We must all hang together, or assuredly we shall all hang separately.
- Benjamin Franklin, at the signing of the U.S. Declaration of Independence-
The previous article in this series on Saudi oil policies asked what the Saudis planned to do as their encore in 2016 after sacrificing approximately $100 billion in crude oil export revenue in 2015 in pursuit of market share.
This article provides the author’s answer: the Saudis must alter course, seek a consensus on prices and volumes with their fellow OPEC members, coordinate with Russia, and reduce output from 2015’s average (approx. 10.5 mmbbl/d) to signal their commitment.
Why? Crude prices staying lower for longer will rapidly devastate the Saudi economy.
Goldman’s $20 scenario could turn out to be optimistic
In recent days, it seems the slogan “lower for longer” for crude prices has become “much lower for much longer.” September 11, Goldman Sachs revised downward its projection for average WTI and Brent per barrel prices in 2016 from $57 to $45 and $62 to $49.50 “on the expectation that OPEC production growth, resilient supply from outside the group and slowing demand expansion will prolong the glut.” Goldman also said prices could reach $20, albeit probably not for an extended period. At a recent conference in Alberta, Jeff Currie, Goldman’s head of commodity research, said low crude prices could persist for fifteen years and that Goldman’s long-term forecast is for $50 crude.
Goldman’s projections both in terms of average 2016 prices and $20 as a possibility could prove optimistic. In a situation of oversupply, which prevails currently, when oil-dependent economies must earn dollars to pay for imports and the interest and principal on US$ loans, the price elasticity of supply is sharply negative. As excess crude oil production threatens to exceed crude storage capacity the price of each incremental barrel of crude presumably could approach $1 for US$ hungry producers.
This is the kind of environment a September 14 Bloomberg article describes: intense competition between major oil exporting nations as Saudi Arabia fights to maintain its place as China’s chief crude supplier, and Iran, Russia, and Angola gird to compete fiercely for second place in this critical export market.
The Devastating Impact of Crude Prices below $50 on the Saudi Economy
What happens to the Saudi economy if crude prices remain below $50 or drop to $20 or lower (say $15)? In the following discussion, it is important to keep in mind that Saudi oil export revenues, which include crude and refined products, fund 90 percent of the Saudi government budget and constitute some 80 percent of Saudi exports, which generate the US$ needed to pay for imports (including vital defense equipment and services).
Thus each US$ lost in oil export revenues reduces the Saudi government budget by one dollar, unless replaced from another source (e.g., Saudi government currency reserves or borrowing).
The following table draws key data from Table 2 (Saudi Arabia: Budgetary Central Government Operations, 2011-2019) and Table 4 (Saudi Arabia: Balance of Payments 2011-2019) in the IMF’s 2014 IMF Article IV Consultation Staff Report on Saudi Arabia.
Column 2 shows the IMF staff’s preliminary estimates for actual 2013 results, while columns 3 and 4 show the IMF staff’s projections for 2014 and 2015, when the staff expected crude prices to remain above $100/barrel. Column 5 provides data from the 2015 approved government budget, published after Oil Minister Al-Naimi’s announcement of the shift to a market share strategy at the November 27 OPEC meeting. Related: This Is What Needs To Happen For Oil Prices To Stabilize
As the table shows, Saudi budget planners anticipated a sharp drop in revenues, total spending, and the budget deficit. The increase in spending wages, salaries, and benefits anticipated the bonuses for Saudi government workers King Salman ordered after he ascended to the throne in January 2015.
(According to the IMF, Saudi budgets traditionally have been conservative in terms both of revenues and spending and both revenues and spending have regularly exceeded budgeted amounts. Since average crude prices fell far more than Saudi planners anticipated when they prepared the 2015 budget, it is possible actual 2015 spending may overshoot budgeted amounts, while actual revenues undershoot).
(Click to enlarge)
Tables 2 and 4 make it possible to model and assess the impact of crude oil prices below $50 on the Saudi economy. With oil exports (crude and refined products) at 8.3 mmbbl/d and assuming $5 production cost, net oil export revenue would be as follows at $50 and at $5 decrements below $50:
(Click to enlarge)
As the following table shows, with oil prices at $50 and below, the Saudi government, absent other sources of revenue/increased revenue, cannot long sustain actual total spending, even at 2015’s reduced levels of $229 billion; even just 2015 approved wages, salaries, and benefits spending at prices below $40; even just the IMF’s projected 2015 budgeted capital expenditures (in general, government financed-infrastructure projects) below $40; combined total approved spending and IMF projected 2015 budgeted capital spending; and the trade balance (exports minus imports and services imports). Related: Oil Prices Could Surge As This Country Fails To Meet Production Targets
Further, decreases of such magnitudes in oil export revenue and government spending will lead to:
- A substantial contraction in GDP (the actual size of the contraction depending on the fiscal multiplier for Saudi government spending).
- Decreases in headcount in Saudi national and local government bodies and employee compensation (according to the IMF, in 2013 71 percent of Saudis were employed in government-related institutions), as well as cuts in social spending. This could lead to and/or intensify social tensions, which the Saudi government has tried to dampen with government spending.
- Sharp deterioration in the trade and services balances, which will reduce Saudi ability to finance the imports on which the Saudi population and government—think defense equipment among other necessities—depend.
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Absent other sources of funding is a key assumption. IMF Tables 2 and 4 make it possible to model the impact of oil prices at and below $50 on Saudi currency reserves—assuming no borrowing and no substantial increase in “other revenues” in the Saudi budget—at 2015 approved total spending levels, the IMF’s projected 2015 budgeted investment expenditure, and the estimated trade and services balances.
The picture presented in the following table isn’t pretty—foreign currency reserves rapidly deplete. Rapid depletion would bring pressure to bear on the Saudi Riyal’s peg to the US$ (3.75/US$) and ultimately could force the Saudis to break the peg (unleashing such unpleasant repercussions as increasing the cost of imports).
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In short, it seems the Saudis will find it difficult to sustain their currency market share policy for more than a year or two at prices below $50, much less the fifteen years Goldman Sachs projects. The Saudis could borrow from local sources - S&P estimates Saudi banks could lend up to $100 billion - and seek foreigners willing to lend, but these sources cannot make up for the lost oil export revenue in the medium- and long-term, perhaps not even in the short-term (one-to-two years).
Progress toward a Balanced Crude Market
Can Saudi Arabia hope Goldman’s projections of much lower for much longer crude prices are wrong and wait for market forces on their own to balance supply and demand and drive crude prices higher?
Probably not. Yes, supply and demand seem to be trending in the right direction. Authoritative institutions have been raising their forecasts for demand and lowering their estimates for supply. In its September Oil Market Report, the IEA raised its estimate of demand growth in 2015 to 1.7 mmbbl/d from 1.6 mmbbl/d and raised its estimate for 2016 to 1.4 mmbbl/day. On the supply side, the IEA’s recently published 2015 Medium-Term Market Report reduced the IEA estimate for crude supply from non-OPEC countries in 2016 to 53.10 mmbbl/day from the 53.80 mmbbl/day it estimated in its 2014 Medium-Term Market Report. Related: Does OPEC Have An Ace Up Its Sleeve?
Yes, several trends suggest possible threats to supply in 2016. Iraq, one of the three major contributors to 2015’s surplus production (Saudi Arabia and the U.S. are the other two), may find it difficult to maintain output at levels it achieved in 2015 (approx. 4 mmbbl/d), much less increase output, given that low crude prices, the ISIS insurgency, and budgetary pressures have forced the Iraqi government to cut funding for current and future petroleum industry projects. Brazil’s political instability, its deteriorating economic conditions and Petrobras’s overwhelming debt burden and ongoing corruption scandal, and Venezuela’s economic and political turmoil, could negatively impact these countries’ ability to maintain current production and increase future production. Conflict and instability in Libya and Nigeria could constrain their crude output.
However, relying on these trends would not be prudent. Positive supply surprises, which could negate any supply disruptions, could come from Iran and the U.S. Iran claims it can increase output by 1 mmbbl/day within three to six months after sanctions end, while U.S. production could prove to be more resilient in the low price environment than the IEA and the EIA currently anticipate, as U.S. producers use technology to increase efficiency and output.
In addition, in the absence of a signal from the Saudis that they intend to back away from their aggressive increase in output in 2015 to approx. 10.5 mmbbl/d (from approx. 9.5 mmbbl/day in 2014), the market may assume continued substantial oversupply and drive prices lower.
There is another important consideration. Currently, most observers seem to believe (or maybe hope) Saudi currency reserves are sufficient to weather the low price environment and thereby give the Saudi government sufficient breathing room. When—as this author believes—not if, this perception changes, Saudi authority and negotiating leverage rapidly will dissipate.
Instead of waiting for the crude market to balance itself, the Saudis should use this breathing room to accelerate the balancing. They could, to lay the groundwork for a longer-term solution, take the following two steps. First, they roll back their output of crude from levels achieved in 2015 toward levels they averaged in 2014 and previous years (approx. 9.5 mmbbl/d).
Second, they could use the next few months to persuade fellow OPEC members that OPEC must become a cartel in more than name only, that is, for example, that binding production quotas must be set, that on-site inspection and monitoring must be permitted, and that there must be penalties for disobeying quotas and the penalties must be effective.
Absent pro-active steps, the Saudis will create the conditions for an interesting trade:
Long crude oil, short the Saudi Riyal
By Dalan McEndree of Oilprice.com
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Add numbers up. Unless Saudi's increase production meaningfully in 2016, market should balance by mid year heading into a shortage in 2017.
"US shale will "roll over" to some degree as producers exhaust their one-year hedges and face the full shock of lower prices. But it is hazardous to bet too heavily on this assumption."