Written by: Guild Investment Management Executive Summary 1. Limited effects from the attack on Saudi oil facilities. This past weekend, unknown actors launched a drone and missile strike on two Saudi oil production facilities, resulting in a temporary disruption. While oil prices spiked on Monday morning, they quickly retraced much of the move as it became apparent that Saudi production would probably rapidly recover, and that the U.S. administration would not respond impulsively with a military strike on Iran (widely considered to be responsible for the attacks, even though responsibility was claimed by Iranian proxies in Yemen). Although analysts have spent endless years considering the risks of regional conflict sparked by Iranian and Saudi rivalry, oil markets have been complacent about that risk. The weekend’s events are unlikely to spark a regional conflagration, and in fact, we believe regional tensions will be more likely to express themselves in the future through local, asymmetrical events such as drone strikes and cyberattacks, rather than in full-scale hot wars. The fresh realization that such modestly disruptive events can occur will probably lead to a gradual pricing-in of a $5+ per barrel risk premium for oil over the next few months. That may be a modest positive for some small and mid-sized oil producers who will be able to hedge future production at more attractive prices. It may also lead to modest inflation bumps in some oil-importing developing countries such as India and China -- and that in turn could be a positive for the price of gold. 2. A market for regenerative agriculture. Although a majority of climatologists concur that climate change is afoot, and likely driven by human activity, many believe that some of the world’s biggest carbon emitters -- such as India and China -- will be unwilling to embrace mitigation solutions that would hamper economic growth and prevent their poorest citizens from being lifted into the global middle class. This has led some scientists and engineers to propose radical solutions such as geoengineering, which in our view could be a cure worse than the disease. However, one U.S. startup, Indigo Ag, is using $600 million in venture capital to encourage farmers to move to “regenerative agriculture” -- a system of practices that can sequester large amounts of carbon, offsetting emissions while boosting yields and reducing chemical inputs. Their voluntary carbon offset market will allow big corporates to become “carbon neutral” in response to increasing public and consumer demand; Anheuser-Busch is their biggest catch so far. Previous attempts at such market-driven programs have failed in the past -- but Indigo Ag is betting that this time, the critical mass of public opinion will be present. We like the prospect of climate-friendly solutions that are market-driven rather than bureaucratic, and that are friendly to the economy. 3. Market summary. Dislocations in the overnight interbank lending market earlier this week do not seem to be a harbinger of imminent stress in the broader financial system. As anticipated, on Wednesday, the Fed lowered short-term interest rates a further 0.25%. Contrary to some reporting, there was not mass dissent at the Fed -- only two members of the ten members of the Fed’s Open Market Committee voted to leave rates unchanged. We do not view the attack on Saudi oil production as a game-changing event that would be highly disruptive to U.S. or global markets. We think that a modest additional risk premium will gradually get baked into the price of oil, but not that a major regional conflagration is suddenly on the table. Even the attack on Saudi did not result in a notable volatility spike or short-term market correction, which we read as a bullish sign. We remain bullish on U.S. stocks, particularly on the barbell of growth stocks, primarily tech-related, and solid, dividend-growing income stocks. A new modest risk premium for oil may help generate some inflation, which will be modestly beneficial for some commodities and some commodity-exporting emerging markets -- but not enough for us to believe that these markets represent an opportunity superior to that of the U.S. market. We continue to be bullish on gold, for all the reasons mentioned in recent letters. The addition of a risk premium for oil, and the inflation it generates, should be somewhat beneficial for gold demand.
The Attack on Saudi Oil Production: Likely ConsequencesLast Saturday, a missile and drone strike on Saudi Arabia took out about half the Kingdom’s daily production capacity -- 5.7 million barrels per day (bpd), or about 5% of the global total. About a third of that lost capacity was restored rapidly, within 24 hours; on Tuesday, Reuters reported that normal production would be restored in two or three weeks. Although rebels in Yemen claimed responsibility for the attack, U.S. and global intelligence quickly determined that Iran was the more likely source -- particularly since the attacks showed a sophistication far beyond what Yemen’s Houthi insurgents had ever previously demonstrated. The price reaction for oil was sharp on Monday. Much of that move was quickly retraced on Tuesday as the limited nature of the damage and the likelihood of a rapid recovery became apparent. A straightforward “mechanical” analysis of supply disruptions suggests that a one million bpd disruption that lasts for a year would cause the price of oil to rise by $15 per barrel. However, the current disruption will fall far short of that damage, with a total market impact of 40 to 70 million lost barrels -- a small amount compared to global stockpiles, and well within the estimated 188 million barrels of crude stockpiled in the Kingdom itself. (Globally, an estimated 1.8 billion barrels are stockpiled, including 600 million in the United States.) The objective damage of the attacks was slight. Their real significance is, of course, geopolitical. The rise of fracking in the United States has dulled the sharp edge of American dependence on a region of the world that’s fraught with enduring conflicts. But much of the rest of the world is not fortunate enough to be blessed with the U.S.’ combination of geology, technology, robust capital markets, and the rule of law (the things that have unlocked vast new U.S. oil reserves). For the much of the rest of the world -- including India and China -- Saudi Arabia remains the “central bank of oil,” the swing producer of last resort with spare capacity that can make up for disruptions elsewhere. The attacks may not have been highly damaging or disrupting, but they have highlighted risks that oil markets have evidently not fully priced in -- not unknown risks, just currently unpriced ones.
- First, in spite of the rise of U.S. oil production, Saudi is still the world’s key swing producer -- and Saudi production has significant bottlenecks, including the Abqaiq processing facility that was struck in the attack.
- Second, a war with Iran has been feared for so many decades that most observers have become complacent about the risk. Still, Iran maintains deep ties with regional asymmetrical militias that are capable of either conducting proxy attacks on Iran’s behalf, or of distracting attention from activity that covertly originated from Iran itself. (Intelligence seems to suggest that the latter is what happened on Saturday.) In short, while a regional war involving Iran remains unlikely, Iran can still have a significant and destabilizing regional influence.
- Third, technology (drones, cyber warfare, etc.) means that destructive asymmetrical attacks can more easily be launched by non-state actors (though often with covert state backing). Those attacks will increase in sophistication and efficacy as the technological means become cheaper and more accessible.