Geopolitical risk fatigue?

Richard S (00:15.982)
Hello listeners and welcome to the Monter Weekly Podcast, bringing you energy matters in an informal setting. In today's episode, we will turn our attention to geopolitics and the worrying military escalation in the Middle East. What are the chances of the USA or the West and Iran being dragged into a wider conflict? And what would this mean not only for energy produced in the region, but also for shipments of LNG through the Red Sea?

Global markets have so far been relatively sanguine about the impact on energy, but that could change and change quickly. Helping me, Richard Sverson, to discuss this and much more, is Saul Kavanich. Helping me, Richard Sverson, to discuss this and much more, is Saul Kavanich, senior research analyst. Helping me, Richard Sverson, to discuss this and much more, is Saul Kavanich, senior research analyst.

of MST Financial. A warm welcome to you all.

Saul Kavonic (01:14.95)
Thank you, Richard. Pleasure to be with you here.

Richard S (01:17.23)
Perfect. I mean, let's just talk more generally first of all. I think what are your expectations of the conflict in the Middle East? Do you think there is a very good chance that there could be a wider escalation that the US and Iran could be brought in?

Saul Kavonic (01:33.126)
Well, I think it's clear that experts on kind of the military situation in the intelligence community and in politics in the Middle East are far more concerned about a conflagration of the conflict here to essentially more directly draw in Iran and engulf the Strait of Hormuz than markets are. As you mentioned, we're not really seeing the size of a risk premium.

being reflected in oil or LNG as a result of these kind of incremental escalating steps that we're seeing in the Middle East. And a lot of that has to do with geopolitical risk fatigue setting in, particularly in financial markets. After last year, so many headlines, so much theoretical risk about supply disruptions coming from Russia in the wake of the Ukraine war, which then didn't materialize.

And now we're seeing markets really very much saying, until we actually see supply disrupted, or at least there's a very imminent risk of supply being disrupted, we're not really going to factor that into pricing. And the problem with that is it's going to leave the market all the worse prepared if a supply disruption does actually eventuate.

Richard S (02:55.182)
So there's a lot of sort of crying wolf happening here then, so what do you say?

Saul Kavonic (02:59.526)
Well, there's been a cry wolf particularly over the last couple of years.

But again, I think when equity markets, financial markets, they're not experts in geopolitics, right? And that's why they tend to have short memories. The trade last year and the year before in this regard didn't play out, right? So actually you've had short positions being the winners over the last six months. And that's what...

Financial markets, remember, and if it worked well for you last time, you tend to keep going with it this time around. Now, I think there's this very clear disjunct between the views of financial markets and the views of experts, intelligence and military and politics in the Middle East. I mean, ultimately, that's a cousin that has to be crossed at some point. And unfortunately, it can happen via a shock. Now,

I think it's important to say, you know, the risk here is really centered on two things and a low level risk to supply is about do we start to finally see tightened sanctions on Iranian output? And that can start to tighten up the market, perhaps 1%, which is manageable. But the real risk is if the conflict widens to the point that the Strait of Hormuz is impacted. So unlike our Red Sea situation where the

we've seen, you know, and again, even that's a situation where the risk has been under reported. I mean, there's been some of these are Huthy fighters been firing RPGs and oil and gas tankers all the way back in December. Right. Again, it's a risk that's been under reported and underappreciated. But even here in the worst case scenario where you're starting to see all the cargo ships being diverted, it's ultimately just a logistical inefficiency. Supply isn't reduced as a result of this.

Richard S (04:42.318)
Mmm.

Saul Kavonic (04:58.374)
But if this conflict moves to the straight of from was it's completely different. There is not going to be any other market route for most of those volumes. And we're talking about 20 % of global oil supply and 20 % of LNG supply require passage through that straight. And the impact, if that is disrupted, is going to be up to three times the size of the market shocks we saw in the 1970s from conflict in the Middle East. So you may recall back then, we're in the wake of the Iranian revolution and the Arab oil embargo.

That saw about 8 % of global oil supply disrupted and LNG was still in its infancy then, so that wasn't really disrupted at all. But now we're talking about something that could be three times that size and up to around 20%. And what would make it worse is gas and oil will be disrupted at the same time. So the natural substitution effects aren't going to be there. And it's coming on top of what is fundamentally a more stretched and fragile market in the wake of the withdrawal of Russian gas supply last year.

So we're talking about, I think, in that extreme scenario, we're talking about $200 oil and $50 to $100 LNG returning again. Now, that, I think, is still a possibility rather than a probability. But this is a possibility that is growing in likelihood every single day since October the 7th. And if you want to do some quick kind of

Richard S (06:12.814)
Hmm.

Richard S (06:18.094)
Mm -hmm. Mm.

Saul Kavonic (06:24.774)
back of the envelope maths and say, well, if the odds of this happening is 20 % and I don't think it's closer to 20 % than 2%, which is what financial markets are giving it. But you say there's a hundred dollar upside to oil in that scenario. Well, then you do the math. You say there should be a $20 premium on oil and we can do the same math for LNG. And the reality is we're not seeing anything close to that. And that's why that as a result, the market will not be preparing with the kind of demand side responses and so on.

Richard S (06:33.134)
Hmm.

Richard S (06:41.87)
Mm.

Richard S (06:46.22)
Hmm.

Saul Kavonic (06:52.678)
to deal with that disruption in a lead up to any kind of supply impact. So I think it's still, again, while it's still a possibility, it is a greatly underappreciated possibility. And you're starting to see, I think, some in the financial markets, people are waking up to this, particularly over the last couple of weeks when we've seen some of the escalations and, you know, most recently with the attack, which has tragically killed some US servicemen.

Richard S (07:15.79)
Yeah.

Saul Kavonic (07:22.278)
in Jordan, that short trade over the last six months is starting to become a bit more precarious. And maybe it's not so wise to be short at this point. You're starting to see some look to neutralize that position because it's becoming quite hard to take a naked short here, given you have this low probability but very outsized outcome in the event that this conflict grows. And again, this is the kind of situation where

Richard S (07:28.974)
Hmm.

Richard S (07:43.502)
Hmm.

Saul Kavonic (07:51.334)
it escalates slowly and then happens very quickly if it does happen. And so there won't be a lot of times in this to prepare if it does come to the worst.

Richard S (07:54.606)
Hmm. Hmm.

Richard S (08:00.43)
I mean, the involvement of oil here. I mean, you know, we had the energy crisis in Europe and before, during and after the Russian invasion of Ukraine. But now, if you're looking at global oil and LNG supply being so greatly disrupted, that basically dwarfs what we saw in 2022. Does it not, Saul?

Saul Kavonic (08:21.574)
Very much so. So I think I talked about on the oil side how it could be up to three times the size of what we saw in the oil price shocks of the 70s. But on the gas size, it could be up to about double the impact that we've seen. We saw from the withdrawal of Russian supply into Europe in 2022. And it's made all the worse because that supply is still withdrawn. I mean, so obviously global markets are in a better place right now, particularly in Europe where tremendous credit to many

European governments and in industry for the level of demand reduction that they've managed to sustainably achieve. But we can't kid ourselves, a lot of it's also been quite lucky with weather over the last two winters and it's still quite a fragile system. And also people forget very lucky that the demand growth in Asia and particularly China did not materialize to the extent that was originally anticipated. But the system we have now is much more stretched.

there's far less redundancy available. So if we do get one more big shock, all the redundancy that was there to take advantage of the low hanging fruit and the easy levers to pull, all those levers have already been pulled in the wake of 2022. And we're not going to have many levers left if we start to see another impact of the same magnitude occur over the next 12 months.

Richard S (09:44.398)
So, to understand you correctly, Saul, you're saying there's a huge level of complacency here, you know, especially perhaps in Europe, we've had the mild winters, but we've got also full storage facilities. People think, okay, the energy crisis, we're hearing executives of big energy companies, both oil and gas and others saying, oh, the energy crisis is over. I mean, would you agree?

Saul Kavonic (10:07.846)
Well, it's the calm before the storm or perhaps, for those of us in cyclone prone areas, we're in the eye of the storm. We've had the first wave come through and then you get complacent and go out, but you're not aware that you actually haven't finished coming out of that storm. I think that is very much the case. And again, there's been an awful lot of strong effort and policy to get to the better position we're in now, but also a lot of luck.

Right. And luck can turn the other way too, particularly when it comes to Chinese demand, the weather and so on over the next 24 months. Keeping in we're not seeing a lot of new LNG supplier for at least the next couple of years. It does start the waves to does start to come in after that. So it's still structurally a tight position. Storage can't go above 100 % in effect. So we can't build up too much redundancy in there. And so we have got through the last winter. We are in a much better place now, but

This could all end up quite bad in 12 months time again, right? And even if we look today, as a result of what we're seeing in the Red Sea, right? As a result, we're seeing Qatari volumes are being diverted to the Far East instead of heading into Europe. And that's fine for now because Europe has good storage, but it is going to potentially eat into that storage now at a faster rate, which will again lead us to more vulnerable position as we head towards the end of the year, in addition to all the shipping inefficiencies involved.

Richard S (11:36.078)
I just want to touch on a few specifics here and for example, you know, we talked before on this pod and elsewhere about the gas projects off the coast of Israel from the Leviathan field. Do you think this will be developed in the aftermath of the war?

Saul Kavonic (11:54.246)
I do. Look, give it a bit of time, right? But I mean, what we've got there is obviously this Israeli gas is a lot of it's going to go to domestic demand. They've contracted some to neighbors, but there's a good story to show that there can be 10, 15 million tons per annum of additional capacity, which I think is ultimately should end up going through Egypt. FLNG is going to be much more economically challenging.

Richard S (11:58.318)
Mm -mm.

Saul Kavonic (12:22.182)
in addition to the security threats it would face. You know, we'd expect that the that increase in capacity is not something that's going to be actively talked about at the moment. But give it 12 months and 18 months to pass. It ultimately should find that home. It's worth keeping in mind that, you know, despite a lot of the rhetoric that we're seeing publicly, there's still a level of cooperation that's going on between many Arab states and Israel.

Um, you would have seen, uh, this news recently, for example, that the Saudis have, uh, uh, developed a land corridor with Israel to use Israeli ports to actually bypass, um, some of the impact in the Red Sea. So that's actually, you know, bringing on the way Saudi and Israel closer together, which is opposite to the intent of the Iranian -backed Houthis. So there's going to be scope for those deals, but the, the, we're going to have to see, um, the conflict in Gaza.

subside probably before we can start to see progress on those fronts.

Richard S (13:25.454)
And how about the Suez Canal? Should the LNG industry, the oil industry ready themselves for a long -term closure of the Suez Canal?

Saul Kavonic (13:43.43)
Well, obviously hard to make an assessment on that, but let's just put bookends on the scenarios and let's look at the worst case scenario where this is a prolonged issue. And I'm just going to talk from the gas perspective and oil perspective rather than other trade of goods where there's a more acute issues. It's fundamentally not a structural problem. Right. So again, supply is not impacted. It does mean you're going to have increased logistics costs. It means you're going to have more floating storage, but

given where we are in the markets and in particularly with Europe with gas, we can readily absorb that for now. So I don't think we need to worry about that per se. There's going to be some softer -florn effects though, right? I think we're going to start to see the industry realize it needs to factor more redundancy into its logistical supply chains, which should be a good thing for shipping companies, for example. But I think we're also seeing...

And it's not just a result of this, but also, for example, recent decisions by the Biden administration and some other key supply points. We're starting to see Asian buyers and we do need to keep in mind for LNG, Asia is still the center of the world. I know the big focus has obviously been on Europe for the last two years, but Asia is actually the main driver here. For them, their security of LNG supply is a national security issue. It's very hard to understand if you're not in Asia exactly how acutely

worried we're seeing key trading partners, particularly Japan, Korea, China, Singapore, who are worried about the energy security because they're starting to see what they thought were very reliable, taken for granted supply sources now have risks put around them. And that's where it's flowing to. So when you see this this issue in the Red Sea, it's not say, well, that could spread. What happens if other waterways are impacted? And you're seeing Australia, for example, where I am at the moment,

who's introduced policies over the last 18 months, which have started to make it more, seen as a less reliable supplier of LNG, both on the approvals front for new projects, but even being able to continue to sustain its existing commitments from existing projects. And now we've seen the decision by the Biden administration to pause all the approvals. They're getting a lot more worried and having to factor in a lot more redundancy and consideration of diversity of supply sources into their LNG procurement strategies.

Saul Kavonic (16:06.278)
And that is a very live conversation right, particularly in the wake of the US decision to pause approvals. And it's going to be, I think we're going to see more emphasis placed by the big buyers in Asia on securing long term contracts and making sure that they can offset some of the risk that you get from some of these policy dynamics.

to the extent that they can. And that's why you've seen, and it started in 2022, we saw, and I'm talking about big LNG buyers like Jira, who for the last decade had moved towards saying less long -term security supply contracts, more flexibility, more spot volumes, a more diversified portfolio of that mix.

They've had to very quickly turn that entire theory on a TED and go back to, no, we need a secure supply. We need to go back to looking at equity in projects, which is exceptionally hard to find actually in equity and LNG projects anywhere in the world. I can think of only two in the entire Pacific basin, both in Australia and one's Woodside Scarborough project and the other one's quite small and probably not all that reliable. And so they've had to turn 10 years of strategic planning on a TED in the face of six months.

Richard S (17:09.518)
Hmm.

Saul Kavonic (17:23.386)
But in the meantime, we've seen China and European buyers jump to read the tea leaves early, jump in quickly and secure a lot of the cheap, easy volumes that were available. And you're seeing the likes of Japan, I think a bit on the back foot here. And they ultimately going to have to come to the table and sign long term contracts to underpin that next wave of supply, even if it's a more expensive wave.

Richard S (17:30.924)
Hmm.

Richard S (17:42.862)
That's very interesting. So I think what you're mentioning there about the Biden pause on new LNG projects, of course, we've got an election coming up later this year in the US. Now, what could a return of the Trump administration then mean for global geopolitics and especially in relation to what we're talking here about LNG?

Saul Kavonic (18:07.878)
Well, I mean, just to touch on that decision was really about it's the decision aside, which ultimately it's going to just delay up to 70 million tons per annum of supply capacity, which was only going to really come alive from 2028. Many in the industry think 2028 is going to be quite weak anyway. So the market can probably absorb a one year delay there. But what's more important is the damage is sort of being done now, right? Because it's highlighting the increasing influence that green activists are having.

even on quite centrist governments around the world, and even on ones with very strong commitments to property rights and so on like the United States. And this idea that the US is going to be this bottomless kind of pit of LNG was already being questioned by buyers. And there was always concern that if there'd be a shortage in the US that the contracts internationally could be at risk. And now it's started, this is, you know, contributing and exacerbating those fears.

And the problem buyers are having is geopolitical risk is rising everywhere. Again, coming from an Australian perspective, Australia's kind of shot itself in its foot under its reputation as a reliable supplier over the last 18 months. But thanks to what's happening in the United States now and a few other places, Australia's all of a sudden not being seen as a high risk it was 12 months ago. It's not because we're getting much better, we're getting a little bit better, but it's just because relatively we're not getting much worse. But to come to your question on Trump,

I think we need to look at perhaps a couple of lenses. So the first one is obviously what will happen in Ukraine and the signals that a Trump administration could essentially reduce support for Ukraine and try and find an accommodation with Russia. Now, on the one hand, if we consider that scenario, we might think that could result in a resumption of Russian gas supply into Europe, which given the amount of demand reduction, demand destruction that's happened could flood the market.

But I think that would be a very kind of premature position to take because on the other hand, it's still quite likely that the European Union is going to support Ukraine to some degree, which then leads into question about whether Russian volumes return. But even if Russia was to look to return volumes, I think there's a real doubt that the European Union is going to take it unless it's actually an emergency. I think their issue is with Putin and

Richard S (20:28.302)
Hmm.

Saul Kavonic (20:37.254)
that to the extent they can, they're not going to take those volumes even if they do return. And if the market stays in its more manageable state that it is now, there won't be an imperative to. The other part we need to look at is obviously to the extent that Ukraine does start to lose some of the support it's getting from the West, the United States in particular, does that start to see Ukraine incentivized to engage in more direct attacks on Russia's energy infrastructure?

which up until recently was something they'd held back from doing. And that's another risk, which again, incidents just in the last week or so suggesting that that's a risk that is rising as well. That's the Europe part of the equation. Then we come to the Middle East. You know, look, I'd be cautious to preempt anything that the Trump administration might do there, but it does sound like it might potentially take a much harder line against Iran. And I think Trump is on record.

in the last week talking about how he's much tougher on sanctions. It's clear that the Biden administration have been willing to, or at least kind of turn the blind eye towards the increased production out of Iran, have not been choosing to be very, you know, enforcing sanctions in a very tough way. But if the Trump administration was to come back, you might expect that they toughen those sanctions up. So that's where we can get.

a million barrels a day coming out of the market. But then it does bring you back to that scenario of are we in a world where we're going to see essentially the Middle East situation, conflict get worse before it gets better? Hard to say. But I think the risk profile at that point, your bookend scenarios start to get pretty wide as we head towards the end of this year.

Richard S (22:29.902)
But I think one thing is clear then, the competition for LNG between European buyers and Asian buyers is only going to get more intense over the coming year or two, and then in the three to five year horizon here.

Saul Kavonic (22:46.246)
That's right. And the truth is we haven't seen proper competition between Asia and Europe yet to the extent that it could happen. Now, much going to depend on the demand profile. Demand has been a lot more sluggish, but if that picks up, so we start to see some real competition or if we get another big supply disruption, for example, from the Strait of Homes, where we get severe supply competition, the next wave of supply competition is going to be different to what we saw in 2022. So remember in 2022 when

Russian supply was cut and you had a lot of European and particularly German government support to rebuild reserves very quickly. The biggest losers out of that was not Europe. It was South Asia. It was the price sensitive LNG buyers who got bit out of the market. And unlike many nations in Europe and Northeast Asia, these are more price sensitive buyers and they just can't afford it. And so...

energy security suffers and carbon emissions suffer because they churn up more coal to the extent that they can. And we saw particular reductions, India, Pakistan, Bangladesh. Now, a lot of that demand reduction is still there. Right. So there's still an energy poverty issue in South Asia in the wake of the Ukraine war and Europe's drive for energy security to be all those volumes away. But.

The problem is, is because that energy probably is already there, the next level of demand destruction is likely to not be in those price sensitive markets in South Asia. It's now going to be in the much more high paying markets of Northeast Asia and Europe. And so when it comes to, for example, Japan and Korea, the lights don't go off in Japan and Korea like they might go off in India. And if it gets to the point where you have a bidding war,

between Japan and Germany to keep the lights on, I shudder to think how high prices could go. We need to acknowledge, I think we're still talking about, again, the realms of possibility in terms of events getting to this point rather than probability. But we haven't seen that yet. And if we do see it, it will be quite extreme. And I think it could retest the highs of the market that we saw in 22, certainly on a sustained basis. We obviously had some spikes for a couple of months, but over the course of kind of a six plus month period.

Richard S (24:54.86)
and

Saul Kavonic (25:14.054)
But even that aside, I think just with incremental demand growth, we're going to see increased competition. And the issue of gas storage is going to become a more pressing issue because ultimately, Asia doesn't have much gas storage. And so we have this kind of finger pointing game going where Europe has a lot of storage. And so Europe sees Asia's free riding on European storage. And you can almost see that to a degree now that the ships are heading east and not going through the Red Sea.

But I think Asia looks at it very differently where they're the ones who underpin the LNG market. And now Europe's pulling away their energy security because of mistakes they've made geopolitically with their pipeline, I guess. And, you know, as much as the finger pointing is not helpful, it's that is reflective of how both sides of the Atlantic and the Pacific divide here see this as such an important issue and such a big problem, which again is something very underappreciated.

from most markets who are not solely dependent on imports. And that's, you know, the United States does not have an appreciation for this. Australia, where I am, does not have an appreciation. And I dare say Europe's going to have an appreciation since the Ukraine war. But even then, imports are just a part of your mix. If you're in Japan, it's 100 % imports. There's no domestic anything, right? And I think most of us who are not in that situation don't fully appreciate.

Richard S (26:30.542)
Mm. Mm.

Saul Kavonic (26:41.092)
how sensitive this issue is.

Richard S (26:43.278)
So I could continue talking for hours, but in the interest of time, we have to cut it short a bit now. But just a final question. I think what we've seen in the Red Sea, what we've seen in the Baltic, especially in terms of energy infrastructure, do you think energy infrastructure is, has it highlighted the vulnerability of pipelines, of vessels that really incidents are on the increase?

that people should be very aware of this.

Saul Kavonic (27:17.574)
It has highlighted it. I do fear it's probably still not highlighted enough. We've talked a lot about the challenges and problems. I think it's worth reflecting that there's been some good outcomes of this as well. Clearly, there's been a renewed impetus to increase the pace of substitutes, particularly greener substitutes of energy on that front. Although we've got to be really careful there. We've seen terms like

hydrogen compatible power. That's just the code for gas, right? It's just, you know, we need to acknowledge what, you know, that the reliance on fossil fuels at the end, we can color it up in language and future plans as much as we like, but that's what's happening. But, you know, there has been obviously great pace, particularly in Europe on that front to diversify away. But I think we're particularly at a global level really underestimating how reliant we're going to be.

particularly on gas and seaborne LNG over the next two decades and not just the next five years. And there's a level of complacency across the entire market about it, notwithstanding all of the headlines and all the shocks we've had over the last two years. And there's still no clear plan in place for how to avoid another shock like this in the future. So whether, for example, Australia does get impacted this year or in five years or in 10 years, are we really going to be any better prepared for the next?

Ukraine like situation on gas. And so far, the answer is no.

Richard S (28:50.67)
So, worrying prospect, but thank you very much for being a guest on the Montel Weekly Podcast.

Saul Kavonic (28:57.51)
Thank you, Richard. It's been a pleasure.