facilities turned on with more coming over the coming months.

This is just a quick example of a facility ramping: “Zhejiang Petrochemical Company Limited continues with the trial runs on the 200,000 b/d Crude 1, 100,000 b/d Residual Hydrotreater, 40,000 b/d FCC Gasoline Hydrotreater, 9,000 b/d Alkylation and 76,000 b/d Reformer 1 at its Grassroot 400,000 b/d Zhoushan (Daishan) Refinery. The units were previously expected to come online by the end of December 2019, however, now plans are to begin commercial production by the end of February, 2020. Meanwhile, a 76,000 b/d VGO Hydrocracker, 52,000 b/d BTX 2 have successfully started up on December 18, 2019, and the 200,000 b/d Crude 2 which started up on May 21, 2019, is currently running around 80% capacity and scheduled to reach full throughput by the end of February, 2020.” “Negotiations for the January paraxylene (PX) Asia Contract Price (ACP) have fallen apart because of a wide bid-offer gap. Japan’s JXTG Nippon Oil & Energy placed its offer at $930/t cfr, while all other sellers offered at $920/t cfr. All the sellers declined to change their offers from initial levels. Bids for the January PX ACP were at $720-770/t cfr. The ACP-linked sellers are JXTG Nippon Oil & Energy, Idemitsu Kosan, SK Global Chemical, S-Oil and ExxonMobil. There are six buyers – OPTC, Capco, Yisheng Petrochemicals, Shenghong Petrochemicals, Mitsui Chemicals and BP. Negotiations for the January benchmark ACP were brought forward to 27 December because of the year-end holidays.” The additional capacity is hitting prices across petrochemicals and refined products on a global level. As margins worsen, the question remains who will be the first to cut runs?

How does this link back to the U.S.? The U.S. typically exports from the Gulf of Mexico into Lat Am and Europe, but with the new wave of products coming out of Asia the whole energy trade flow is adjusting. The new product from China is filling local demand just as other product from South Korea and India is pushed out of Asia and into other areas- such as Europe and Africa. This limits flow from the Middle East into Asia, so pushes more Middle East product into Africa, Europe, and some LatAm demand. So now you have European product that is competing into the LatAm market as well as the East Coast of the U.S. Now that we are back to the coast of the U.S.- where is the place that the product can compete? The U.S. can try to protect market share in LatAm and Europe, but it is getting harder as more refined product is moving around the world at fire sale prices. This has caused a buildup of U.S. product, which is now reverberating back through the system with rising builds in Europe and Asia. It is a key structure that is weighing on crack spreads and pricing as product can’t flow along its normal routes.

The pace of Exports will fall for refined products, but crude exports will recover as demand rises given the increase in shipping rates and the spread widening between Brent and WTI. This will keep exports elevated from the U.S. on a crude level.

To make matters worse, South Korea and China have been focused on a view that others should roll out economic run cuts- so each country has been producing products at unfavorable pricing waiting out the rest of the market. U.S. refinery utilization rates have kicked off the year near the 5-year low from 2016.

The pace of builds will increase on a seasonal level as Martin Luther King Day is the last big travel weekend before we hit the winter lull. This will result in a reduction in utilization rates, which is so far below the average and trending lower. The slowdown in exports has pushed more product into storage and keep crack spreads capped. It is already showing up in time spreads, and will struggle as the flow of product out of China accelerates.

The market is struggling with both a structural change out of Asia, and the cyclical impact of lower demand on a global level. There is a positive view that the China/US Trade deal will unlock more near term demand, but the market is saturated in light/sweet crude, and the trade war still has many steps involved to get back to a “normal” trading relationship. In the near term (aided by seasonal slow downs), WTI should trend lower towards $53, completion crews will shift back to 300, Permian back to 100, and rigs should find some support at these levels.

Geo-political Update

Libya is moving front and center as the Libyan National Army and the Government of National Accord (UN Recognized) failed to come to an agreement after General Hafter (leader of the LNA) refused to sign the truce. The cease-fire still remains in place after being brokered between Russia, Turkey, and all Libyan parties. The next attempt at coming to a “longer-term” agreement will be in Berlin later this week. Saber rattling has increased as Egypt demonstrated “readiness” drills in response to Turkey sending proxy troops to Libya. General Hafter holds the upper hand currently based on the areas under his control- essentially cornering Tripoli. So far, the LNA have held off on a new offensive in Tripoli and Misrata. The cease-fire took effect Jan 12th, and so far- crude production hasn’t been impacted and should remain relatively stable. Both sides NEED the oil revenue to survive going forward, so all infrastructure and assets will be spared. There could be some near-term stoppages if fighting gets too close, but NO ONE and I mean NO ONE is going to target anything oil related. This is something to watch for near term disruptions, but little in terms of long-term impacts.

Iran remains a key focal point, and now France/ Germany/ and the UK have triggered the dispute mechanism in the 2015 Joint Comprehensive Plan of Action. This was driven by Iran’s violaton under the agreement terms, and European leaders now have 15 days to resolve their differences or the UN sanctions snap back into place. This would be more of a symbolic gesture as many of the sanctions have already been re-instated, and will find new support given the shoot down of the Ukraine airline and rampant killing of protestors. The protests are ramping against the current regime, and chanting for the end to the current regime (which is punishable by death). This is also coming after about 1500 protestors were killed following the rallies against the rise in fuel prices. These protests occurred throughout Nov and Dec, so the anger against the regime has only been fanned with the death of their enforcer (General Soleimani) and now the killing of innocent Iranian citizens when two missiles destroyed the plane. Below is a follow-up of the Iran response to the U.S. precision strike.

Iran Fires Ballistic Missiles into Iraq as Soleimani is buried in Kerman

Iran officially launched 15 ballistic missiles (NOT ROCKETS!!!!!!!!!) into Iraq striking two Iraqi bases housing both U.S. and coalition troops.

The IRGC launched the following:

  • 10 Fateh 313 missiles at Ain al-Asad (very similar to the Fateh 110 Missile)
  • 5 Qiam-1 at Eribl
    • 3 of them failed in flight
    • 1 was shot down by a US CRAM

All relevant militaries placed assets on high alert in anticipation for a response to the killing of the high-level people listed in my previous report. The high alert allowed equipment to pick-up the launches instantly and take appropriate measures to ensure no loss of life. All personnel were able to take cover, and the sheer size of Ain al-Asad also means a “successful” strike can occur without causalities. A helicopter can be replaced… a runway can be rebuilt… a life is irreplaceable.

The attack was a way to boost morale at home or as it was quipped “funeral fireworks” as the strike was timed with the official burial of Soleimani in his hometown. Iran launched a strike against Iraq assets, as the tit-for-tat continues to take place outside of Iran borders. I mention this because Iranian assets have launched attacks on Iraqi citizens in multiple regions, which has spurred further protests. Here is just one example-“Iraqi protestors attack pro Khamenei Hashd al Shaabi militia building in Dhi Qar, #raq. The fight against Soleimani & Khamenei’s oppression continues.” The U.S. and Iraq government need to send a signal of unity at not tolerating further aggression, but Iraq must go further and focus on expelling the Iranian assets operating within their borders. The U.S. has been moving assets around the region in order to provide air support and a potential response if deemed necessary. The early indications are that the USAF at al-Dhafra (located in the UAE) and Diego Garcia are on high alert (just meaning they can launch aircraft in under 15 mins). The U.S. has moved high value assets F-35s and B-52s to Diego Garcia in order to provide support throughout the region.

It is also worth noting that the Iraq meeting held on expelling the U.S. from their sovereignty could not come to a vote or hold a quorum because all Sunni and Kurdish members held a walk out in protest. This just means that what was “officially” entered into the record books was a non-binding request. So out of 328 people only 170 remained to hear the potential timetable for U.S. withdrawing assets. It is also possible for the U.S. to remain in Iraq within the semi-autonomous region controlled by the Kurds. “The vote, he explained, was a party-line vote by Shia Iran supporters in the parliament. Kurdish and Sunni lawmakers had boycotted the session despite threats from the very same Shia militia that kicked off the current cycle of violence, leading to a barely functioning quorum in the chamber.

Of course, to admit threats of political violence from pro-Iranian militia would undermine the media narrative that the parliament, like the militia mob that attacked our embassy, represents everyday Iraqis. What these pro-Iranian lawmakers passed was no United States ouster, but a non-binding, partisan resolution that the United States should leave. The “quorum,” Abdul-Hussain writes, “was 170 of 328 (half + 4, just like Hezbollah designated a [prime minister] in Lebanese parliament with half + 4).”?”[1]

Iran has stated they will next strike Israel and Dubai if the U.S. responds to the attack, and based on the course of action- the U.S. is within its right to strike Iranian soil since the launches occurred from inside Iran. The launch sites are well documented, as well as other strategic sites that would be of importance. I find it unlikely that the U.S. will launch such a counter due to the ineffective (thankfully) nature of the ballistic missile attack resulting in no causalities. The U.S. may instead take action on Iranian assets and proxies within the Iraq borders, but most of the Iranian populace doesn’t support the current regime and it would be foolish for the U.S. to provide propaganda. Some will point to the funeral procession as saying this is false, but when you close all bases, government buildings, schools, and business and require people to show up- it is easy to show a large “outpouring of support.” I am by no means saying some of these people weren’t vehement supporters- 35 people were killed and others injured as a surge and riot occurred just to touch his coffin. It also shouldn’t be lost on the populace that he was a popular war hero from the Iran- Iraq war as well as a very savvy military strategist and leader. So some may have come out for support, others out of respect for his service in the Iran-Iraq war, and others because they had too. The generational dynamics of the country are clear, and this regime is facing a changing tide at home.

Those in power have been in power since 1979, but the younger generation doesn’t want to live under the thumb of a repressive regime. If we look throughout time, the Persian Empire (Iran) has a long history with Europe, India (other parts of Asia), and throughout the region. The current toxic relationship between Iran and the west is something (if we look at this as measured in generations and not single years) a blip in the long history of cooperation and trade between the two parties. This is coming full circle, and a U.S. response against the populace, holy sites, or important civilian assets would just galvanize the population and delay a conversion back to an open society. Nothing happens overnight- especially generational cycles- but the movements are in place and taking out one of their top assets can help speed the process. Soleimani was responsible for putting down many of the protests throughout Iran, Iraq, and Syria, and is responsible for killing, jailing, torturing, and raping 1,000’s over his reign. The Bush and Obama administrations have always considered him as a viable target, but deemed the ends didn’t justify the means. This has changed over time as protests against the Iranian government have intensified across Iran and Iraq.

An interesting point to be made- Iran carried out a precision attack against Abqaiq, but failed to strike “revenge killings” as they called it. Does this mean the remaining technology isn’t as good as perceived? (Iran has an estimated 2k ballistic missiles) Did they miss on purpose to save face and truly don’t want direct conflict with the U.S.? Was there an inside deal between multiple parties to eliminate Soleimani? Some of these are farfetched and others are plausible, but at the moment- everything points to a limited U.S. response and no escalation at this time. The assumption is additional attacks on Iranian proxies within Iraq, but not a strike on Iranian soil currently. Anything is possible as the whole remains fluid, and we will get more details over the next several days- but things will calm down over the next few hours. It doesn’t mean we tell our USAF to stand down or take anything off of high alert, but it just means this could be an exit ramp for de-escalation. Iran also shot down a Boeing 737 Ukrainian passenger jet carrying 180 people using two anti-missiles crashing near Tehran just after takeoff. The government tried to blame mechanical error and bulldozed the site, but intelligence gathered from the U.S., Europe, and Canada concluded differently.

This forced Iran to admit it’s error, and has enraged the populace launching even bigger protests throughout the country against the regime. Sadly- this wouldn’t be the first time something like this has happened, and just after the attack from Iran- China and U.S. barred passenger jets from flying anywhere near the area.

On the market front, WTI hit a high of $65.65 before turning lower to sit at about $63.63 up about 1.5% from the close today. The S&P futures reached a low of 3181, which was down about 40 handles from the close as gold future briefly spiked to over $1600. The oil markets will hold some risk premium from the initial attack while the rest of it fades into the morning, and if the EIA confirms the API report of a massive product build- oil prices will quick fall. All of this remains negative for refiners across the board, and provides a good time to fade crude. Gold remains a key holding, but timing is everything on re-entry. Even if the risk premium remains, there are many nations (Russia and KSA) that would quickly look to sell into this elevated price environment. There is a significant amount of oil supply available in the world and a massive glut of refined products around the world. The main goal is to take advantage of fear and price dislocation as fundamentals always win out in the commodity/physical world- which can’t be said for the equity markets.

The final point is on the U.S./China trade agreement that is expected to be signed this week in Washington D.C. So far the details emerging are as follows:

  • China will agree to purchase $200 Billion in U.S. goods per year
    • $75 Billion in manufactured goods
    • $50 Billion in energy
    • $40 Billion in farm products
    • Between $35 billion and $40 Billion worth of services

In exchange- the U.S. will lower the 15% tariff on $120 billion in goods imposed earlier last year to 7.5%, and delay imposing the new 25% tariffs that were initially slated to hit in December of 2019. The U.S. also took the symbolic action of removing China as a “currency manipulator”, which has no impact on operations. The deal reverts the standoff between China and the U.S. back to October, and doesn’t even scratch the surface of the real issues of bilateral tensions across IP theft, state support of Chinese firms, IP protection, state- sponsored espionage, and a litany of other bigger issues. The biggest issue for the U.S. will be designating a way to “retaliate” and “measure” if the deal is broken or if things worsen on the bigger issues. There has already been a lot of questions if China could actually absorb that amount of new goods from the U.S. or is this just another Chinese tactic of “appease” with no real desire (or ability) to honor the agreement. China (on a state and corporate level) has always signed deals and blatantly ignored every piece of the terms if they were no longer in China’s favor. They have walked from countless contracts, joint ventures, and other agreements once it no longer suited their needs- regardless of the terms everyone signed on too. The official terms will be key as the devil will be in the details, and the above is purely the “leaked” or “scooped” terms that have been put forth by China and the U.S. Each side will try to pick the details that maximize the spin on why this is a good deal, but the full information will be needed for everyone to decide if this is positive for the market.

Headline risk will remain high across the trade deal as well as Middle East tension. Iran proxies will continue to launch rocket attacks against Iraqi bases that house coalition troops and equipment. As of this writing, a rocket and mortar attack is being carried out on the Taji Military Base North of Baghdad. These attacks will continue to occur throughout the region as Iran attempts to drum up support from their proxies, while they tackle rising domestic turmoil. Headline risk remains high, but the underlying fundamentals demonstrate headwinds for crude and refined product pricing and demand. The goal will be to find the signal in the noise and focus on the underlying market fundamentals.

[1] https://thefederalist.com/2020/01/07/media-coverage-of-iraq-is-a-case-study-of-ignorance-and-manipulation/#.XhVEjROM6JE.twitter

US vs Iran

By Mark Rossano

A follow-up on the Middle East ongoing Conflicts

  • Protests have escalated in both Iran and Iraq- both against the Iranian government and the IRGC (Islamic Revolutionary Guard Corps.)
    • In Iran- protestors are demanding a change in leadership due to squandered funds on proxy wars, poor employment, and a lack of overarching civil liberties.
    • In Iraq- Iraqi Shia’s (predominantly in the southern part of the country) are protesting against the influence of Iran in the Iraq government- as well as many similar social issues.
    • There are many similarities between the two protests, and they all focus on the lack of opportunity due to high unemployment and corruption squandering oil money
  • I mentioned previously: “The key overarching theme is a rise in Middle East tensions, and while the current situations aren’t enough to lead to a broader conflict—the groundwork is being laid.” The issues have been building over the following course with some key escalation points below:
    • Iran used mines to attack a tanker
    • Gibraltar seizes an Iranian oil tanker
    • Iran seizes a British oil tanker
    • Iran shoots down Global Hawk US Drone
    • Iran has infiltrated the Iraqi government blocking operations from within, and is a key reason for Iraqi Shia protests- Iran involvement and corruption
    • Iran targets the Abqaiq-Khurais facility in Saudi Arabi
    • K1 military base in Kirkuk, Iraq comes under rocket fire killing a US Military Contractor and wounding other US Soldiers reportedly carried out by the PMU (Popular Mobilization Units.)
      • There have been other rocket attacks, but until K1 were carried out without loss of life or injury
  • Each of the attacks on US and Iraqi Military Assets were supposed to be investigated by the Iraq government, but has been slowed down by politicians tied to Iran. There was a growing view that Soleimani (and general Iran) assets have important seats in parliament, and have effectively stonewalled investigations.
  • In response to the K1 attack, the US carries out an attack in Iraq and Syria killing about 27 and destroying facilities all believed to be a part of an Iranian proxy called Kata’ib Hezbollah (Kataib Hezbollah).
  • Following this attack, the PMU and Iranian proxies attack the U.S. Embassy in Baghdad requiring the deployment of the Marine Rapid Response Team.
  • The U.S. took the attack on their sovereignty, and escalated it further by targeting a convoy near the Baghdad airport killing:
    •  Qasem Soleimani- Commander (General) of IRGC Qud Forces
    • PMU’s head of PR
    • Senior Hezbollah/ PMU leaders
      • Mohammed Redha al-Jabri, head of protocol of Iraq’s state-sponsored Popular Mobilization Forces
      • deputy head of Al-Hashed, Haj Abu Mahdi al-Muhandis
      • General Hussein Jaafari Naya
      • Colonel Shahroud Muzaffari Niya
      • Major Hadi Tarmi
      • Captain Waheed Zamanian
  • There are also unconfirmed rumors that US Special Forces have raided several buildings of Iraqi PMUs capturing Qais Khazali, leader of Asa’ib Ahl al-Haq & Hadi al-Amiri, former head of IRGC’s Badr Organization in Jadriyah, Baghdad
  • Germany has come out and placed the blame at the feet of Iran (which is a break from previous views held between the US and Iran.)
  • Response from the Cleric Muqtada al-Sadr was a bit different calling on Iran to avoid escalating and continue to criticize the pro-Iran Militia. Al-Sadr has also started talking about resurrecting his Mahdi Army.
  • Information remains fluid, and there is increasing intelligence being reported that Iran’s Soleimani was planning a bigger attack on the U.S. Based on his flight from Lebanon, the people he was traveling with, and actions at the US Embassy- there is reason to believe these were credible.
  • The U.S. has increase the Rapid Response Team in Kuwait with the deployment of 3500 troops as asset movements remain fluid across the area.
  • Impact to oil will be minimal and will fade as headwinds persist across the supply chain- especially in the refined products area.
    • This move will fade as refined product builds continue to rise globally and force economic run cuts.

Iran has been provocative in the region with consistent activity around rocket attacks and mobilizing assets in and around Syria and Iraq. Tensions have been on the rise as protests rip through Iran and Iraq all against the Iranian government, and their involvement in proxy wars spanning across the “Shia Crescent”. The U.S. has shown restraint while dealing with Iran given the fear of galvanizing the local populace against the West. The Iranian people are reaching a tipping point, and the inability of Ali Khamenei to put down the uprising is a telling sign. The IRGC and government have used violent tactics as well as turning off the internet in order to disperse the protestors. They have also taken more aggressive actions against international actors in order to project power and help isolate protestors.

The U.S. killing of so many high-level Shia assets was a calculated risk as many of them have been responsible for deaths throughout Iran, Iraq, and Syria (including US soldiers). There has been talk of “acts-of-war”, but this all took place on Iraqi soil and begs the question why such a high-level Iranian was in Iraq. A key talking point has been Soleimani’s involvement with training counter-terrorism, but the growing concern was his involvement with attacks against U.S. assets (including the embassy) and a potential bigger motive in a coup. The U.S. has tolerated a significant amount of provocation as the focus has shifted into Asia and away from the Middle East. After trillions of dollars spend in Iraq, the U.S. (as outlined below) has been pulling out assets which began in Syria and Kurdistan. As the Iranian’s attacked the KSA facility, it started to adjust the flow of US military back into the region, but with a bigger focus in Saudi Arabia, Kuwait, and Bahrain. As protests raged in Iraq, Iran sent in assets to help “control” the situation which resulted in more deaths and instead enraged people further.

As Peter Zeihan highlights, Qassem Soleimani has been the “fixer” for many of Iranians problems on the battlefield as well in politically sensitive situations. He has put down protests with an iron fist and used his skills as a military leader to carry out highly effective guerrilla attacks and battlefield logistics. The problem was- Iran overplayed its hand with an outright attack on a US Embassy… just look at the Iran Hostage Crisis where US personnel were held hostage for over a year and Benghazi. The attack in Baghadad called in the Rapid Response Team that helped deter things from getting worse, but a message was sent through a very carefully orchestrated attack. The U.S. has clearly been keeping eyes on MANY of Iranian and Iraqi high level personal. The fact so many very senior people were traveling together- highlights the U.S. caught them in a lapse of judgement as they assumed the U.S. would continue its passive nature in the region. The targeted attack means the US (and allies) has some deep intelligence penetration around Iran’s leaders, and is a wake-up call to many of those in the region. The U.S. named the IRCG a foreign terrorist organization in April, which provides legal cover to carry out attacks when provoked. This was a small cover that was widely forgotten about, and is a key reason having that many high level people in one convoy was a very risky endeavor. The only net increase in personnel into the region came after the attacks on KSA, as current troop movements are adjusting balance of man-power across the GCC (Gulf Cooperation Council). [1]

Rym Momtaz in this great thread[2] highlights that Soleimani has been a recruiting tool as his designation as “Iran’s most important military leader.” There was a growing belief that he was untouchable and could move about with ease and carry out Iran’s operations domestically and abroad. Khamenei has now vowed a response, which is possible but will need to be highly calculated because the U.S. has now shown restraint but green-lit the use of deadly force. The U.S. strikes have killed about 27 militia in 5 different locations and a convoy of high value targets. The threat will put all U.S. assets in the region at risk and on high alert, but the reach of Iran is limited given the years of sanctions, low oil prices, and extensive proxy wars.

Israel has been targeting Iranian convoys around Syria to limit the movement of equipment into key Lebanon strong holds where Iran has significant influence. Israel actions will help limit the scope of an attack on U.S. assets in Lebanon and Jordan, but by no means makes it impossible given the embedded nature of Hezbollah on a global level. The new IRGC Quds Force Commander Ismail Qani has now come out to double down on attacking Americans all over the Middle East. While these threats have to be taken seriously, the U.S. human and signal intel is very strong and any movements by Iran will be watched closely for a counterattack.

The drawdown of U.S. assets from the Middle East has adjusted to a relatively stable level with redeployment and adjustments of equipment and manpower around the area. C-17s and ship movements have been active as the pieces of the puzzle are adjusted to provide support to the Rapid Response Teams, counter terrorism Special Forces, and anti-missile defenses. Iran’s ability to close the Strait of Hormuz is now near impossible given the U.S’s willingness to use live fire and not tolerate provocation. If Iran attempts to take action in international waters or shipping lanes- they will be met with decisive action.

In terms of actions, crude should normalize lower as headwinds persist across the space with Russia posting oil production above OPEC+ levels as well as Nigeria. The bigger issue remains the growing glut of refined products on a global level, and this is not something an Iranian action will adjust. Iran has been exporting limited oil, and at the moment, there hasn’t been any real disruption to oil production and exports. The “softest” target for oil disruption would be out of Iraq’s Basrah port. This has a very specific caveat as Iran utilizes shared fields to export into the market (under the Iraq flag) through this area. This means that other areas- specifically in the GCC would be ideal locations, but have seen a heavy increase in defenses since the KSA attack. This limits the scope of a response, but by no means makes one impossible.

As the EIA data confirmed, oil barrels manage to avoid Texas when the tax man comes along to count. This pushes refiners to reduce imports, pull more crude from storage, and make more refined products. The U.S. remains with all time high gasoline in storage, which has pushed product back into Europe by shutting down flow into the US. Builds in Europe have also grown as more product enters from Asia and other markets with limited export markets. China has created short term tightness in the oil market with new imports and a rise in their quota by 10% year over year. The little talked about (but bigger issue on pricing) is the increase in refined product export quotas by 53%. There is an ever increasing amount of refined product looking for a home with very few places able to handle the new flow. Russia is raising its condensate production, and will send more into the market over the coming months just as new facilities become operational- specifically in Guyana. Saudi Arabia has strategically cut light crude pricing into Asia and Europe to try to compete against US exports, so the flow of oil isn’t abating- but as refinery run cuts accelerate demand for oil will fall precipitously as crack spreads are indicating.

The geopolitical situation will remain very fluid, but the U.S. has put itself in a position of strength in the escalation process by playing their hand very well on the geo-political front. Iran has already tried spinning this as an attack on their sovereignty, but it has been rightfully rejected by the locals. These are the same people facing 35% unemployment, social persecution, and a deteriorating quality of life. The Iraq parliament has called a special meeting where they will most likely condemn the violence and say this was an infringement of their nation. While we can play devil’s advocate, it is the host nations responsibility to secure embassies and bases at which international and local soldiers and personnel are stationed. Instead, the government (which has been wildly ineffective- more on that below) has failed to deploy troops or investigate the underlying cause of the rocket attacks. This is due to Iran’s involvement in the government, and how embedded the PMU is within the Iraq military ranks. The PMUs became embedded in the Iraqi military after fighting alongside each other to expel ISIS from the region, and instead of returning to Iran have remained in the country increasing their influence and proliferation. This may seem “frightening” but the Iraqi military (and many locals) aren’t all that happy with the presence of these entities, but lack the ability to expel them from the ranks.

Iran could also respond by increasing their uranium enrichment and going against the JCPOA on missile development and heavy-water reactor. This could be a way of retaliation in a way of saving face, while limiting the escalation process as a direct altercation with the U.S. is out of the question. Iran can also increase their missile deliveries to Palestine, Lebanon, and Yemen to increase attacks on US, Israel, and GCC nations. The overarching problem (highlighted below) is the poor economic condition that Iran finds itself, which really limits its options. Russia is happy to keep Iran involved in Syria, but wants to be sure to limit the reach and scope- so Russia is agnostic to the current situation. Turkey welcomes any weakness from Iran, so they find themselves isolated between Russia, Turkey, the US, and GCC nations. Their only help could come from China, but China has limited ability to step in and delivery any form of aid outside of continuing to purchase crude. China doesn’t have the assets to enforce or project any real strength in the region, and Russia will also look to maintain the upper hand with any of the proxy’s relationships. This leaves Iran isolated as they no longer carry favor in large parts of Iraq, have lost a “war hero” and “marketing tool” hailed as the “most valiant warrior and effective US Challenger, facing major security breaches on their inner most level, economic struggles from sanctions and low oil prices, and protests throughout the country. All of these points will keep the issue regional, with limited contagion in the area until at least the funerals have passed. Iran is very calculating and precise and don’t often make missteps, so there will be some form of saber rattling and retaliation- but the U.S. has taken the upper hand.

Previous updates on the Middle East Conflicts

The Ever-Changing Middle East Landscape:

  • The events in the Middle East won’t push lasting price increases to crude pricing
    • Outside current geo-political impacts —Heavy-light spread will tighten with heavy/sours getting a bid in the market due to both structural and cyclical changes in the market
  • Current Iraq protests will be localized with minimal impact to crude pricing.
  • Contagion of Iraq protests to other regions is unlikely.
  • Iran and the U.S. will remain at odds with little or no chance of an agreement for the foreseeable future (or at least not before elections).
  • An attack on Iran in response to the strike on the Saudi facility will be limited in scope to coastal assets and radar stations to avoid civilian casualties and turning populace views against the West.
  • The U.S. pulling out of Syria will lead to an increase in destabilizing the region as the YPG are extended and won’t be able to effectively stop an expansion of Turkish forces into Northeast Syria. It is unlikely Turkey will make it all the way to Euphrates, but will build a “buffer” zone. If Turkey gets too aggressive, it will unify the Kurds across Syria, Iraq, and potentially, Iran.
    • The Syrian situation (as it stands) will have little to no impact on crude pricing as they aren’t a key player, and the only Turkish asset is the Ceyhan pipeline originating from Kirkurk.
  • The key overarching theme is a rise in Middle East tensions, and while the current situations aren’t enough to lead to a broader conflict—the groundwork is being laid.[3]
  • The events in the Middle East won’t push lasting price increases to crude pricing
    • Outside current geo-political impacts —Heavy-light spread will tighten with heavy/sours getting a bid in the market due to both structural and cyclical changes in the market
  • Current Iraq protests will be localized with minimal impact to crude pricing.
  • Contagion of Iraq protests to other regions is unlikely.
  • Iran and the U.S. will remain at odds with little or no chance of an agreement for the foreseeable future (or at least not before elections).
  • An attack on Iran in response to the strike on the Saudi facility will be limited in scope to coastal assets and radar stations to avoid civilian casualties and turning populace views against the West.
  • The U.S. pulling out of Syria will lead to an increase in destabilizing the region as the YPG are extended and won’t be able to effectively stop an expansion of Turkish forces into Northeast Syria. It is unlikely Turkey will make it all the way to Euphrates, but will build a “buffer” zone. If Turkey gets too aggressive, it will unify the Kurds across Syria, Iraq, and potentially, Iran.
    • The Syrian situation (as it stands) will have little to no impact on crude pricing as they aren’t a key player, and the only Turkish asset is the Ceyhan pipeline originating from Kirkurk.
  • The key overarching theme is a rise in Middle East tensions, and while the current situations aren’t enough to lead to a broader conflict—the groundwork is being laid.

U.S. Company Impact Based on Current Events

The current Middle East situation won’t impact U.S. companies at the moment given the limited scope and minimal impact on supply. The demand problem on a global level is an increasing problem, which is now made worse by sanctions placed on Cosco- China Ocean Shipping Company Limited. The blacklisting of about 100 oil carrying vessels was in retaliation for transporting Iranian crude. By limiting the availability of ships, the cost to transport oil has nearly tripled across the globe- with the most recent news: “OC and HPCL book VLCCs from West Africa to India at costs of $9.5m or more, nearly triple the rate a month ago, amid widespread gains in crude shipping rates. Vitol offers Forcados on Platts window.” The fact that U.S. crude has to travel further to Asia will inherently lead to a higher cost given available vessels, which will put pressure on realized prices and spreads. In fact, rates to move crude is so high refined product tankers (clean tankers) are moving crude. This will persist as the market capitalizes on the shortage created by the Office of Foreign Assets Control’s (OFAC).

The IOCs and majors will be able to offset some of these costs by leveraging supply chain economics and reducing expenses throughout the process, but the smaller E&Ps are selling crude into a market that is experiencing rising costs (shipping) and reduced demand (crude quality, economic heads, seasonality). Some spreads are stronger in the physical market driven by location and quality of available shipments, which will persist in the market. This opens up opportunity for majors that have a broad exposure to various locations and crude qualities-especially the ones that control their own shipping fleet. The fact companies are shifting refined product tankers to move crude will also lead to tightness in the movement of products. This helps to drive home the fact—even though the U.S. is shifting around military assets, there remains a laser focus on economic impacts through sanctions on hydrocarbons and ships hitting both Iran and China.

Outside of the shipping impact, the Middle East situation won’t drive up U.S. prices as any supply disruptions will be short-lived and small in scale. While the shifts at the moment are relatively small, the area is become less stable with rising tension between Sunni and Shia factions, which is being expressed between countries and within borders. This risk helps to support U.S. flows over the long-term given the inherent stability of the U.S. infrastructure and business operations. The winners will remain the companies that are vertically integrated, while SMID cap companies will struggle to compete against larger entities with balance sheets and international cash flow. The ability for companies like- Exxon, Noble, Chevron, and BP, to extract value from abroad and funnel into operations within the U.S. and manage the process from the well-head to the dock/refiner provides valuable upside. The limited scope of Iraq disruption won’t materially impact U.S. E&P and oilfield service companies doing business in the region. The need for expertise, equipment, and continuity will also protect assets from sabotage at the moment, but these situations will consistently be monitored. The political situation will remain fluid globally driven by economic impacts, seasonality, and shifting geo-politics- so stay tuned and more below on the current Middle East problems (just naming a few).

The U.S. is in the process of shifting assets within the Kurdish (YPG: People’s Protection Unit) held locations, which make up the largest contingent of the SDF (Syrian Democratic Forces). This comes at a precarious time as tensions are rising throughout the Middle East. Turkish President Erdogan has been pushing for a safe zone that runs 20 miles deep and 300 miles along the Turkish-Syrian border east of the Euphrates.[4] Erdogan wants to place 3 million Syrian refugees back into northern Syria, which is about 75% of the current refugees believed to be in Turkey. There have been tension at the border between Turkey and Syria, with Turkish border police firing warning shots as the border remains closed and guarded by about 500 miles of fence. The area where Turkey and Free Syrian Army forces reside in Afrin has been inundated with refugees that are stretching the economic limit of the area.

I have said for several years that as ISIS falls, loose allies would turn weapons on each other as the battle for land and resources push armed groups to battle each other. President Erdogan has always had the desire to acquire land to re-establish pieces of the Ottoman Empire. This comes at a time where Russia, Iran, and al-Assad (Syrian Forces) continue to launch questionable attacks on civilians. The lack of civilian protection has driven refugees to the Turkish border incentivizing or supporting a potential need for a “safe zone”. The Kurds have done a lot to maintain control of the area, while maintaining and securing ISIS detention facilities throughout their controlled areas. The ability to properly guard these areas has already been strained, and the removal of U.S. assets could complicate the situation, especially if the Kurds (People’s Protection Units) are forced to defend against Turkey without support. Turkey has already launched initial strikes against ammunition depots targeting anti-aircraft equipment, and the Kurds currently have little help from the outside world limiting their ability to strike back. The question remains open—would Turkey and Russia join forces to carry out strikes against Kurdish held regions? Could this re-ignite a broader Syrian Civil War? The short answer is: Turkey will go at it alone in the near term, and this won’t re-ignite the Civil war at the outset.

Iran would face recourse within its own borders if they launched an offensive attack against the Kurdish populace, but the current issues will bleed over into Iraq, who is currently facing its own upheaval. The vote for Kurdistan was cut short as Iraq (and some Iran assets) moved into Northern Iraq (where most Kurds reside in Iraq) to squash the movement of freedom. The U.S. did nothing to stop these proceedings, and the same is being carried out in Northern Syria with the U.S. offering limited to no support. The Kurds have been the most effective fighting force against ISIS, and were key allies to the U.S. in its destruction—and now with a claim of “mission accomplished,” the U.S. is leaving a power vacuum that will be filled with warfare along tribal lines influenced by the whims of Russia. It is unlikely Turkey would look to fight all the way down to the Euphrates, but they will look to establish a buffer zone along their border—under the guise of creating a cushion zone. The interesting component will be if there is any movement from Iraqi Kurds into Syria, or will it be deemed a lost cause since the Kurdistan vote was split based on specific Kurdish party affiliation.

The Syrian announcement comes on the back of rising protests and violence throughout Iraq, driven by the poor economic conditions for large parts of the populace. The main grievance of protestors surrounds rampant corruption and nepotism with a failure of the government to increase economic and social services to allow jobs and oil revenue to reach all citizens of Iraq. There doesn’t appear to be one distinct leader in the protests as they continue to rip through multiple cities: Baghdad, as well as other areas in the center and south. Iraqi security forces have so far killed about 40 protesters (as of Oct 4th) with numbers expected to be closer to 100, with hundreds injured. Iraq’s parliament has tried to slow the spread of protests by promising reform. Iraqi Prime Minister Adel Abdul-Madi promised a new stipend program to poor families as well as the firing of about a thousand government employees accused of corruption. This has done little to quell the protests, as these comments and promises have been common and fleeting over the last several years.

The Shia cleric Grand Ayatollah Ali al-Sistani has condemn the use of violence, with the Shia leader Muqtada al-Sadr’s Sairoon taking it a step further and proposing his bloc will stop participating in parliament until the current government leadership resigns. The situation could spiral quickly as the split of Sunni and Shia in Iraq is about 42% to 51% respectively, with some putting the spread a bit wider. The failure of a Shia government without a quick adjustment could spring up in-fighting along religious lines making things worse. On the other hand (and more likely), this could provide an opportunity to replace Adil Abdul Mahdi in Iraq by taking advantage of the upheaval. There is always concern that Saudi Arabia is planting discontent to stir up the Sunni populace and put pressure on the Shia dominated government. Based on current reports, there hasn’t been a great deal of outside influence to the protests that appear to be more “grassroot” oriented. As I mentioned earlier, protests aren’t new to Iraq, but these are different given size and scale. The Shia Popular Mobilization Units could gain political favor as they have abstained from putting down protests and kept relatively close ties to Iran. At the moment, Iraq protests remain localized with limited wide-scale impact.

The current impact to oil will be minimal throughout Iraq as any party understands that oil revenue is paramount to maintaining peace/unity in the region. There may be disruptions as some protests take place near oil fields or, more importantly, export hubs (such as Basrah). The current protests won’t be enough to keep a premium in the oil markets as demand remains the core concern. The broad economic slow-down will be further impacted by seasonality as refiners enter their fall maintenance season. Protests will continue throughout the southern region, and the below map highlights the country’s oil regions and pipeline networks that could be impacted.

Even if ISIS or other terrorist groups look to take advantage of the situation in Iraq, it is unlikely anyone would destroy equipment, as ISIS appreciated the importance of oil infrastructure as a means of revenue. In an attempt to create more chaos, there could be some damage to infrastructure, but most would be small in scale and quickly fixed by each faction jockeying for control. The lack of formality and leadership in the protests will (at least for now) keep them from spreading or becoming more than just a disruption and display of broader displeasure. In the near term, this doesn’t seem to be the beginning of broader civil unrest turning into a civil war, but rather a move to highlight the poor economic condition of many regions. It should be of no surprise that as oil prices remain depressed, oil-based economies will see a rise in unemployment and cuts to social funding driving further unrest. Iraq won’t be the only spot to see a rise in tensions.

Iran is a perfect example of a place that has seen growing animosity as the populace failed to see the benefits of the Iran Nuclear Deal. This has led to a rise in tensions internally as the additional revenue didn’t translate into local jobs and economic uplift. There is no near-term solution to the Iran deal as the U.S. looks to put pressure on the government and The Iranian Revolutionary Guard to drive a regime change. The problem is, the 15% (or so) that support the government are also the individuals that control large parts of the military and local funding. This will limit any effective protests or civil unrest while the U.S. looks to pressure Iran. At the same time, this will restrict the U.S. military’s ability to strike targets within Iran as to limit civilian casualties and avoid turning popular opinion against the U.S. and the West in general. The populace (for the most part) has shifted their anger away from the West and focused it more on the current regime, so the goal is to apply maximum pain while limiting shifting local demand. The frequency of protests has risen in Iran, but the inability to create a cohesive unit— based on crackdowns and limited resources —will keep protests from really creating a regime adjustment.

The only thing that will allow for a new deal (outside of regime change) would be the limit and discontinued use of ballistic missiles by Iran. This was a key issue with the previous agreement, as it failed to limit the development, use, and delivery systems of ballistic missiles. The current Iran government is unwilling to even consider this as an option, which will keep sanctions in place. The limit of heavy crude in the market will keep the trade for Iran crude flowing at volumes ranging from 500k to 1M barrels per day, which the U.S. has (for the most part) turned a blind eye to. The U.S. ignores some of these barrels, as they fulfill a need for heavy sour crudes in key allied interests across South East Asia and limits some of the price premium in the open market that would impact U.S. purchases. Iran has also effectively moved crude through Iraq pipes from shared fields, with kickbacks flowing to Iran. This is a well known (but mostly ignored) part of the increase in Iraqi exports, but the shortage of heavy crude in the market has kept exports flowing. The below chart highlights the spread in Basrah vs Brent, where a large part of Iran crude finds its way to the market:

The spread of protests from Iraq to Iran will be tough as the Iranian government has much more control across the populace (though this will rapidly change as generational cycles hit Iran). As those in charge are aging and will struggle to hold on to control, the Iranian Revolutionary Guard allegiance can be bought to the highest bidder. We are still several years away from having meaningful change, but with many of those still currently in power from 1979, the generational cycle will provide a shake-up. The hope (or so it seems) by President Trump was to accelerate the adjustment, but that is highly unlikely. Iran will have to tread lightly with Syria (as they have their own Kurdish population that is already unhappy with the Iranian government), as well as Iraqi unrest in areas such as Basrah spreading. Given the lack of leadership of the Iraq protests, the spread in Iran is unlikely and anything that pops up would be fleeting.

Crude pricing will fade as refined product movements continue to fall below 5-year averages as demand wanes and refiners hit their maintenance season. The Iraq protests will remain localized given their lack of cohesive leadership, and may cause disruptions in crude exports, but not long-term outages. This will be something to watch, but nothing to be concerned about in the near term. The Iran sanctions will remain in place, with little movement between both sides—U.S./ Iran—given entrenched positions and the limit for U.S. to give ground in trade negations. The spread between heavy and light sweet crude will continue to collapse with heavy crude experiencing growing tightness. As Fernando Valle from Bloomberg has highlighted, Mexico and Venezuela are in terminal decline, with Mexico’s fields deteriorating exponentially due to age and underinvestment, while Venezuela is impacted by sanctions and mis-appropriation of funds driving the production decline. Venezuela could see production rise with proper investment and management, while Mexico has a long-term issue on source rock. Iran could bring production online relatively quickly if a U.S. deal is finalized, but there is global apprehension of investing within Iran as the global economy worsens. This means Iran could get back to 3.7M barrels from its current 500k-1M. Growth past 3.7M will be hard to achieve within 2-3 years of lifting sanctions based on the hesitancy of investment. For example, China has reportedly pulled a $5B investment in Iran due to sanctions, and the U.S. sent a message by sanctioning Cosco—a Chinese shipping company that shipped sanctioned crude—sending dayrates to 15 month highs and rising.

The Syrian situation between Turkey and the Kurds will remain fluid, but has little impact on crude given the location. If the Iraqi Kurdish population gets involved, it could cause some disruption, but the Iraqis need the cash flow through the Ceyhan pipeline that flows through Turkey. The U.S. has already said they wouldn’t stand in the way of Turkish military actions, and current reports say the Turkish airforce has destroyed a military depot with anti-aircraft weapons. The issues will be localized to Syria with limited impact to oil production and exports. The bigger problems will be actions taken against Iran for the Saudi Arabia attack. The loss and recovery of Saudi Arabia flow highlights the resilience of their underlying system, but also the glut of light crude that sits in the market.

The bigger impact could come from further loss of heavy crude in the market, which will be made worse by policy changes, such as IMO 2020. The International Maritime Organization adjustment to bunker fuel burned in ships will have impacts across diesel (ULSD/HSD), gasoline, and octane. Crude pricing remains capped to the upside due to worsening economic data, U.S./China trade deal (that won’t happen for a long time), and seasonality. This will keep a lid on Brent and WTI prices, but the changing blends and needs in the broader market will keep a persistent spread between Brent and WTI and tightness in heavy vs light. The spread between Brent and WTI will widen as shipping costs continue to move higher, as about 100 vessels were sanctioned by the U.S. The political situation across the Middle East is always fluid, but their remains growing tension across the region with any one specific move enough to create a broader conflict. Several years of weak oil prices has eaten away at cash reserves, and tempers (both internally and externally) are beginning to flare in response. A quick removal of U.S. forces could be disastrous as local assets are already stressed in Syria leaving the area vulnerable, and the lack of U.S. commentary/control in Iraq could destabilize the entire region. While all of these components impact supply, crude flows continue to rise from non-OPEC regions as the global slow-down intensifies. Cyclical pricing mixed with a structurally changing world won’t end peacefully.

Previous comments on the Saudi Attack

What the Abqaiq impact will be to the market?- Crude Quality Matters!

In the near term, crude pricing will jump in response to a shortfall in the market ($3-$4 will stay in the price after the dust settles). The $3-$4 represents the new political risk that will linger even after operations come to a normalized level globally. The spike in pricing could rise to as much as $10 depending on longevity of the downtime- but that move would be short lived. Saudi Arabia will be able to take some actions to keep oil flowing into the market: 1) Draw down from reserves to fill sold volumes; 2) reduce refinery runs (import refined products) while selling into the market; 3) cut petchem facilities utilization rates. The loss of natural gas production from the facility will require an increase of refined product burn in the power generation market, which can be found in the floating market. KSA can sell from near term storage of 50M -60M barrels, so near term disruption to supply is unlikely- but it will drive prices higher immediately due to political risk and potential extended supply risk. The country and Saudi Aramco has global storage of about 175M barrels with “quick” access to about 50M. The complex (containing 3 separate facilities within it), Abqaiq, has the capacity to process 7M barrels of oil per day of Arabian Light (32.8 API and 1.97% Sulfur) and Arabian Extra Light (API 39.4 and 1.09% Sulfur). “The Abqaiq Plants facility handles crude pumped from the Ghawar field. It is linked to the Shaybah oil field through a 395-mile pipeline and to the export terminal in Yanbu through a natural gas liquid pipeline.” The facility can also produce Arab Super Light (51 API and .09 Sulfur). The crude in the region, while sweet, has a lot of sulfur that requires processing through hydro-desulfurization units. If any of these units are lost (there are 18 in the complex)- it would cause a bigger issue in terms of crude quality. This could result in prolonged downtime if enough of the assets were damaged/destroyed but the complex has many of these assets on the premise. The lost production can be replaced by U.S., West African (Nigeria and Angola), ESPO/Urals (Russian), and Brazilian grades. There are others- but these are the most widely available flow, and many of them have spare capacity. As early as 10 days ago- Angola had 13 October shipments and Nigeria has had about 3 deferred shipments. Russia has doubled ESPO production to about 700k barrels a day as Brazil has ramped production from the coast. The below chart highlights some grades that can find additional demand in the near term- or whatever KSA can’t cover through their storage network. The problem will be logistics in the near term as many replacement barrels are in places further from the end users and will get tighter as volume is quickly purchased to make up the difference. In the near term, Nigeria, Angola, U.S., and Russia have spare cargoes to put into the market, but a prolonged disruption (over 30 days) will cause tightness in the market. As we enter shoulder season, the demand for oil always wanes as refiners enter maintenance season- which means that the loss of KSA supply technically won’t be as impactful as the call on oil producing nations always shifts lower in the shoulder months (fall and spring). “The Abqaiq Plants facility comprises three primary processing units – an oil processing unit, an NGL facility and a utilities unit. The oil processing unit consists of multiple spheroids and 18 stabilizer columns where hydrogen sulphide and light hydrocarbons are removed from the crude oil. The NGL facility contains eight compression trains, stripper columns and de-ethaniser column. The utilities unit supplies power, steam, treated water and instrument air to the oil and NGL facilities. The power needed by the facility is generated by six power generators – three steam turbines and three combustion gas turbine generators. Steam generated by 14 boilers is supplied to the oil processing unit, NGL facility, turbines and compressors. 1” The timing of the reactivation will depend on the type of equipment impacted, and some key assets were struck extending total downtime. The complex is built with triple redundancies with assets both above and below ground. The precision of the attack points to a coordinated effort with an understanding of refining/processing and the facility. The strike took out several of the desulfurization towers and spheroid storage tanks. The facility has many desulfurization units so that impact won’t be as widely impacted. The problem is- the storage tanks are required to stabilize/ process the crude (remove the light ends and impurities.) This means that even though the stabilizers were left relatively untouched- they will struggle to operate with no place to put the removed products (resulting in an extended downtime). KSA has redundancies to shift flow into unaffected storage tanks, other facilities, or by flaring some products. This will prolong downtime as the tanks are replaced, and due to the nature of their contents it will be an arduous process. By extending the repair time, this will keep a minimum of 1M barrels out of the market for an extended period. The fire will always look worse as when a facility is struck with that kind of attack (fire) protocol will shut down many of the valves (automatically to contain the fire) and to initiate flaring (burn anything being processed) to keep equipment from exploding from improper pressure/ cracking. This creates an “all-stop” in order to allow personnel to assess all the damage and begin making repairs. The equipment and redundancies will be turned on in a ramp up fashion to ensure the integrity of the equipment- for example- a high pressure line that is cracked and leaking fluid near an ignition source would be problematic to say the least. This is why many of the reports say “by Monday” because it will take several days to assess damages and adjust the flow of product to avoid damaged assets. There is a high likelihood there will be lost production of 2m barrels (including NGLs) and not the full 5.8M that is currently offline. The 3.8M or so barrels will be processed through their redundancies while the rest of the facility is fixed (which could take months) Depending on severity- I would assume the full 75% is operational within 30 days. In the meantime, Kuwait/UAE will bring on a spare 1M barrels while KSA activates idled capacity or parts of their oil complex that consists of their spare capacity. The bigger issue is what does this do to crude pricing. Based on the reports regarding the severity of the damage, about half of the production will be out of the market for an extended period of time. This will put the floor of crude pricing at a minimum of $3 uplift across the curve even after other areas, such as Kuwait/ UAE bring on spare capacity of about 1M barrels. The crude market will respond with a quick $3-$4 move based on geo-political/ military escalation risk. This will stay in the market as the damage is processed, and next steps are evaluated in retaliation. The impact to supply (if more severe) will peak at about $10- if we assume the whole facility is offline for 30 days (highly unlikely). The market is very long NGLs- so that can easily be replaced given current volumes and pricing, and the light/sweet market is also well supplied. The problem will be the loss (if any) desulfurization units as the world prepares for IMO2020. There is also a plethora of light crude available in the market- so this event will help absorb some of these spare cargoes (from Angola, Nigeria, and U.S. specifically). The U.S. has also seen their crude purchase slow as the flow stuck off the coast of China has been moved into India and South Korea- keeping them well supplied in light/sweet through the end of Oct. The extent of the facilities damage will keep about 25% of its volume out of the market. The attack on the facility most likely originated in Iraq, Basrah based on location and early reports (still the most reliable versus the Houthi nonsense). The ability to go about 1,000Km over Saudi Arabia to strike the facility with 10 drones (cruise missiles/drones) seems highly unlikely. The Abqaiq facility is close to the Persian Gulf, and would be more susceptible to an attack launched from the Gulf vs over land. The Yemen originated missiles have proven to be unsophisticated and haven’t had the ability to reach 1) that deep into KSA territory 2) deliver the kind of precision impact. The bigger question is- how did Iran (or some other entity) find the ability to strike the lifeblood to Saudi  https://www.hydrocarbons-technology.com/projects/abqaiq-aramco/ Arabia’s crude flow. If we assume KSA has the ability to pump 12.4M barrels at peak- the complex handles 7M barrels of it. This means the facility (given the location) would have multiple lines of defense regarding anti-missile/ aircraft and personnel implementations. This facility should have multiple levels of defenses especially since it was targeted in 2006 in a failed terrorist attack. I have attempted to highlight the escalating tensions throughout the world, and as the global economy slowscertain countries/regions will be worse off than others. This will lead to rising tensions and conflicts that will flare up. The bigger question will be- is this event big enough to pull everyone into a bigger conflict. Throughout history, many major wars were caused by a series of events that culminated in a broadening military action. This action also comes at a time when global GDP is struggling and a crude price shock would be detrimental for emerging markets. The US Dollar strength has already impacted countries, and now a price spike would cause more pain as additional foreign reserves are needed to keep oil and refined products flowing. On a global level, a weak economy, elevated crude pricing, and strong dollar is going to stress emerging countries and struggling markets. This is going to intensify the need to act in a way to stabilize the slide of economic growth, and given the failures of QE and Central Bank Easing- escalation of tensions will only continue to rise. The fact the attack happened now and not in July is crucial as we are currently entering refinery maintenance season, which will reduce the call on the global oil market. This will limit the upside of crude pricing, but an extensive downtime that enters into winter will drive up prices further. The focus should be further down the curve- 3 to 5 month contracts as the extent of the damage will prolong cargos. I think we are the precipice of a broadening conflict timing remains uncertain- but at the moment: buy crude and U.S. integrated/ high quality E&Ps/ and Petrobras.

[1] https://us11.campaign-archive.com/?u=de2bc41f8324e6955ef65e0c9&id=a8d843ea82

[2] https://twitter.com/RymMomtaz/status/1213045609281789952

[3] https://www.aljazeera.com/indepth/interactive/2015/05/syria-country-divided-150529144229467.html

[4] https://www.nytimes.com/2019/10/07/us/politics/trump-turkey-syria.html