By Matein Khalid: Chief Investment Officer and Partner at Asas Capital
It is impossible to analyze the real time dynamics of the global oil market without a grasp of the myriad domestic/regional economic, diplomatic and national security dilemmas that govern the formulation of Saudi Arabia’s oil pricing strategy. Saudi Arabia owns the highest proven reserves in OPEC, is its leading exporter, controls its largest space capacity and has its lowest oil extraction costs. A founding member of OPEC, Saudi Arabia has played the role of the oil cartel’s primary powerbroker ever since the end of the October 1973 war and the OPEC petrodollar bonanza in the reign of King Faisal, whose protégé Oil Minister Sheikh Ahmed Zaki Yamani, was the first global media icon of Arab oil.
There are natural tradeoffs and even contradictions in Saudi oil pricing and production strategy. Keeping oil prices low helps Saudi Arabia preserve its downstream market share, boost economic growth in key allies such as Britain, France, the EU, Japan and China and restrain Iranian subversion in the wider Middle East. However, at a time when the kingdom currently runs a budget deficit (“deficit set to fall to SAR 131 billion in 2019” KPMG), it has embarked on ambitious socio-economic transformation embodied in Vision 2030, relies on “riyal politik” to assist close regional allies (Egypt, Bahrain, Morocco, Jordan and Pakistan), and has a natural incentive to maximize the value of its only significant natural resource – 260 billion barrels of proven oil reserves.
The meteoric growth of US shale oil output and the imminent floatation of a stake in Saudi Aramco, the world’s largest oil company, necessitates the kingdom averts another catastrophic oil price crash, as happened in 2014-15. Saudi Arabia also needs to coordinate with Russia in its global oil diplomacy. In fact, a Saudi-Russian entente to coordinate output cuts enabled oil prices to recover from a meltdown below $30 a barrel in early 2016.
Above all, as recent events in Algeria, Yemen and Sudan demonstrate, Saudi Arabia is implementing economic reform at a time of epic political violence and social unrest across the Arab world. Security, not economics alone, dictates Saudi Arabian oil diplomacy at the highest nexus of world politics. Saudi Arabia simply cannot be seen as the catalyst of a “gasoline price shock” that could cost President Trump reelection in 2020.
After all, the US Navy’s aircraft carriers and missile boats maintain the balance of power in the Gulf, as demonstrated by the deployment of the USS Abraham Lincoln, with its squadrons of F-18 Hornets and its Tomahawk missile batteries to the Gulf. This constraint alone suggests Brent crude above $75 a barrel will be met with an increase in Saudi output to nudge down prices.
Saudi Arabia’s national interest also dictates that it raises output to supply Asian countries dependent on of Iranian oil imports, which the Trump White House has pledged to strangle with draconian sanctions. This is another factor that amplifies divisions in OPEC between Saudi Arabia, Iran, Iraq and other price hawks desperate for higher petrocurrency revenues.
Oil prices have plunged 20% since early May 2019 after US-China trade talks collapsed and US crude inventories rose 22 million barrels to 1990 highs. This steep fall in oil prices forces Saudi Arabia to fine-tune its 1.2 million barrels output cut pact negotiated with OPEC and non-OPEC exporters led by Russia. Russia has actually increased tanker shipments from its Baltic/Black Sea oil ports in order to offset contamination in Gazprom gas pipelines to its German Benelux and Italian clients in the EU.
This means Saudi Arabia and its GCC allies Kuwait and UAE will bear a disproportionate share of any future cuts negotiated at the 176th OPEC ministerial meeting in Vienna, set for June 25, though a date postponement is being negotiated. Yet, Saudi Arabia will be reluctant to inflict a “shock and awe” output cut at Vienna, since Chinese GDP growth has slumped to 6.2% and Indian GDP growth is a mere 5.8%. The risk of a decline in global petroleum demand in late 2019 is all too real. It is entirely possible that G-20 head of states will request the Saudi Crown Prince to accept lower oil prices to boost global economic growth even as China’s PBOC, the US Federal Reserve and the EU’s ECB ease monetary policy in unison. This is exactly what happened in the Shanghai summit in 2016 after contagion from China led to stock market panic selling in Wall Street, Europe and Japan.
The recent declines in King Dollar suggests the financial markets are pricing in this exact geopolitical/reflationary scenario. This is the reason oil prices have fallen in a swift, brutal bear market in May despite sanctions/supply outages in Iran, Venezuela, Libya, Nigeria and Russia. As US shale oil output scales up to 12 million bpd and climate change/clean energy becomes the mantra of the world’s biggest industrial constellations, Saudi policymakers know an oil price spiral to $75 – $80 is simply untenable.
Vision 2030 and the Kingdom’s opening to global investors means the Saudi economy is at a historic inflection point. While the IMF calculates the kingdom’s budget breakeven price is $80 Brent, international relations and the realities of Saudi-US relations dictate that Riyadh will not countenance such a high price level amid a supply glut and mediocre petroleum demand growth worldwide. With about SAR1.1 trillion in public spending planned in the 2019 State Budget, Saudi Arabia will be forced to boost taxes/tolls, attract foreign capital and float Eurobonds in the global capital markets. I envisage Brent crude will trade in a $50 – $65 range after the world’s captains and kings meet at the G-20 conclave in Osaka, Japan. The recent mine damage to Norwegian and Japanese oil tankers in the Gulf of Oman injects a new dimension of geopolitical risk in oil prices – yet unlike 1973, 1979 and 1990, a supply glut will abort a bullish oil shock and price spiral.