The End of an Epoch: Saudi Arabia, sailing into the perfect storm

Blue Quadrant Research Team
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Market Commentary

US oil production has recovered notably since bottoming in September 2016 at an average daily production rate of 8.5mn barrels per day (bpd). US oil production (excluding Natural Gas Liquids or NGLs) is now averaging around 9mn bpd, although still below its cyclical peak recorded in early 2015 at around 9.5mn bpd. Nevertheless, the rapid recovery in output in just six months coupled with the sharper rebound in the oil rig count (Baker Hughes data) as illustrated below, suggests that US oil production will continue to climb throughout 2017 and may eventually exceed its former cyclical production peak of 9.5mn bpd.

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Although the rig count remains well below its 2015 peak, improved efficiencies and cost reductions now means that fewer rigs will likely be needed in order for US oil production to reach and exceed its former production peak of 9.5mn bpd. Furthermore, significant cost reductions (well completion costs have on average declined by roughly 50% over the past 5 years in many shale basins) have enabled many US energy producers to return to profitability at current prices of around $50 per barrel. In fact, in some of the more prolific basins (Permian basin in Texas) some energy companies are now able to produce oil profitably at $40 per barrel.

The further rebound in US oil production expected this year comes against the backdrop of declining non-OPEC, non-US production growth and continued curbs in production by OPEC. The resilience in the US shale industry will be particularly alarming for many countries in the Middle East, and in particular those that continue to peg their currencies to the US Dollar, such as Saudi Arabia. As the largest producer within OPEC, Saudi Arabia has had to bear the brunt of the recent decision to curb production, and no doubt without Saudi Arabia’s commitment and discipline, OPEC’s ability to engineer and sustain any type of coordinated production cut would be impossible.

As such, the key question investors need to ask themselves is whether Saudi Arabia can afford to sustain a reduced level of production or a “new normal” for oil prices below $60 per barrel. More marginal oil producing areas (such as deepwater offshore and Canadian oil sands) will generally require oil prices above $60, and one can assume that below that price level, non-OPEC, non-US production growth will remain flat or even decline modestly. Assuming normal global demand growth of around 1.2mn to 1.4mn bpd, this will probably leave sufficient “space” for OPEC to return to production levels preceding the recent decision taken in November 2016 to cut output by 1.2mn bpd, and for US oil production to return to or even exceed the prior production peak of 9.5mn bpd, without forcing oil prices back below $40 per barrel.

But, is $60 a sufficient long-term price for Saudi Arabia, assuming that rising US production growth will limit the ability of Saudi Arabia (and other major producers) to substantially increase their own production? As illustrated below, as a result of growing internal consumption, despite some production growth, the actual volume of Saudi Arabian oil exports have remained little changed over the past three decades.

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Saudi Arabian oil exports briefly rose to 8mn bpd in 2015 and H1 2016, as the Kingdom sought to maintain “market share” and temporarily depress prices in a bid to eliminate many US shale producers. This strategy did result in a decline in US oil production of roughly 1mn bpd, but given the evolving recovery in US production, it is certainly possible that Saudi Arabia could end up in a situation producing and exporting no more than it has over the past three decades (roughly 7mn bpd), while US production continues to grow and exceed its prior production peak.

From this perspective, Saudi Arabia’s strategy of “flooding the oil market” in 2015 can be said to have been met with limited success. The strategy could be viewed as a success in terms of maintaining its relative market share, although this has come mainly at the expense of non-OPEC, non-US producers. As we will highlight in the rest of this article, this is also a strategy that Saudi Arabia can ill afford to repeat again, given its own financial and economic challenges.

Saudi Arabia’s economy has grown significantly over the past few decades. However, it remains a remarkably distorted economy, where as an example, nearly 90% of Saudi nationals are still employed by the large public sector. Saudi Arabia also has a large, youthful and growing population, while youth unemployment rates remain at very high levels. Recent data suggests youth unemployment rates remain around 40%.

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Source: IMF

The Kingdom has been able to maintain a semblance of calm by diverting much of its oil revenues to the public sector and maintaining and growing employment in this manner. As the chart below shows, total employment of Saudi nationals in the public sector has grown from just under 2mn in 2000 to roughly 3mn in 2014.

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Source: IMF

The growth that the Saudi Arabian economy has delivered over the past three decades and concomitant growth in government expenditure (notably military or defense spending) as well as increased imports of goods and services, should be seen in the context of stagnant oil export volumes (an average of roughly 7mn bpd since the early 1990s). The large increase in the US Dollar price of oil between 2001 and 2008 helped boost export revenues and support ongoing growth in the economy, despite stagnant or flat oil export volumes.

However, with oil prices now half of that, they averaged between 2007 and 2014 and with a notional “ceiling” of $60 as discussed, it seems that Saudi Arabian oil export revenues may also have “hit” a ceiling. This ceiling is already reflected in the charts below, which show the sharp decline in oil exports revenues as a % of GDP, government expenditure, imports and defense spending.

The data in the charts produced below assumes annual export volumes of 7mn bpd (even though in some years it was more and in others less) and the average price for West Texas Crude as per the St Louis Federal Reserve Database (FRED). As such, it does not necessarily reflect actual reported oil export revenues but an approximation which should be close enough to accurately illustrate the general trend.

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Given that the Kingdom continues to “peg” its currency to the US Dollar, there is little prospect for export revenues to rise in local currency terms. Furthermore, given Saudi Arabia’s high level of import dependence for many goods, including and perhaps most importantly military equipment, the Saudi regime will also be extremely reluctant to devalue its currency or allow it to “float”. In part, this desire to maintain its currency peg explains the regime’s decision to begin issuing substantial amounts of government debt (US Dollar bonds) as well as listing a portion of the state-owned oil company Aramco.

In the final analysis, if Saudi oil export volumes have reached a ceiling at around 7mn bpd and prices cannot sustainably trade above $60 per barrel, it is very likely that the Saudi Arabian economy has also reached a growth “ceiling”. This will have seismic longer-term ramifications. A growth ceiling also implies that the Kingdom will no longer be able to increase government expenditure. As such, it will limit the ability of the Kingdom to further expand public sector employment and tackle the country’s high level of youth unemployment, and may also undermine the regime’s ability to maintain its existing military complex over the medium to longer-term.

What is the endgame for Saudi Arabia?

In our view, there are really only two options available to the Saudi regime at present or over the shorter-term. No doubt over the long-term, Saudi Arabia needs to reform and liberalize its economy and diversify away from its dependence on oil. However, such an outcome will take serious political will (more specifically, perhaps a more democratic and open regime) and at least a decade, if not more in time.

Clearly one option is to devalue the currency against the US Dollar. This will enable the Kingdom to maintain or even increase government spending levels in local currency terms. However, politically, this will create a risk to the exiting monarchy as such a policy decision will lower the living standards or purchasing power ( imports will become more expensive) of the employed in Saudi Arabia. Rising dissatisfaction with the monarchy could lead to political instability and a large-scale devaluation (rising food price inflation) in the currency could certainly be one catalyst leading to an eventual uprising and revolution.

A devaluation of the currency will also likely force other “Gulf” producers in the region that currently peg their currencies to the US Dollar to follow a similar path. A regional policy of currency devaluation would likely be negative for dollar-denominated oil prices and could lead to a renewed decline in the oil price back below $40 per barrel. This in turn would negate much of the benefit that would accrue from any currency devaluation.

The second option is for the Kingdom to maintain current OPEC production cuts for an extended period of time, which coupled with rising global demand, could push oil prices higher and back towards $80 to $100. As an example, at export volumes of 7mn and at a price of $80, the Kingdom would earn oil export revenues of roughly $204bn as opposed to $146bn at export volumes of 8mn but at a price of $50 per barrel. Even if the current OPEC cuts are not extended later this year, it is hard to envisage a scenario where such production cuts were not enacted again at some later date, in the event oil prices declined anew to below $40 a barrel.

However, at higher price levels ($60 to $80) non-OPEC, non-US production growth (albeit at a slower pace) will also begin to climb once more, ultimately only buying, at best, a few years of “fiscal breathing space” for the Kingdom. Still, this policy choice may be more desirable to the current regime at present, as opposed to devaluing the currency. It may also provide the regime with more time to inact necessary reforms and liberalise its economy in the hope that the Kingdom will be in a stronger position to withstand lower oil prices in a few years time. Inevitably, if we are indeed now entering the “age of electric vehicles”, the prospect of “peak demand” for oil and terminally lower prices may only be 5 to 10 years away.

Of course, the potential for hostilities and a disruption in oil supply in the Middle East remain a serious risk. This risk is particularly elevated at this time, given the ongoing low-intensity conflicts taking place in Syria and Iraq, as well as recent signs of increasing Sunni/Shia tensions in the region (the proxy war in Yemen). Such a scenario, to the extent that it does not negatively impact on Saudi oil production (as was the case during the two Iraq wars) would greatly help alleviate (at least for the duration of such a conflict) some of the financial challenges facing the Kingdom at present.

Finally, there may also be a realistic scenario where Saudi Arabia’s actual remaining oil reserves are much lower than the currently reported 268bn. There are many in the oil industry who continue to doubt the validity of these reported reserves, at least in terms of magnitude. As such, it is quite possible that the Kingdom may not be able to sustainably lift its current oil production (and therefore export volumes) above current levels in any event.

If this is the case  (and we will soon find out given the anticipated and more detailed public disclosures of these reserves following the Aramco listing), then the Saudi regime would be more than happy to maintain or even decrease its existing production (as Saudi “peak oil” sets in) and push prices back towards $100. The rationale is that if Saudi oil output is nearing a secular peak, it will be better to lower production steadily over a 10-year period and keep prices as high as it possibly can in order to maximize oil export revenues during the “twilight” period once terminal production declines set in at the Kingdom’s major oil fields. As an example, even at export volumes of 6mn bpd, the Kingdom would generate more oil export revenues ($175b) assuming a price of $80 than at 8mn bpd but assuming a lower price of $50 ($146bn).

Energy in Saudi Arabia:  the next decade

As we have already noted in this article, a key long-term policy aim for the Kingdom, must be to diversify its economic away from its dependence on oil. However, in addition to this diversification, the Kingdom will also have to dramatically reform its domestic energy sector. Saudi Arabia, like many other oil exporting countries in the region, provides energy products (motor vehicle fuel, electricity) to the entire population at prices well below international levels.

As an example, gasoline or fuel prices in Saudi Arabia were almost one sixth of the retail price in the US in 2014. In a recent country report compiled by the IMF, the agency calculated that the implicit cost to the fiscal budget of this large and growing energy subsidy amounts to around $85bn per annum or as much as 13% of overall GDP. More importantly, a large proportion of Saudi Arabia’s electricity is generated from domestically produced oil. Domestic consumption of refined and crude oil reached 2.5mn bpd in 2014, with crude oil consumption, excluding that consumed by domestic refineries (mostly serving as an input to the generation of electricity) amounting to 0.6mn bpd.

Saudi Arabia produced 1.95mn bpd of natural gas (equivalent) in 2014, but already almost all of this was consumed domestically. The IMF has calculated that at current growth rates additional demand for refined oil would completely crowd out the current 1mn bpd of refined petroleum (not crude oil) exports. Quite clearly, Saudi Arabia will have to invest substantial capital in new forms of energy generation such as renewables and possibly nuclear energy, while looking to reduce the implicit energy subsidies that it now has in place.

Reducing the implicit energy cost to the fiscal budget from these generous subsidies will provide some additional “fiscal space” to compensate for lack of likely oil export revenue growth going forward. The revenues that could flow to the fiscus from a reduction or eventual elimination of these subsidies could be used to fund a large and multi-year capital expenditure program directed towards new energy sources for electricity generation. This will help limit the further erosion of oil export volumes as the current 0.6mn bpd being consumed by the electricity and water sectors (water desalination plants) could eventually be exported instead of being domestically consumed.

However, reducing or eliminating these energy subsidies while economic and employment growth remains under pressure, will only further heighten the risks of political and social instability over the next five to ten years. Again, this dynamic adds to the general view that the Saudi regime may not want to devalue its currency and add to the inflationary pressures that will inevitably materialize as energy subsidies are reduced or eliminated over time.

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