Attack on Saudi refineries

On Saturday 14 September 2019 a drone and missile attack halted half of Saudi Arabia’s oil production. On Monday 16, when markets reopened, Brent had its biggest single-day rise in decades. The news combined a serious geopolitical event with an immediate economic consequence of worldwide reach: the possibility that a significant part of crude supply was out of the market. Beyond prices, an episode like this is a reminder of how dependent the world economy is on infrastructure concentrated in a few locations.

Saudi Arabia is one of the great pillars of world oil supply, and a blow of this magnitude was therefore immediately read as a risk to the balance between supply and demand. Although the long-term consequences depended on how long it would take to restore production, the reaction of prices showed how sensitive energy markets are to security news.

A supply that is interrupted

Saudi Arabia is one of the world’s major oil producers, so an interruption of that size hits the market squarely. The price of crude reflects the balance between supply and demand, and when supply is cut suddenly and there is fear it will last, prices react strongly.

In such cases, the market does not only discount what has already stopped being produced, but also what could happen if the interruption is prolonged or if there are further incidents. Uncertainty about the length of the crisis largely explains the intensity of the initial reaction, which can soften or widen depending on new information about the state of the facilities.

Brent as a benchmark

Brent is the benchmark that Europe and much of the world use to set the price of oil. Its quotation serves as the basis for numerous contracts for the purchase of crude and derived products, so any sharp move is quickly transmitted along the whole energy supply chain.

Its rise feeds through, with more or less delay, into fuel, transport, production costs and, finally, the prices paid by companies and families. The pass-through is neither automatic nor uniform: it depends on contracts, hedges and each sector’s ability to pass the increase on. But over time, a sustained rise in crude ends up reaching almost everyone. That is why companies with significant energy costs usually watch closely the evolution of crude and the hedges available in the market.

Energy costs and forecasting

For a business with heavy energy or transport use, an episode like this is a reminder of how exposed it is to changes it does not control. Logistics, farming, industrial or tourism companies can see their costs shift noticeably without anything having changed in their own activity. That is why it pays to know how much energy weighs in the cost structure. It helps to distinguish between a one-off price jump and a lasting increase: underlying decisions should be based on the latter, not the former.

Reviewing supply contracts, assessing price-revision clauses and calculating the effect of a sustained increase helps avoid being caught out. A simple exercise is to estimate how much costs would rise at different crude price levels, and how much could be passed on to customers. With that information, the adviser can help decide whether to fix prices or hedge part of the risk.

In energy, volatility is part of the landscape; it is wise to plan for it.

This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.