McNelly has seen conflicts from up close. He was the former senior energy advisor on both the National Economic Council as well as the National Security Council of George Bush Junior’s White House administration and between 2001-09, Robert was part of the US government that saw the 9/11 attacks on the Twin Towers, which eventually led to the 2nd Gulf War. Edited excerpts.
Q: Going straight into the world we live in. You know, we’ve already seen unprecedented global volatility. starting from Covid and now West Asia is on the boil. The United States and others are desperately trying to contain the conflict, but every day there is a new development. Has 2022-23 been among the most volatile years you have seen in recent times?
Robert McNally: The answer is yes. We have an expression in the financial markets, a black swan. Black swan events, black swans being, as you know, a rare event that has outsized implications. These days, the sky is full of black swans. It’s no longer rare. Covid, the Russian invasion of Ukraine and the oil price spike it caused last year, a war getting going in the Levant and hopefully it will not spread to the region, but there’s every risk that it might. On top of that, 40-year highs of inflation, central banks raising rates, all this occurring when the world was, as you mentioned, hoping to go to the UAE and Cop28 and talk about a sort of centrally planned, aggressively rapid transition away from the 80% of the world’s energy that comes from hydrocarbons to alternatives and renewables. So really, not only in terms of the black swans in the events that are hitting us. But coming at a time when the world is trying to decarbonize and trying to kind of create a new order after this post-World War II order crumbles makes for the most volatile period I think I’ve seen in my professional lifetime.
Q: That’s a pretty bold, uh, statement to make. You talked about markets and the macro uncertainties. Now, the markets priced in, there’s a lot of recession risk in 2022, and priced it out in 2023 as recession, especially, the US recession, had not been happening this year to the extent it was originally forecasted. But like West Asian wars of the past, the current conflict has the potential to disrupt the world economy and even tip it into a bigger recession if more countries are drawn in. As I said, the number of actors involved keeps rising, as do the number of fronts.
Robert McNally: You’re right. So, you know, when we think about how the world dodged a bullet with regard to the most recent recession risk, I think we have to look to last year and how oil prices shot up from $80 to almost $130 a barrel in several weeks. Why? Because we thought, experts thought, the International Energy Agency advised that as a result of the Russian invasion of Ukraine, we would lose 3 million barrels a day of Russian exports.
And so it was when that disruption didn’t happen and oil prices fell, that I think the world dodged a recession bullet. India played an important role in sort of making sure that Russian oil still flowed because Europe imposed an import ban. But India went from almost nothing in terms of importer of Russian oil to now one of the major importers of Russian oil, and that helped keep oil prices low. But I think we need to step back and ask ourselves, ‘What about the structural drivers over the last 40 years, that were positive for the global economy?’. The entry of China as a low-cost manufacturing centre for the world. The end of the great power conflict in the late 1980s. Beating inflation in the 70s and early 80s, democratization, liberalization, free trade. All of these things were structural factors over the last four decades. That, in retrospect, created a very positive period in terms of global growth and India is now developing rapidly into that.
But the bad news is every single one of those positive structural factors is reversing. We have great power conflict. China is now viewed as an adversary, and this comes in the transition discussion as well. Interest rates are not going down. They’re going up. Inflation is not going down. It’s going up. So you have a series of structural, let’s call it headwinds that even if we dodged a bullet with recession last year, uh, the world economy has to reckon with.
And this is already at a time when I would say OPEC plus have been impacted by supply cuts, declining inventories and concerns that lofty prices will once again destroy demand.
Q: And that’s why even our finance minister was expressing her concerns a few days back. Oil price rise is directly linked to inflation.
Robert McNally: Absolutely. Most as we say, barrel counters, those of us who attempt to, uh, you know, calculate, monitor the supply and the demand of inventory in the world. Most of us, at the International Energy Agency, United States Department of Energy, and OPEC Secretariat, OPEC has its own very fine analysts, most of us who calculate the balances see a very tight second half of this year.
Uh, and oil prices rose sharply in August and September, as we saw, but they sold off just before the war began. So the market is in a very uncertain time. There is a concern about underinvestment on the supply side and Saudi Arabia is very concerned about that.
The good news is the world economy is recovering. The bad news is we’re having this under-investment and supply. And I’m concerned in my view that we are at the foothills of a multi-year boom cycle in oil prices, uh, that demand is going to be strong and supply has been crippled by years of under-investment. And as a result, you know, we should expect a multi-year boom cycle. That will be a challenge for major oil importers. Like India, lChina, Japan and Korea.
Q: Immediately after the weekend surprise attack Brent went up 5% to around $88 a barrel. Goldman Sachs came out with an estimate saying $100 a barrel. But if Iran gets drawn in, you know, then all gloves are off, which many people say it might, then as per Bloomberg estimates, oil prices could potentially soar to $150 a barrel and global growth could drop to 1.7%. That means a recession that takes about 1 trillion off global output. Would you say the war risk premium has returned to the oil markets?
Robert McNally: It certainly has. There has been about a $3 to $4 premium put into the price, but in my view, it’s probably too low. And were the war to expand to the Gulf region and not just in the Levant and Israel and Gaza, I think, you know, we’d be seeing oil prices rise well above $100 a barrel. For the simple reason that the Middle East, and especially the Arabian Gulf remains the world’s most important energy supply and export source. 40% of the world’s exported crude oil passes through the Strait of Hormuz. About 18% of refined products like gasoline and diesel also pass through there. The world’s largest LNG liquefaction facility is in Qatar is also inside the Gulf, and there are not many easy ways to circumvent the Gulf if it’s blocked. You may recall in September of 2019, Iran launched a missile attack on Abqaiq, perhaps the most valuable piece of real estate on planet Earth — the 7 million barrels a day Saudi processing facility. That day when the markets opened in Asia, we saw the largest single day increase in crude oil prices in history because that was a direct attack on literally the world’s most important energy facility, and it raised the perceived risk of a broader conflict. So when we think about Iran possibly getting involved in this war and the conflict in the fighting spreading to the Gulf, we have really the potential loss of supply that would cause an oil price spike well into the $100 barrel level, the potential loss of LNG supplies going into winter with Asia and Europe, particularly dependent on Qatar and I think you would have a price spike big enough to, unfortunately, cause a recession.
Q: So Iran clearly, as of now, seems to be the big wild card in the room because, as you drew parallels from 2019, it could do the same as retaliation if it finds itself under Israel or American attack.
Robert McNally: That is the risk. I don’t think the Iranian regime wants to challenge the United States. However, as we see throughout history; sometimes wars and conflicts spread and engulf other parties in ways that, in the beginning, perhaps major countries did not want to see happen; but this can happen. And so there is a risk that the conflict will spread to the region and that Iran, as the main supporter, particularly of Hezbollah in Lebanon. This is what most analysts and market participants like myself are watching. Will the war expand to the north of Israel, south of Lebanon and involve Iran’s proxy Hezbollah?
And if it does, there is the risk that it spreads then to the Gulf region, and um, and it becomes a general engagement, in which case we’d be looking at much higher energy prices, unfortunately.
Q: Incidentally, 2023 is also the 50th anniversary of the Arab-Israeli war of 1973 – the year of the 1st oil shock which led to crude prices rising by 300% by 1974 following an embargo on many Western consuming countries by the Arab producers. So are we staring at another shock?
Robert McNally: I think there are some underappreciated aspects. The Arab-Israeli War of 1973 was the 3rd in a series of wars that began in 1956. The 1956 Suez crisis actually saw the biggest disruption in oil market history. Yet it did not cause a global oil shock. In 1973 there was actually quite a small disruption. The embargo, which was really in some ways a redirection of supply, was actually quite small. The global oil shock was due to the United States handing over supply and power to Arab producers after being the supplier of last resort for decades. So to your point, sometimes I think we tend to overdo the embargo side of things, the actual reduction of supply and lose sight of what you described as this transfer of historic power in terms of spare production capacity from the United States to Arab oil and producers led by Saudi Arabia.
Q: Most oil industry players believe it won’t be a repeat of 1973 but they predicate their thesis on the fact that both Saudis and the UAE have significant spare capacity that they will use to curb prices. Plus Saudi Arabia’s promise to the White House that it’s willing to boost production early next year if crude prices are high as a goodwill gesture for a defence pact. But does all that look shaky now?
Robert McNally: Prior to the Hamas attack on Israel, there were press reports that the Saudis would be willing to increase oil production next year to lower oil prices and help Congress in the United States pass laws that would be necessary to help with a normalization between Israel and Saudi Arabia and U.S. support for Saudi nuclear activities. I have questions about the veracity of that. I think it’d be surprising if the Saudis would allow geopolitics to affect their oil production that way. They take stability in the oil market very seriously and I think they would be very cautious about that. But all that has been overtaken by events since October 7th. Now, there’s a freeze on those normalization talks, and the question becomes there’s about 5 million barrels a day of spare production capacity in the world and isn’t that something that we can rely on to protect the world from oil price shocks if this war expands? And, my answer would be no. There are only limited options for redirecting Saudi oil exports around the Strait of Hormuz and the UAE. This is the challenge when you have geographical concentration, not only of supply and exports but also spare capacity in that one region.
Q: This conflict escalated just before COP 28 in Abu Dhabi, it almost makes me feel that even before it has started, it’s beset with challenges.
Robert McNally: At the Glasgow Cop, a couple of years ago, oil companies were not even allowed inside. We were in a very different place. Now the UAE, the world’s leading oil and gas producer, is hosting it. And oil and gas companies were playing a large role. And the discussion has shifted. It’s no longer ‘keep it in the ground’ when it comes to oil and gas. It’s how we can still use oil and gas; but in a way that’s consistent with emissions reductions. Many are upset that UAE and its national oil company ADNOC is the host this time. But emblematic of the broader distraction the world’s going through other issues like climate change taking a backseat to more pressing and urgent geopolitical problems.