Restoring deterrence

Published at 16:14 20 Sep 2019 by . Last edited 17:14 20 Sep 2019.

Last night, six days after the attack on the Abqaiq facility, Saudi-led coalition forces carried out strikes against ‘military targets’ in Yemen. We believe this is the first step in trying to achieve three clear goals of the US and its allies in the region in confronting Iran and its proxies. One, restore a credible deterrence in the region; two, avoid a spiralling escalation that pulls all sides deeper into a conflict; three, continue to pursue a diplomatic track that brings Iran to the table.

Meanwhile, the oil market continues to struggle with the details surrounding Aramco’s ability to fully restore its production and capacity in the timeframe suggested. Reports that Aramco is heavily tapping the products and crude markets to secure volumes raise concerns that the damage is more significant than so far admitted and it may well take longer for the Kingdom to fully restore its lost oil production and refining capacity than it has claimed. In the coming weeks, perhaps months, markets will need to contend with low spare capacity, large stockdraws in September and October at a time when inventories were supposed to build, and tremendous uncertainty around supply security as Iran and Saudi Arabia continue to test each other. At a minimum, it seems that market participants are beginning to realise that even if the Kingdom is able to fully restore its capacity in the coming months, there is no guarantee that there won’t be further attacks that will cripple Saudi crude.

Don’t go wobbly now
This week, US Secretary of State Mike Pompeo travelled to the Middle East to shore up support for a response to the aggression after what he called an Iranian ‘act of war’ against Saudi Arabia. However, he softened his tone following meetings in Riyadh and Abu Dhabi, saying that the US wants a peaceful solution, while Iran threatened all ‘all-out war’ if it was attacked. Both the UAE and Saudi Arabia have been chastened by Iran’s actions over this summer, but they remain extremely cautious over retaliation—the US failure to respond forcefully to Iranian actions has left them doubting assurances that the US would come to their defence if directly attacked by Iran. The reality is that both countries remain extremely vulnerable to any Iranian reprisals, and not just in the oil sector. Critical infrastructure remains completely exposed to attack. For example, both countries are dependent on desalination plants to provide drinking water to their citizens—significant damage to those facilities might result in mass evacuations from Riyadh, a city of around 6 million people. Moreover, after pulling additional forces from the region over the past decade, the US footprint is not as heavy as it once was. It is not clear that the US can or will fully protect them, making the consequences of miscalculation for the Gulf states very grave indeed.

However, at the same time US intelligence is on the verge of announcing its conclusion that the strike originated from southern Iran, and more importantly that it was directly sanctioned by Iran’s Supreme Leader, Ayatollah Khamenei. This would bring intense pressure on the Saudi monarchy to take the lead in a direct response against Iran. Much of this evidence is expected to be presented to the UN General Assembly on 24 September in New York when Trump is due to address the body.

Debating the response
President Trump is against military action, especially ahead of the US elections—one of the reasons he fired John Bolton was because he believed his NSA was goading Iran into a confrontation. The president has been looking for a diplomatic off-ramp over the summer and was receptive to French President Macron’s de-escalation package that would include some form of sanctions relief/credit line in exchange for Iran returning to compliance with the JCPOA, cooling regional tensions and engaging in diplomacy that would put everything back on the table. Of course, Iran, by dictating the terms on which talks can resume (no bilateral talks with the US and only agreeing to meet in a multilateral framework when sanctions are lifted and under the auspices of the JCPOA), effectively closed that door to diplomacy. This was too much of a climbdown for Trump to accept.

Meanwhile, congressional hawks, in addition to Vice President Mike Pence and Secretary of State Mike Pompeo, believe it was specifically America’s failure to respond to Iran downing a US military drone in June that emboldened Tehran to attack Abqaiq. Iran believes that President Trump will not retaliate as he does not want to go to war ahead of the elections, so there is no credible deterrence to Iranian aggression right now. Hawks place a high value on re-establishing deterrence.

There is no treaty
The US and Saudi Arabia have never signed an unconditional mutual-defence treaty, such as the one agreed by the US and Japan. When Iraq invaded Kuwait in 1990, the US made clear that an attack on Saudi Arabia would draw a US response—but that decision was based on the perception at the time that US interests were at stake rather than a codified obligation, and it had the full backing of Congress. A decade later, President George W. Bush twice sought and obtained congressional authorisation to use force, against Al-Qaeda and then against Iraq. Given the general mood within Congress towards Saudi Arabia at present, it is not clear that Congress would support military action to defend the Kingdom.

Part of this reluctance to step in to shore up the House of Saud is the growing consensus that the US shale boom has made the country much less vulnerable to global supply and price shocks than it was before. The case to defend Saudi Arabia unconditionally against Iranian aggression is not as clear cut today as it was in 1990 when Saddam invaded Kuwait.

But even if there are receptive ears in Congress for action, the administration has not as yet articulated, in either a policy position or even in words, the goals of a strike on Iran, let alone what it would require. Both previous Gulf Wars had clearly defined goals that, once achieved, would end the fighting—at least that was the theory, although 2003 showed how things don’t always go to plan. Right now, there has not yet been a clear articulation of Trump’s policy goal towards Iran.

For the Saudi monarchy, there are consequences for both action and inaction. Crown Prince Mohammed bin Salman now has some extremely difficult choices to make in the coming days. US officials are scrambling to try to come up with policy prescriptions and responses to simultaneously re-establish deterrence, avoid escalation, and leave the door open for diplomacy. But Iran has threatened ‘all-out war’ if the US or Saudi Arabia launch any military action, i.e. pressure for pressure, meaning the list of options must be extremely small.

While strikes against IRGC assets in Yemen, Syria and/or Iraq may seem facile and cynical, they may be part of the approach to achieving these goals. But in conjunction with such limited strikes against Iran’s proxies, the US is considering covert and cyber action intended to more directly hurt Iran, but not necessarily in a public way, in order to make Iran think twice about responding overtly. If the US wants to re-establish deterrence, then Iran must feel that the US can still hurt it, or so the thinking goes.

But the growing fear in US defence circles is that if the US and its allies do nothing, Iran will be even more emboldened to carry out more attacks, especially while the US maintains its policy of maximum economic pressure. The US either needs to establish deterrence or climb down on sanctions.

One possibility being considered is for Saudi and US forces to launch a strike on the Iranian launch sites used in the Abqaiq attack. But again, both Saudi Arabia and the UAE would be vulnerable to any Iranian retaliation regardless of US assurances that it would leap to their defence.

Whether or not there is retaliation for Abqaiq, it is becoming increasingly clear to us that if there is no movement on a de-escalation agreement either between the US and Iran or Saudi Arabia and Iran directly, the intelligence community consensus is that Iran will continue these attacks until the US abandons its maximum pressure campaign. The risks for the oil market remain incredibly high.

The shock of the attack on Abqaiq, combined with the tepid response to date, has fractured the illusion that the US can maintain a security umbrella to protect its allies in the Middle East.The strikes on Saudi Arabia provide a clear strategic warning to US allies that its total air supremacy in the Gulf is perhaps fading.The only thing that would be worse than this realisation in the coming weeks and months would be for the Gulf Arab monarchies to learn that not only can the US not protect them, it may not want to.

The Outlook
Brent: The physical crude market continued to tighten, and spreads and differentials continued to rally even as flat price has come off over the course of the week after initially spiking last week following the attack on Abqaiq. With global crude stocks having already fallen at a rate of over 1.3 mb/d since June, the disruption to Saudi production is beginning a scramble to secure barrels. There have been reports that Saudi Aramco has sent feelers to trading companies to try and secure crude barrels. The Saudis are going to rely on a combination of inventory drawdowns and diverting crude away from domestic refineries in order to meet export obligations (see E-mail alert: Saudi Arabia restarts 2.5 mb/d of production, full capacity will only return by end-November, 18 September 2019) This very likely means that September and October, months that were meant to see drawdowns ease and maybe even stocks rising due to refinery works, will now see continued stock draws. Meanwhile, gasoil has been bid up aggressively in the last week, which is helping to support margins. We believe that the fundamental outlook will remain constructive, primarily on supply shocks, even amid a tepid demand environment.

Fig 1: Dubai cracking margins, $/b Fig 2: Prompt gasoil spread M1 - M2, $/ton
Source: Refinitiv, Energy Aspects Source: Bloomberg, Energy Aspects

WTI: US crude stocks built modestly this week, as did total petroleum stocks. However, Cushing drew for the 11th consecutive week. With stocks at the hub below 40 mb, and USGC grades stronger on the Saudi crude outage, we expect Cushing stocks to easily fall below 30 mb by year-end. There may be some near-term headwinds however as refinery turnarounds pick up and some disruption occurs due to the flooding from Tropical Storm Imelda. Indeed, with the closure of the Marketlink pipeline due to the storm, we now expect September Cushing draws to be minimal compared to our previous 2 mb draw expectations. This will likely flip the front WTI spread into light contango. But, once planned turnaround season is firmly behind us, we expect steep draws to resume, thus tightening WTI-Brent again.

Fig 3: Oman crude differential, $/b Fig 4: Prompt benchmark spreads M1 - M2, $/b
Source: Argus Media Group, Energy Aspects Source: Bloomberg, Energy Aspects

Yasser Elguindi, Market Strategist
+1 646 760 8100 (direct)

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