Getting to grips with Middle East risk
Recent Iranian provocations have exposed the weaknesses of markets in addressing disruption in the Gulf
The escalation in geopolitical tensions in the Gulf over the past 18 months has provided a sharp reminder of the risk to investors and businesses presented by the various conflicts, both hot and cold, in the region.
Yet the impact on markets is painting a confusing picture. Events such as the attacks on oil facilities in Saudi Arabia’s Eastern Province on 14 September and the killing of Iranian General Qasem Soleimani on 3 January caused oil price spikes, but these impacts have not been sustained.
On 19 January, the downing of a large part of the 800,000 barrels a day of Libyan oil output only moved the price of Brent crude by 1 per cent. Stock markets were likewise hit on 3 January, but also quickly recovered.
Then there are the less tangible effects of risk, such as the impact on foreign direct investment, that will only become clear over the long-term.
When Aramco finally listed a 1.5 per cent stake on Saudi Arabia’s Tadawul on 11 December last year, the Saudi government more or less achieved its symbolic objectives – the fruition of its three-year-long pledge to list the company and a valuation that surpassed $2tn, albeit momentarily.
But in the end the initial public offering took place in less than ideal conditions for maximising the potential interest of external investors. Aramco floated amid volatility in oil prices following disruptive attacks on Gulf oil infrastructure, including a strike on its assets at Abqaiq just three months earlier.
As a result, the listing has provided a window into the cost of risk in the region at a time when escalations in geopolitical tension have had only fleeting impacts on broader indicators.
In spite of the company’s highly illiquid listing, it has become “interesting to look at Aramco as a proxy for risk in the Gulf”, according to Charles Hollis, managing director at UK-based risk intelligence and strategic advisory firm Falanx Assynt. He points to the ongoing decline in the share price, “even despite banks coming out with recommendations that it is under-priced”.
Since the listing, Aramco shares have covered a lot of ground, rising to a brief peak of SR38 ($10.13) on 16 December to settle at SR35.5 on 19 December. They then fell sharply on 5 January, following the US killing of General Soleimani, hitting a low of SR34.2 on 8 January, before rising again on 9 January, following Iran’s unexpectedly measured retaliatory missile strike in Iraq, to SR35.
Given that the Aramco listing is dominated by local sovereign and long-term institutional investors, with as little as 0.19 per cent foreign ownership and very little true free float, it is interesting to see the price pushed so clearly downwards by events – and then subsequently, as seen in the steady ongoing decline in pricing over the past month to SR34.35 on 19 January, by continuing and underlying concerns.
It provides a clear indication of the impact of hostilities between the US and Iran on sentiment towards the Middle East oil industry.
This comes in stark contrast to what appears to be an increasingly muddied impact of regional risk on global oil prices, stock markets and insurance premiums.
Since 2014, a key contributor to the gradual obfuscation of the relationship between geopolitical unrest in the Middle East and oil prices has been the rise of US shale or tight oil production. This has raised overall global oil supply and reduced the focus of global energy analysis on regional developments.
On the demand side, there are also rising concerns over slowing growth globally, and particularly in China.
Yet this new-found faith in shale oil is misplaced, says Cyril Widdershoven, Netherlands-based founder of Verocy and head of strategy at Berry Commodities. He points to two problems with the emphasis on US production.
First, he explains: “On the supply side, I find the optimism extremely strange. Most organisations say the main supply increase is going to depend on US energy supplies, but if you look at the financials, US shale is in the largest financial crisis ever. You see shale oil companies filing for Chapter 11, the financials are very weak, and you have institutions that are saying they are not going to provide extra cash.”
Indeed, the US rig count is already falling and growth projections across the sector are being slashed as the industry, which developed rapidly at the cost of taking on high debt, struggles with the extremely fine profit margin between the oil price and the higher cost of extraction compared to conventional oil operations.
Second, he notes: “If you look at crude quality, you cannot substitute a lack of growth or decline in Opec oil by the same volume coming from US shale oil. It is a different oil. Most refineries are not even able to take this without blending it with heavier crude, even in the US.”
Here, while efforts are under way in the US to build more capacity to refine the type of light crude that shale oil is, they are lagging behind production. A lot of the volume is simply being exported to the few places, such as the Netherlands and China, that have the spare capacity to handle it.
In recent years, the problem has been made more pronounced by a shortage of the heavier crude that is suitable for blending with shale oil, due to problems with supply from key producers such as Venezuela and Canada. Morgan Stanley analysts have described US shale oil refining capacity as “close to being maxed-out”.
And yet, global analysis of oil volumes is based on US storage, which is currently dominated by shale oil. The result is a “discrepancy between what is really happening in the markets and the basis upon which oil futures are being calculated”, according to Widdershoven.
He adds: “At this moment, I would say that 60 to 70 per cent of the volatility in futures is based on financial emotions. Looking at normal fundamentals, the oil price would be $8 to $10 higher, not even looking at the geopolitical risk.”
Overall, geopolitical analysts appear to agree that they would have expected the price of Brent crude oil to have risen further and stayed higher given the significance of recent escalations in regional tension.
“I do feel that the more fundamental risk is perhaps being underestimated by the oil markets, which really have not shifted very much,” says Hollis, pointing to not just US-Iran tensions, but also the ongoing conflicts in Libya and Yemen.
“Oil prices are pricing-in the possibility of a short-term disruption, but perhaps not the possibility of a prolonged disruption to the same extent.”
The same pattern has also played out in the insurance industry, where rates, particularly on the marine side “have risen over the last year”, but showed little change in the first few weeks of the year, says Anthony Harris, senior executive officer at Dubai-based insurance brokerage RFIB Middle East. “We had this flurry with Iran, but that has blown over and life has gone back to normal.”
For regional oil exporters, the softening of oil prices, whether fuelled by incorrect analysis or not, in itself creates risk in the sense that volatility and the risk of price slippage can upset national budgets and cause or worsen fiscal imbalances.
For the moment, however, given the apparent disconnect between oil prices and the long-term risk to supply, geopolitical risk will remain hard to assess. At the same time, reputational risk is also emerging as an important consideration, particularly given its potential impact on the type of foreign investment that the Gulf Arab states especially are seeking.
Saudi Arabia is perhaps the most pre-eminent example of this trend at the moment, says Widdershoven, but it is simultaneously also the market with the most obvious opportunity and upside potential.
Given the similar challenges of assessing such risk, however, investors may be better off seeking advice than checking markets and stocks in order to determine if the risk is worth the reward.