Oil Markets Blow Yemen Crisis Out of Proportion

March 26, 2015 2:38 PM EDT

Saudi Arabia launched airstrikes in Yemen, causing oil prices to jump on fears over Middle East instability.

The markets clearly reacted with concern over the rising violence in the Arabian Peninsula, which pits Saudi Arabia against Iran in a proxy war. Saudi Arabia is targeting Shia rebels seeking to topple the Saudi-backed Yemeni government. Reuters reports that Saudi bombs targeted an airport and airbase held by the Houthis, which seized Yemen’s capital of Sanaa last September.

“We will do whatever it takes in order to protect the legitimate government of Yemen from falling,” Adel al-Jubeir, the Saudi ambassador to the United States, said in Washington DC. A Saudi official told Reuters that a “land offensive might be needed to restore order.”

The conflict involves a convoluted set of regional rivalries. The U.S. is supporting Saudi Arabia with “logistical and intelligence support.” Iran has denounced Saudi Arabia’s attack. The United Arab Emirates has denounced Iranian influence in the region. Meanwhile the U.S. and Iran find themselves on the same side with their attacks on ISIS in Iraq, although their campaigns are not coordinated.

The overnight surprise attack by Saudi Arabia caused oil prices to spike. WTI has surged over $50 for the first time in several weeks. Oil prices are now up 13 percent in the last week alone. The surge comes amid growing concerns of oil overflowing storage tanks in the U.S. and around the world, which threaten a new round of weakness in oil prices.

But oil markets have a tendency of becoming swept up by unforeseen geopolitical events. Oil traders are apparently concerned about Yemen’s instability sucking in one of the world’s largest oil producers.

However, the markets are overreacting. Yemen is a negligent oil producer, and any disruption to its output would hardly be noticed on the global market. Not only does Yemen produce very little oil, but its production has been declining for much of the last 15 years. Yemen is now producing less than 150,000 barrels of oil per day, or around one-twentieth of what the state of Texas produces each day.

Not only that, but Yemen has been rife with conflict for quite some time. There were somewhere between 10 and 24 major attacks on oil and natural gas pipelines in Yemen in 2013. The Houthis seized control of much of Sanaa months ago in what has been labeled a “half-coup.” Violence at the bottom of the Arabian Peninsula is not new.

Perhaps the markets are concerned over Yemen’s strategic location? Yemen is a neighbor to the most important oil producer in the world, and is also located along the oil trading chokepoint of Bab el Mandeb, a sliver of water that connects the Red Sea to the Gulf of Aden. In other words, it connects oil tankers from the Mediterranean to the Indian Ocean. An estimated 3.8 million barrels of oil travel through these narrow straits each day.

While, in theory, violence could lead to a supply disruption at the 18-mile wide strait, that is highly unlikely to happen. After all, the U.S. Navy routinely patrols the region. Moreover, Houthi rebels do not exactly have a strong maritime presence. The violence will likely remain onshore.

That means that after the initial shock of Saudi Arabia’s attack wears off, oil prices will likely pare back their gains as traders focus on the fundamentals that have kept them up at night in recent weeks. Crude oil storage at Cushing is three-quarters full. China’s strategic petroleum reserve is nearly full. U.S. refineries are temporarily closing for Spring maintenance. All of these things will push the price of oil back down. That has to be weighed against falling rig counts and perhaps the beginning of oil production declines in several key shale areas in the United States.

The violence in Yemen is very much a serious geopolitical and humanitarian concern, but unless the conflict between Saudi Arabia and Iran transforms from a proxy war into a broader and more direct military clash, there is little justification for oil markets to be so rattled.

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