SOC GEN – THE CASE FOR $150 OIL

Send lawyers, guns, and money: what does Syria mean for the oil markets?

Geopolitical analysis

In recent days, the US has been leading a drive to use military action to punish Syria for the alleged use of chemical weapons last week. The severity and tone of the threats and rhetoric has been getting stronger, not just from the US, but from close allies  such as the UK and France. As a result, the oil markets have begun to price in the risk of military action. Today, front-month ICE Brent gained over $4 to $115.30, while NYMEX WTI was up over $3 to $109.50 (more on the oil market impact below).

We believe that such an attack is likely within the next week, but not before the weekend. The talk from the US and others has been so tough that, at this point, the option not to attack does not exist any longer. The US would be seen as very weak for not keeping its word  and doing what it said, and this has very important ramifications for other countries and problems in the region, including the Iranian nuclear issue. Like Syria, there are also red lines for Iran.

Our geopolitical analysis indicates that the question is not whether there will be a military action against Syria. The questions are “who?”, “what?”, and “when”? The coalition being assembled reportedly includes the US, the UK, France, Germany, Turkey, Canada, Saudi Arabia, Qatar, and Jordan. A range of options prepared by the Pentagon months ago has been under consideration. At one end of the spectrum is a relatively short period of surgical cruise missile strikes directed at military targets, not directly related to the chemical weapons complex in Syria (such targets could be dangerous to civilians). In the middle is a lengthier air campaign targeted at eliminating the Syrian Air Force. At the other end of the spectrum is the establishment of a no-fly zone designed to protect rebel forces and civilians. This open-ended strategy is similar to the one used two years ago in Libya, where the no-fly zone was liberally interpreted by NATO to allow attacks on government ground forces, also to protect rebel forces and civilians.

Fed by leaks from the US officials to various media outlets in the last two days, the current reporting is that President Obama has all but decided on a short two-day surgical cruise missile attack aimed at punishing Syrian and deterring further use – and also proving to others that the US keeps its promises. This makes a lot of sense, and also keeps the US and its allies out of the broader civil war, where the most effective opposition fighters are hard-line Islamists that the US does not want to support.

In addition, having perhaps learned some lessons from Iraq, Afghanistan, and Libya, the US wants to avoid entanglement in a civil war where the “what comes next if Assad falls” question does not have an easy answer. Having said all that, it is also possible that the leaks by US officials are part of a disinformation campaign. The military and intelligence community may want Assad to believe in a short surgical cruise missile attack, when in fact one of the more severe options is being planned.

The US and key allies have made clear that they will act without the approval of the UN Security Council, in a “coalition of the willing”, because they expect Syria’s ally Russia to veto a UNSC resolution. However, to win approval in the court of world opinion, the US-led coalition may want to present their evidence at the UN and try to get a UNSC resolution to a vote, despite the expected Russian veto (China may well abstain). In addition to making final preparations for an attack, the political aspects will take a few days, which is why we believe the attack will not come before the weekend.

Oil market analysis

Why are prices going up? What is the oil market worried about? It’s not Syrian crude production or exports. As shown on the left-hand chart above, in the two years since the Arab Spring and the Syrian unrest began, Syrian output has fallen from 350 kb/d to 50 kb/d. It is not a factor. The concern is that an attack on Syria will reverberate through the region, increasing the spill over into other countries and possibly resulting in a larger supply disruption elsewhere.

Our big worry is Iraq. The Sunni vs. Shiite conflict in Syria has a direct parallel in Iraq, and the violence in Iraq has reached levels not seen since 2008. For oil, the northern pipeline carrying Kirkuk grade to Ceyhan, Turkey in the Med has been repeatedly attacked for the last 2-3
months, reducing exports from 350 kb/d to unde  200 kb/d (on average). Our concern is that the oil-directed attacks move south and potentially disrupt the 2 Mb/d of Basrah grade exported through the Basrah port complex on the Persian Gulf. There are signs that the non-oil violence (bombings, etc) may be moving south, and oil-directed attacks may follow. Iran, who is Syria’s only state ally in the region (Hezbollah and Russia are Syria’s other allies), may choose to stir up such attacks, in order to hurt the economies of the Western countries by causing an oil price spike.

Base case scenario: $125 for Brent

We believe that in the coming days, Brent could gain another $5-10, surging to $120-$125, either in anticipation of the attack or in reaction to the headlines that an attack had started. In our base case, we assume an attack begins in the next week. If it takes longer, and there are no signals that an attack is imminent, the oil price uplift from the entire Syrian situation will start to fade. Our base case scenario does not include any actual supply disruptions resulting from the US-led attack on Syria.

Upside scenario: $150 for Brent

If the regional spill over results in a significant supply disruption in Iraq or elsewhere (from 0.5 – 2.0 Mb/d), Brent could spike briefly to $150. In this case, the focus will turn to Saudi spare capacity, shown on the right-hand chart above. Saudi spare capacity is 1.7 Mb/d (total capacity at 11.5 Mb/d), but will likely go up to 2.0 Mb/d or higher, as output eases after the summer. The Saudis could handle most likely scenarios, but the markets will look at the shrinking spare capacity that remains after any disruption is made up, and that would be bullish.

Price surges and spikes won’t last There are several factors or mechanisms that would limit the duration of any price increase. First, there would be a negative impact on GDP growth and on oil demand, with demand destruction visible quickly, within a couple of months. Second, the Saudis would use their spare capacity to pump more oil to make up for any disruption and also cool off prices, to bolster GDP and oil demand. Third, depending on the price and the severity of any actual disruption, the IEA countries could release their considerable strategic oil reserves. Their goals would be identical to the Saudis – to make up for any disruption and also to help cool off prices. The IEA countries would be particularly concerned with protecting the fragile economic recovery, which has only recently been gathering momentum in a sustainable fashion.