Saudi oil optics

The release of the March Official Selling Prices begins to illustrate Saudi Arabia's complex and calculated moves in the global oil markets.

After years of trying to figure out the market dynamics of the brave new world with US shale and testing market responses to various signals, it knows that cutting its own production is not the only thing that matters (not to mentioned damaging to its own market share).

In fact, targeting data points that are strongly followed by the markets is more important, even if the signals they give are only superficial.

In March, Saudi Arabia increased its Official Selling Prices, pricing out its usual Asian buyers despite a market that is awash with light crude. However this is important in paving the way for more visible Atlantic Basin crudes (North Sea and West African) to be cleared,

In the first quarter, EIA data also shows that Saudi Arabia exported no barrels to its Motiva refinery in Port Arthur, USA, helping to manage storage levels in the US Gulf Coast and Caribbean, data from which drive global price sentiment.

Over the same time period, Saudi domestic inventory levels appear to have been rising.

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Saudi and Russia dominate gossip columns in run up to June OPEC meeting

As we approach the June OPEC meeting, all eyes on Saudi Arabia and Russia for any clues on the direction they will go on 22nd June. With the sanctions on Iran and imminent collapse of Venezuela, Trump has asked the two power weights to step in to avoid oil prices going any higher. This in itself is ironic as the US has been trying to wean itself off imports and attain energy independence from OPEC, yet it is now openly asking Saudi Arabia to help.

In recent days, both Saudi Arabia and Russia have hinted at wanting to increase production by 300mbopd, although the details remain to be thrashed out- i.e. will it be these two countries shouldering the increase or will it be spread amongst the OPEC members. The path this will take and desire to increase production will be dictated by whether consensus can be reached next week.

On the one hand, keeping a lid of oil prices is important for OPEC to avoid a wave of US production coming onstream with producer hedging. On the other hand, a number of OPEC nations urgently require cash flow from higher oil prices to balance precarious budgets.

If consensus can be reached to increase production, the additional barrels can be met by Saudi Arabia and Russia making up the production but will likely be criticised by other OPEC members of using the opportunity to snatch market share. An alternative would be for the members’ quotas to be renegotiated although this will open up another can of worms. In the case of the latter, it is noted that not all members are in a position to raise production (e.g. Venezuela, Nigeria, Libya which are fraught with domestic difficulties). Finally, OPEC members have been in over compliance so there remains running room to utilise the existing quotas, although this will again be shouldered by Saudi Arabia and Russia.

In the medium and longer term, fundamentals point to a supply shortfall so gradually raising production now will keep prices under control although the path ahead will remain choppy.

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OPEC may extend yet

Saudi Arabia has been working tirelessly behind the scenes and appears to be gaining good momentum with the major actors of OPEC + 1 (i.e. Russia) for extending the OPEC output agreement beyond April 2018. Saudi Arabia and its new ally, Russia, are keenly in favour of maintaining the cuts until June 2018 and several other producers have recently signaled their support for an extension as well.

Iran: Initially one of the tougher partners at the November 2016 pact discussions given its demand to return to pre-sanction production levels, Iran has played along with the creation of the special cap arrangement. Iranian oil minister, Bijan Zanganeh, has indicated that the country “will cooperate with the majority” on any extension proposal.

Iraq: Has publicly been a vocal critic of the current arrangements arguing that it was not exempt from the cuts (like Libya and Nigeria) as it needed funding to fight the war with Islamic State. Iraqi oil minister, Jabbar al Luiebi, has also been critical of the fact that Iraq has not been allowed to use its own numbers for the calculation of the output cut). Up until now, Iraq has been sending mixed signals about whether it would actually agree to any extension. However the Saudi oil minister, Khalid al-Falih, has been working behind the scenes and made a special visit to Baghdad in May before the OPEC meeting to ensure that Iraq would agree to a 9-month timeframe. Saudi’s diplomatic efforts may have paid off as Iraq is now softening its tone and affirming its commitment to the current agreement; in August 2017, Luiebi stated during a visit to Moscow that it would go along with an extension if one is agreed.

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Saudi Arabia - joining the dots: Part 6 - Emergency meeting

Saudi Arabia - joining the dots is a series of blog entries exploring Saudi Arabia's role in the oil markets with a brief look at the history of the royal family and politics that dictate and influence the Kingdom's oil policy.

Part 6 - Emergency meeting

OPEC's traditional strategy has been to cut production to maintain prices, but recent behaviour of the cartel or at least that of its largest member (and swing producer) shows a marked deviation from the strategy.

Saudi Arabia has been a key driver of the protect market share strategy, convincing other OPEC members that a period of low prices would cut US supply and therefore restore the supply-demand dynamics of the market. However, Al-Naimi's stance of keeping to this strategy "even if prices hit USD20 a barrel" (December 2014) has scared the other OPEC members, who do not have the deep pockets to keep their countries afloat.

Nine months into the oil price decline, many of the members are feeling the pressure with fiscal reserves running low. Saudi Arabia and its Gulf neighbours are the exception with their vast monetary reserves, but with large social spending programmes, these countries are now running deficits and chipping away at those reserves.

Discussions between the various OPEC members on the next course of action are ongoing with the next meeting scheduled for June 2015. However, in February 2015, Ms Alison-Madueke, president of OPEC said in an interview with the FT that if the oil price "slips any further, it is highly likely that I will have to call an extraordinary meeting of OPEC in the next six weeks or so". Extraordinary meetings have to be agreed upon by all 12 members.

Ms Alison-Madueke also admitted that "When you cede market share continuously, you drive yourself into oblivion...many OPEC members are going to suffer greatly from a a drastic fall in the price". There-in lies the dilemma - the OPEC members' problem lies in the deeply rooted dependence on oil revenues and large social programmes; cutting production risks further loss of oil revenue, while maintaining production keeps the oil price low...and no-one wants to be first mover. Huge structural reforms are needed but these will not be easy, especially in the aftermath of the Arab Spring and will likely take many decades to achieve.

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Saudi Arabia - joining the dots: Part 5 - Breakeven, OPEC's downfall

Saudi Arabia - joining the dots is a series of blog entries exploring Saudi Arabia's role in the oil markets with a brief look at the history of the royal family and politics that dictate and influence the Kingdom's oil policy.

Part 5 - Breakeven, OPEC's downfall

The above chart, taken from the Wall Street Journal, paints a grim picture.  It shows the oil price required by the various OPEC members to meet their budgets. As of 10 October 2014, Brent was at USD90/bbl; today it is at USD62/bbl. All the OPEC countries are in the red, and some are in a worse position to handle this low oil price environment than others.

Saudi Arabia, for now, will be able to survive. Others are crying in pain - Venezuela, Iran and as of late, Nigeria as it enters into a period of elections with campaigns funded by oil money and the corrupt paid off with oil money. As an interesting aside, Iran (a Shiite power) blames its neighbour and rival, the Sunni Kingdom of Saudi Arabia for using the oil prices as a political weapon and keeping prices low by refusing to cut production.

After years of high oil prices, Saudi Arabia has managed to amass over USD750bn in reserves. However, it also has a large social programme and a high youth unemployment rate; keeping its citizens content and off the street has been in the aftermath of the Arab Spring. Following the ousting of Egypt's Hosni Mubarak, King Abdullah implemented $130bn in new social programmes including unemployment payments, housing and scholarships for Saudi's to study abroad. 

Most worryingly, Saudi Arabia tends to outspend its budget and the Kingdom will need to run a deficit in a USD50-60/bbl oil price environment.

Saudi Arabia has issued a record budget of USD229bn for 2015, with a 5% deficit forecast. The split is as follows: 25% education, 19% health and social, 7% transport and infrastructure, 7% water and agriculture, 5% municipal and 36% "other priorities". Other priorities is largely composed of military spend, which is of increasing importance with the ongoing ISIS conflict in the region.

Al-Naimi's policy has been to defend market share, to the annoyance of King Salman, at the expense of allowing oil prices to fall. However, with oil prices at their current low levels, Saudi Arabia is chipping away at its massive monetary reserves with an over-inflated and hard to cut back spending programme. This policy (or Al-Naimi) may need to be changed in the absence of an oil price rebound in 2015.

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Saudi Arabia - joining the dots: Part 4 - The price wars, defending market share

Saudi Arabia - joining the dots is a series of blog entries exploring Saudi Arabia's role in the oil markets with a brief look at the history of the royal family and politics that dictate and influence the Kingdom's oil policy.

Part 4 - The price wars, defending market share

The sudden fall in the oil price in the middle of 2014 and the subsequent lack of response by OPEC is a stark reminder of its members' policy of defending market share, although the cartel may openly deny it .

Forgotten in recent years and beyond recollection for those who are still young, the 1980s was the last time Saudi Arabia demonstrated its significant power in the oil markets in its efforts to defend market share. In hindsight, one questions whether Saudi emerged victorious from that war and whether it was worth fighting.

In the early 1980s, oil prices fell to record lows after hitting highs in the 1970s. Consumers (namely the US) vowed to reduce reliance of on oil given the high prices and actively implemented policy to switch to substitute energy sources, such as coal for power generation. 

In an effort to shore up oil prices caused by falling demand, Saudi urged its fellow OPEC members to cut production. Saudi cut its own production by c.80% to 3.5mmbbl/d, but many of the other members refused to follow suit. Saudi was furious as by taking action, it had lost out on revenue and market share. In retaliation to the non-compliers, Saudi ramped up production to full capacity and flooded the market with crude. The excess production caused oil prices to slump to c.USD7/bbl and it was another 20 years, before oil price began to recover to pre 1980 levels.

That part of history continues to haunt Saudi today and one can see its remnants in Saudi's stern policy of maintaining production, communicated to the world in that all important OPEC meeting on 27 November 2014.

Luckily for Saudi, and other OPEC members, its low cost of production (<USD20/bbl) means that production remains profitable even at USD50/bbl oil price. The current price war will see much production around the world being choked with high cost North American unconventionals and mature North Sea production being hurt.

Whether Saudi still holds (or wishes to hold) its nominated role of swing producer is a key question to ask. For now, it still has the ability to retrench production, but its low cost production base will mean it can withstand lower oil prices for longer whereas its non-OPEC counterparts will fall over one-by-one unless prices rebound in the near future.

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