In the last quarter of 2014, in the face of possible oversupply, Saudi
Arabia abandoned its traditional role as the global oil market's swing
producer and therefore it role as unofficial guarantor of existing ($100+ per
barrel) prices.
In October, Saudi sources first prepared the market with statements that
the country would be comfortable with oil prices as low as $80 per barrel for
"a year or two." At the November OPEC meeting, the Saudi oil
minister, Ali Al-Naimi, publicly announced Saudi Arabia would allow market
forces to set prices. He argued that rapidly growing production outside OPEC
made the existing status quo unviable, and that lower prices in the short
term would increase prices in the longer term through reduced investment and
ultimately benefit all OPEC members.
Parallel with this shift, Saudi officials expressed confidence in their
country's financial wherewithal to withstand the repercussions of lower oil
prices.
The Saudis Expected a Hole, Not a Bottomless Pit
The Saudis obviously miscalculated the degree to which their shift would
negatively impact oil prices. The average price of Brent, the global
benchmark, fell below the Saudis' $80 floor in November, fell to $62.34 in
December, then fell below $50 in February. Prices rebounded to $60 for a few
months, before falling once again below $50.
Plunging oil prices have substantially reduced Saudi revenues. With Brent
prices averaging roughly $100 per barrel in 2014, Saudi oil exports of 6.31
million barrels per day would have generated roughly $631 million in revenues
daily. In the first quarter, with Brent prices averaging $53.92, the same
output would have generated roughly $340 million daily, $291 million less per
day than oil at $100 per barrel.
The Saudis have attempted to mitigate the revenue shortfall through
increased production, ramping
up output from 9.6 million barrels per day in the fourth quarter of 2014
to an eye-popping 10.5 million barrels per day in June.
The revenue from increased production, however, is overwhelmed by the
collapse of prices, which has ripped a substantial hole in the Saudi budget.
In December 2014, the Saudi government approved
spending $229 billion in 2015, resulting in an estimated deficit of $39
billion, or some 5 percent of GDP.
As mid-year 2015 approached, the IMF estimated
the budget deficit would equal approximately 20 percent of Saudi GDP. The
Financial Times quoted analysts as estimating
the Saudi budget deficit in 2015 at $130 billion. Even with massive deficit
spending, the IMF estimated GDP growth would slow from 3.6 percent in 2014 to
3.3 percent in 2015, and then just 2.7 percent in 2016.
Racing to Barrel Oil
The Saudi miscalculation has several sources. One is the negative feedback
loop between oil production, GDP, and national budgets that plagues many
non-Western oil producers. Their GDP and national budgets depend
significantly on the revenues from their oil exports. As a result, the
revenue shortfalls incentivize them to produce as much oil as possible to
mitigate the shortfall.
According
to the IEA, daily output in June 2015 increased 3.1 million barrels over
2014, with 60 percent (1.8 million barrels) coming from OPEC. At 31.7 million
barrels per day, OPEC output reached a three-year high.
This increase in output occurs with the context of a narrow global demand
opportunity. Growth in demand in 2015, which the IEA forecasts to
average around 1.4 million barrels per day, comes primarily from Asia and
North America. In other major export markets, demand is stagnant. That has
oil exporting countries, including OPEC members, Russia and others, focusing
their sales on Asia, particularly China. North American demand is growing
now that oil prices are low, but due to high levels of domestic production,
the U.S. is no longer a growth market for oil exporters.
Each producer, therefore, is incentivized to undercut other producers
directly (price per barrel) or indirectly (absorbing shipping cost or
delivery risk) to win sales in Asia (or displace incumbent suppliers in other
major markets). National oil producers can and are shifting the cost of the lowered
prices to other sectors of the economy. The U.A.E., for example, has ended
fuel subsidies, thereby essentially, increasing its budget revenues, while
Saudi Arabia recently floated
a $4 billion domestic bond offering to help finance its budget.
Asian customers are taking advantage of the competition. They are reducing
the share of long-term contracts in favor of spot purchases. For example, as
the Wall Street Journal reported,
some Japanese refiners are cutting the proportion of oil purchased through
long-term contracts to around 70 percent from more than 90 percent, while
some South Korean refiners are reducing the proportion from 75 to 50 percent.
Furthermore, several national oil companies, Venezuela's among them, are
building refineries with local partners in Asia, which will use their crude.
Given this environment, it is not surprising that the revenue elasticity
of production is highly sensitive, and negative. Saudi Arabia increased
production by 6.8 percent in the first quarter of 2015 but saw export
revenues shrink by 42 percent.
Any Saudi Victory Will Be Pyrrhic
Saudi confidence in their financial wherewithal is proving misplaced.
Their need for revenue is intensifying rather than moderating. They are
fighting a multi-front war with Iran directly (in Yemen) and indirectly (in
Syria, Lebanon, and Iraq). ISIS, Al Qaeda, and disaffected Shias present a
significant domestic security threat. Countering external and internal
threats demands increased spending (including, perhaps, a very expensive
future nuclear weapons program), as does placating the fast growing male and
female youth demographic, which requires substantial spending on education,
training, employment, and support. Hence, the budget deficit equal to 20
percent of GDP, noted above.
Increased production does not offer a solution. Saudi Arabia doesn't have the
capacity to increase production sufficiently to reduce the shortfall
significantly in any meaningful timeframe. They currently do not have the
spare capacity -- to make up for the $291 million in export revenue lost in
Q1, 5.4 million more barrels a day would have been necessary at $53.92 a
barrel. Of course, such a drastic increase in output would have driven prices
even lower.
It is doubtful they can increase capacity substantially even in the
medium- to long term. They won't be able to spend significantly more than
other major national oil companies. First, low prices reduce Aramco's cash
flow and therefore its ability to fund investment. Second, the Saudi
government likely will increase its draw from this cash flow to fund higher
priority national security and domestic security needs.
Third, Saudi refusal to act as price guarantor undercuts the confidence
foreigners need to invest in, or loan to, oil projects. What might be
attractive at $75 per barrel oil isn't at $50 oil, and even less attractive
if the price of oil is thoroughly unpredictable. Fourth, in terms of
political risk, Saudi Arabia with its Gulf allies, Iran, and Iraq, and the
Middle East in general, is at the epicenter of global tension, turmoil, and
tumult. Fifth, its influence within OPEC, and therefore its ability to manage
OPEC output and prices, is diminished. Their underestimate of the impact of
their policy change on prices, their indifference vis-à-vis the financial
damage to other OPEC members, and their willingness to take market share at
the expense of other OPEC members undercut their credibility within OPEC
(particularly since it derived from Saudi willingness to protect the
interests of all members (and sometimes to endure disproportionately).
While Saudi financial reserves are substantial (circa
$672 billion in May), drawing on them is little more than a stop-gap
measure. If its major competitors (Russia, Iraq, Iran, and North America)
maintain or even increase output (and they have the incentive to do so),
prices could stay lower far longer than the Saudis anticipated. Saudi
reserves have decreased some $65 billion since prices started to fall (in
November), so ~$100 billion to ~$130 billion at an annual rate. The longer
prices stay low, the faster their reserves fall, and, as reserves plummet,
the greater the pressure to prioritize spending, to the disadvantage of some
Saudis.
Saudi Arabia Caused The Problem, Can It Engineer A Solution?
Saudi officials apparently viewed $90 or even $80 per barrel oil for
"one or two years" with equanimity. Can they maintain the composure
they have displayed thus far as they incur in a single year the revenue
losses they expected to take four years (at $90 oil) or two years (at $80
oil)?
And if they can't -- and surely, though they are loath to admit it, they
can't -- can they engineer a durable increase in prices -- i.e., a durable
decrease in output? At first glance, it seems impossible. Daily
output from Saudi Arabia (10.5 million), and its allies, UAE (2.87),
Kuwait (2.8), and Qatar (.67), is roughly equal to the daily output from
countries with which it is in conflict, directly or indirectly, Russia
(11.2), Iran (2.88), and Iraq (3.75), and therefore have an incentive to take
advantage of any unilateral Saudi output concessions.
Yet, in effect, these countries are engaged in the oil equivalent of
mutually assured destruction. The sharp drop in oil revenue damages each of
these countries economically and financially, while the wars they wage
directly and indirectly against each other drain resources from vital
domestic projects.
Moreover, given the sensitivity of prices to changes in volume, it is
possible, if not likely, that holding output steady or matching a Saudi
decrease barrel for barrel could generate an absolute increase in revenues
for all.
