By Rajan Vazirani
Saudi Aramco, the Saudi Arabian state-owned oil giant, was attacked by a drone strike this past Saturday. A group of Houthi rebels from Yemen have claimed responsibility for the drone strike, which affected two major Saudi oil processing facilities. But, the identity of those behind the attack is not yet clear due to conflicting reports from U.S. government officials. Aside from the political concerns of who is responsible, the attacks have vast economic implications.
Crude Oil and Commodity Markets
The Saudi Arabian Oil Company, known as Saudi Aramco, is the world’s largest producer of crude oil. Crude oil is a natural resource with a wide array of applications, including the production of transportation fuels and plastic products. Crude oil is a commodity. Commodities are goods and services that people view as similar enough to not care about the producer or the quality. For example, coffee beans, which are commodities, that I sell are essentially identical to the coffee beans that anyone else sells simply due to their universal quality and similarity. Therefore, in commodity markets, the quality of each instance of a certain commodity is the same. Therefore, commodities trade primarily based on price, with supply and demand as the sole determinant of the price. That is important in understanding why oil prices moved the way they did.
Crude oil is measured in barrels. One barrel is equivalent to 42 gallons. The price value of a barrel of oil is subject to fluctuations, based on the supply and demand of oil. Generally, when something, like the attacks on Saudi Aramco’s facilities, threatens the supply of oil, the price of oil rises. That reflects the basic laws of supply and demand. Natural disasters, like Hurricane Harvey in southern Texas 2 years ago, and turmoil in an oil-producing region could disrupt the supply of oil and cause the price to rise.
Valuing Oil Companies
Increases in oil prices will usually increase the value of oil companies. This is due to the fact that oil companies are primarily valued by their oil reserves. If a company holds a certain quantity of oil, and the price of oil goes up, the value of their reserve, and therefore the company, increases. The attacks on Saudi Arabia will presumably cause oil prices to increase. That will, in turn, likely cause the market value of publicly-traded oil companies to rise. However, the geopolitical climate in the Middle East, which may develop to further cut oil production and reduce oil supply, represents a risk to the global oil supply. There are also concerns that the industry may not meet global energy demand.
In the case of the recent attacks, Saudi Energy Minister Prince Abdulaziz bin Salman stated that the drone strikes affected over half of the company’s production capacity. The production capacity is the quantity of oil that they are capable of refining at a given time. Half of the company’s daily production capacity represents approximately 5% of the daily global oil production capacity. That is a significant enough disruption in supply to warrant a major change in oil prices.
Due to the reduction in oil supply and the threat of geopolitical conflict in the Middle East, investors can expect a large spike in oil prices in the coming week. As of Sunday, United States crude oil futures have risen 11%. Brent crude, a European variant of crude oil, is up 12%. Crude oil futures are derivatives of crude oil. A derivative is a tradable security that is based on the value of an underlying asset. Therefore, crude oil futures are securities that are based on the price of crude oil. An oil future is a contract to buy or sell 1,000 barrels of crude oil at a certain price by a deadline.
U.S. crude oil futures are up 11%. This means that oil derivative traders have anticipated that the price of U.S. oil will increase and buyers are willing to pay an 11% premium on the trade, given the foreseeable improvement. In simple terms, investors believe that the value of oil will increase significantly due to the events affecting Saudi Aramco.
Investors have long expected Saudi Aramco to file for an initial public offering. If it does, it would be the most valuable public company in the world. Likely, the current conflicts with their production and the disruption of their refining capacity will put a damper on the development of those plans. As of now, investors can expect oil shares to increase Monday with a high potential for further turmoil in the Middle East to ensue.