Oil prices surged Monday after attacks on Saudi Arabia’s Abqaiq processing plant and Khurais oil field Saturday suspended more than half the country’s oil production. While the ultimate impact will depend on a combination of the extent of damage, the U.S. and Saudi response, and whether further attacks occur, the current production decline will exacerbate the tightening in the oil market that was already underway and could add a more lasting geopolitical risk premium to prices.

What happened

The attacks halted production of 5.7 million barrels per day (b/d) of crude oil, 2 billion cubic feet per day of natural gas, and more than 500,000 b/d of natural gas liquids, amounting to more than 5% of global oil supplies (according to Saudi government reports and the International Energy Agency). While media reports suggest one-third of this production could be restarted as early as Monday, the outage has the potential to be one of the largest in history if the damage is significant and recovery slow.

Abqaiq plant: the heart of Saudi oil

While the focus has been on risks in the Strait of Hormuz, we believe the Abqaiq processing plant presents a bigger vulnerability. Simply put, this plant is the heart of the Saudi oil industry, removing hydrogen sulfide and dissolved natural gas and stabilizing the oil for export and refining – and therefore critical to transport and sale. The plant sits at the cross-section of the country’s oil and gas infrastructure, and the output loss will limit supplies not only to export terminals, but also to domestic refiners and power plants, which could affect desalination operations. We’ve already heard reports of reduced operations at domestic petrochemical plants and refiners due to lack of feedstocks. The body doesn’t work without the heart. In addition, while pipelines may be relatively simple to repair, processing units of this complexity are a different story.

Investor takeaways: Outages and rising geopolitical risk will curb supply, add to price risk premium

We believe market sentiment had been overly bearish before this weekend’s events and was ignoring tightness in the physical oil markets. And with spare production in Kuwait, United Arab Emirates, Russia, and unaffected Saudi fields likely only contributing 1 million b/d, and this output requiring 30 to 90 days to enter the market, inventories will only continue to draw (decrease).

While the attacks have pushed prices up, their ultimate impact will be largely a function of how Saudi Arabia and the U.S. respond. With the U.S. pointing to Iran and Iran-backed groups for the attacks, and with limited capacity to impose further sanctions on the country given the extent of those already in place, the question becomes whether the response could include military action or if a dialogue could de-escalate the situation. However, each incident in the region thus far has added to tensions, even if some voices call for a détente.

In our view, the oil market simply doesn’t have enough flexibility to make up for additional supply outages, and we would expect this to add to the geopolitical risk premium in prices. 

Visit our inflation page for more of our views on developments affecting oil and other real asset markets.

Greg Sharenow is a portfolio manager focusing on real assets and is a regular contributor to the PIMCO Blog.