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Simon Watkins

Simon Watkins

Simon Watkins is a former senior FX trader and salesman, financial journalist, and best-selling author. He was Head of Forex Institutional Sales and Trading for…

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Saudi Arabia’s Oil War Could Bankrupt The Kingdom

Those with a functioning memory may have thought that last week’s decision by Saudi Arabia to maximise oil production to crash oil prices and bankrupt U.S. shale producers was an early April Fool’s Day joke. Apparently, though, it is not, and collective amnesia seems to have gripped senior Saudis and other OPEC members alike about how disastrous the last Saudi Arabia-led attempt to destroy the U.S. shale oil industry from 2014 to 2016 actually was. Appalling though the consequences were last time for Saudi and its now-much-poorer allies, this time around things are likely to be much, much, worse.

The last time the Saudis tried this exact same strategy in 2014, it had a much greater chance of success than it does now. Back then, it was widely assumed that U.S. shale producers could not produce oil on a sustained basis for a breakeven price of less than around US$70 per barrel of Brent. Saudi also had record high foreign assets reserves of US$737 billion in August 2014, allowing it real room for manoeuvre in terms of sustaining its SAR-US$-currency peg and covering the huge budget deficits that would be caused by the oil price fall caused by overproduction. In addition, Russia at that point was just an interested observer on the sidelines.

Saudi Arabia was so confident in its plan that in October 2014 during private meetings in New York between Saudi officials and other senior figures in the global oil industry, as analysed in full in my latest book on the global oil markets, the Saudis revealed that the Kingdom was willing to tolerate Brent prices ‘between US$80-90 per barrel for a period of one to two years’. This was a 180 degree turn from the previous understanding by other OPEC members that Saudi was their champion, doing its best to keep oil prices high in order to boost the prosperity of OPEC member states. Saudi, nonetheless, at the New York meeting, made it clear that it had two clear aims in pursuing its overproduction/oil price crashing strategy. The first of these was to destroy (or at least slow down progress in) the developing U.S. shale energy industry and the second was to pressure other OPEC members to contribute to supply discipline. This marked a significant divergence from the acceptable range of prices previously stated by then-Saudi Oil Minister Ali al-Naimi as being: “US$100, US$110, US$95,’ per barrel. Related: Saudi Arabia Strikes Back At Russia In Key Oil Market

Within the space of just a few months of embarking on this shale-destruction strategy, though, it became extremely clear to the Saudis that they had made a terrible mistake in underestimating the ability of the U.S. shale sector to reorganise itself into a much tighter operation than they had thought possible. It transpired that many of the best operators in the optimal regions, such as the Permian, were able to not just breakeven at price points above US$30 per barrel of Brent but also to make decent profits at points above US$35-37 per barrel area. U.S. shale players, in large part through the advancement of technology, were quickly able to drill longer laterals, manage the fracking stages closer and maintain those fracks with higher, finer, sand.

This allowed for increased recovery for the wells drilled, in conjunction with faster drill times. They also started to gain cost benefits from multi-pad drilling and worked out the optimal well spacing for efficient development, further allowing them to reduce costs. Crucially, the inexorable rise of the U.S. shale sector allowed the U.S. to reduce its energy dependence on Saudi and to broaden out the scope of its geopolitical clout even more by dint of becoming the number one oil producer in the world itself.

Given these developments, during the two years alone (2014-2016) that this Saudi strategy lasted, OPEC member states lost a collective US$450 billion in oil revenues from the lower price environment, according to the IEA. They are still dealing with trying to fill in holes in their foreign exchange reserves and budgets accrued as oil prices were pushed down from over US$100 per barrel of Brent to below US$30 per barrel.

Saudi Arabia itself moved from a budget surplus to a then-record high deficit in 2015 of US$98 billion and spent at least US$250 billion of its foreign exchange reserves over that period that even senior Saudis have said are lost forever. Even before this new oil price war was launched, Saudi Arabia was facing sizeable budget deficits every year until probably 2028 by most projections, with a budget breakeven price per barrel of Brent this year of US$84 (that does say US$84, yes).

So bad was Saudi Arabia’s economic and political situation back in 2016 that the country’s deputy economic minister, Mohamed Al Tuwaijri, stated unequivocally – and completely unprecedented criticism of government policy from a Saudi minister - in October 2016 that: “If we [Saudi Arabia] don’t take any reform measures, and if the global economy stays the same, then we’re doomed to bankruptcy in three to four years.” That is to say, that if Saudi kept overproducing to push oil prices down – just as it is doing right now, yet again - then it would be bankrupt within three to four years.

Three to four years, though, now looks optimistic as it has to be remembered that back in 2016, the Saudis did not expect that the U.S. shale sector would continue to grow in output capability or that the budget breakeven price for Russia would be as low as US$40 per barrel. What this means in purely empirical terms, is that the U.S. and Russia can absolutely afford to sit back for much longer than Saudi with oil prices at or below US$40 per barrel and, quite aside from the absolute level of oil price, both benefit in key broader ways as well.

For the U.S., there are economic benefits which, especially in a year in which there will be negative economic effects from the coronavirus, will mean significant political benefits too. As a rule of thumb, it is estimated that every US$10 per barrel change in the price of crude oil results in a 25-30 cent change in the price of a gallon of gasoline, and for every 1 cent that the average price per gallon of gasoline falls, more than US$1 billion per year in additional consumer spending is freed up. Politically this has enormous ramifications for a sitting president seeking re-election in the U.S., as Donald Trump is. Related: Yergin: No End In Sight For The Oil Price Crisis

According to NBER statistics, since World War I the sitting U.S. president has won re-election 11 times out of 11 if the U.S. economy was not in recession within 24 months ahead of an election. However, only one president out of seven who went into a re-election campaign with the economy in recession actually won (Calvin Coolidge in 1924). The very idea that any U.S. president would allow the country’s hugely geopolitically important shale sector to be seriously damaged in any way is jejune at best, and within the last few days President Trump has stated that a raft of new measures to support the sector is being considered. These may also include the double-sided winning strategy of using lower priced oil bought from shale producers to boost the U.S.’s Strategic Petroleum Reserve.

For Russia, meanwhile, whose core foreign policy strategy under President Putin has always been ‘create chaos and then project Russian solutions and therefore power into that chaos’ Saudi Arabia’s oil price war could not be better. Firstly, if oil settles back at around the US$40 per barrel of Brent level when Chinese demand comes back in scale at the end of this month, Russia is fine from a budget perspective and its oil companies can produce as much oil as they want. Even if it does not trade around those levels, Russia is still going to benefit from the fact that twice now in the space of less than 10 years Saudi has declared economic war on its only real ally in the world – the U.S.

Already in a controlling position in all key countries in the Shia crescent of power in the Middle East – Lebanon, Syria, Iraq, Iran, and Yemen (via Iran) – Russia continues to work on those countries on the edges of the crescent in which it already directly or indirectly has a foothold. These include Azerbaijan (75 per cent Shia and FSU state) and Turkey (25 per cent Shia and furious at not being accepted fully into the European Union), although others remain longer-term targets, including Bahrain (75 per cent Shia), and Pakistan (up to 25 Shia and a home to sworn-U.S. enemies Al Qaeda and the Taliban).

And all of this comes at a time when the current de facto ruler of Saudi Arabia – Crown Prince Mohammad bin Salman (MbS) – is facing the most serious crisis to his authority. This was underlined only a few days ago when reports came through that Salman had ordered another round-up of his high-ranking opponents (the previous major one was at the end of 2017 in the notorious Ritz-Carlton round-up). This included Prince Ahmed bin Abdulaziz, a younger brother of King Salman, and Prince Mohammed bin Nayef, the King’s nephew and the former crown prince. According to numerous reports, the health of the 84-year old current king, Salman, is very poor, and this has prompted a jostling of senior royal Saudis for the succession.

It should be remembered that MbS was not always the natural successor to the current King: prior to June 2017 when the succession was changed in MbS’s favour, the heir-designate was the recently-arrested Prince Mohammed bin Nayef, whilst the also recently-arrested Prince Ahmed was one of three members of the Allegiance Council (the senior royal organisation that endorses the line of succession), to oppose MBS’s appointment as crown prince in place of his cousin bin Nayef in 2017. Precisely why MbS thinks that potentially bankrupting his country, spending the remainder of its dwindling foreign assets reserves, and alienating its only significant ally in the world is a mystery but whatever the reason both the U.S. and Russia will be perfectly happy to watch on the sidelines to see exactly how it all pans out for MbS. 

By Simon Watkins for Oilprice.com

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  • Nessy Oil on March 15 2020 said:
    The Saudis and Russians shorted oil in shell companies. They will have billions stashed away to ride out the storm. Then sweep in and pick up the prices. Let’s not kid ourselves

    Greedy shake executives did this. They kept pumping no matter what. Eventually Saudi and Russia were gonna pull the pin. They used corona as the perfect play
  • Art McTeagle on March 16 2020 said:
    Excellent article! It seems that the US shale sector seems to have been saved by a convergence of various factors. Who could've forseen that a virus would lead to a bailout? The tight oil producers have been handed a lifeline, that it's an election year is also a big factor.
    Surely MBS has access to the best advice? There must be more behind all of this. Questions remain as to how large the remaining reserves in SA are and the what the actual breakeven cost of producing oil is.
    I suspect the levels of corruption are huge, comparable to Venezuala where Maduro and associates have bled that country dry.
  • Mars Lake on March 16 2020 said:
    This article couldnt be less true, ignor all so called facts here and look at the bond saudi has with America and see how the UK put the iranian government back in the islamic revolution
  • Mamdouh Salameh on March 16 2020 said:
    The oil sector accounts for 87% of Saudi budget revenues and 90% of export earnings. Moreover, Saudi Arabia needs oil prices higher than $85 a barrel to balance its budget.

    Therefore, it beggars belief that Saudi Arabia has resurrected a discredited policy of flooding the global oil market with oil that proved wanting in 2014 having inflicted the worst damage on the Saudi economy moving it from a budget surplus to a then-record high deficit in 2015 of US$98 billion and costing it more than $150 bn in lost oil revenue in one year alone. This time it could bankrupt the economy and destabilize the kingdom.

    The biggest loser in the oil price war is the global economy particularly the oil-producing nations of the world and within the global economy the two biggest losers are Saudi Arabia and the US shale oil industry.

    Despite the bravado, Saudi Arabia can neither win a price war with Russia nor is able to flood the global oil market with oil as it did in 2014. Russia’s economy can live with an oil price of $25 a barrel for years compared with a price of $85 or even higher for Saudi Arabia.

    Moreover, Saudi Arabia has never ever had a production capacity of 12.5 million barrels a day (mbd) and will never ever achieve one. So the talk about raising its production by 3.0 mbd is a farce. Its production peaked at 9.65 mbd in 2005 and has been in decline since. Saudi Arabia can at best produce some 8.0-9.0 mbd with another 700,000 barrels a day (b/d) to 1.0 mbd coming from storage. This is so because its current production is coming from five giant but aging and fast-depleting oilfields discovered more than 70 years ago.

    Without the influx of billions of dollars of oil money, projects that are considered vital for Vision 2030 for the diversification of the economy will be delayed or even shelved indefinitely. Moreover, the economy will not be able to create more than 6 million jobs needed to employ Saudi Arabia's youth. The economy could crash on the back of an oil price with a mushrooming budget deficit estimated at $100 bn.

    Analysts should also keep an eye on the share price slump of Saudi Aramco. A steep devaluation is a major threat, as Saudi citizens have been investing not only their own money but also borrowed money from banks to buy Aramco shares.

    The stability of Saudi Arabia depends on the Aramco IPO, Public Investment Fund projects and diversification. All can be linked directly and indirectly to OPEC+ and oil prices.

    The second biggest loser is the US shale oil industry. With a breakeven price of $70 a barrel and a well depletion rate of 70%-90% after first year production, low oil prices would for sure hasten the demise of US shale oil industry.

    Of course President Trump’s administration will bail out the US shale oil industry not only because it is a $7-trillion industry employing more than 2% of the work force and therefore very important for the US economy but also because it enables the United States to have a say in the global oil market along Russia and Saudi Arabia. Long-term, nobody can save an unprofitable industry.

    Wouldn’t be better, therefore, for Saudi Arabia to take a breath and consider mending fences with Russia since they both could calm the jittery in the global economy and maybe stop the oil prices sliding further perilously.

    Dr Mamdouh G Salameh
    International Oil Economist
    Visiting Professor of Energy Economics at ESCP Europe Business School, London
  • Dotard Trump on March 16 2020 said:
    This is a load of BS, oil just dropped below $30 WTI. If this keeps up till end of next week, you're going to see mass layoffs. If it stays like this or goes down even further, there will be mass bankruptcies. And the trickle effect will cost the American economy $100 billion or more. The Saudis and Russians can easily hold out at $20 per barrel!
  • Arch Region on March 16 2020 said:
    The false prophets kept saying "we are running out of oil! we are running out of oil!"

    Al Gore however observed "we did not go beyond the Stone Age because we are run out of stones". So the fossil fuel economy is going under not because of a paucity of crude but it is drowning in a glut of oil.

    The probable truth is that Mohammad bin Salman's wise advisors told him to pump it out as fast as he could before demand falls to zero dragging down the price to oil to equal the price of wind or sun, which is zero.

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