The Saudis are on track to sacrifice ~$100 billion in crude export revenues in 2015, or 45 percent of 2014’s ~$219 billion in crude export revenues, in pursuit of market share, the measure of success Saudi Oil Minister Ali bin Ibrahim Al-Naimi announced at the November 27, 2014 OPEC meeting.
What do the Saudis plan as their encore in 2016? Will they continue pursuing market share over other goals (e.g., total revenue, economic diversification, OPEC conciliation), or will they alter course, and if so, is there a superior alternative?
Publicly, Saudi officials appear unwavering in support of market share. The crude oil futures markets and many pundits reflect this official line. Saudi economic fundamentals, IEA projections through 2020 for the oil market, and the currency markets—pressuring the Riyal-US$ peg—suggest the pursuit of market share is at best a chimera, at worst necrotizing fasciitis (flesh eating bacteria) for Saudi Arabia.
A Saudi Economic Reality Check
Depending on the data series used, the Saudi economy either is escaping unscathed, if not prospering, from the move to market share or is suffering from that move. The IMF Press Release reporting on an IMF team’s findings, published June 1, 2015, expressed the former:
“The decline in oil prices is resulting in substantially lower export and fiscal revenues, but the effect on the rest of the economy has so far been limited. Real GDP growth is projected by IMF staff at a healthy 3.5 percent this year, unchanged from 2014, with an increase in oil production and continued government spending expected to support the economy. Growth, however, is projected to slow to 2.7 percent in 2016 as government spending begins to adjust to the lower oil price environment. Over the medium-term, growth is expected to be around 3 percent. Inflation is likely to remain subdued.”
In July, Jadwa Investment, a Saudi investment company, in its Quarterly Oil Market Update exuded the same optimism, revising upward its projection of Saudi Arabia’s GDP growth in 2015 from 2.5 to 3.3 percent.
Different statistical series give different results. The IMF publishes its World Economic Outlook semi-annually, in April and September/October. The WEO provides economic statistics and projections for individual countries, which include three estimates of GDP, one in constant national currency, the other two in current national currency and constant (U.S.) dollars. Related: California Oil Bill Defeated
The April 2015, statistical GDP series for Saudi Arabia in constant national currency show steady GDP growth in 2015 and subsequent years, if somewhat less than the projections in the October and April 2014 WEO databases:
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It is, of course, counterintuitive that the Saudi economy can lose revenue equal to 13 to 14 percent of GDP (~$100 billion of $752 billion 2014 GDP) and continue to grow. The April 2015 IMF GDP projections in current national currency show a 14.8 percentage point drop in 2015 GDP—roughly equal 13 percent-14 percent revenue loss—with the downturn in GDP continuing until 2017. The April and October 2014 forecasts—which preceded the Saudi decision to pursue market share and reflect $100+ crude prices—naturally show growth. (The picture is the same for GDP in constant US$, since the Riyal, the Saudi currency is pegged to the US$):
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The difference between GDP in constant national currency and current national currency results from the National Statistical Office, Central Department of Statistics and Information’s estimate of deflator, which it calculates and uses to convert current national currency GDP into constant national currency.
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Decreasing the deflator to 97.066 for 2015 from 115.889 for 2014—tracking its estimate earlier this year of 2015 crude prices—results in GDP growing 2.97 percent in (2,433.64 billion divided by .97066 gives 2,507.208 billion). Without this substantial adjustment, the estimate for GDP would have shown a recession—using the 2014 deflator, GDP would have been 2,163 billion in constant national currency (2433.64 divided by 1.15889).
The IMF’s updated WEO, due in September/October, is likely to show a larger drop in 2015 current national currency GDP and a longer and slower path to exceeding 2014’s GDP level. As the IMF’s report, Saudi Arabia: Tackling Emerging Economic Challenges to Sustain Growth, published March 18, 2015, states, “The Saudi Arabian economy remains very dependent on oil revenues to support growth and fiscal and external balances—over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil.” The April 15, 2015 WEO assumed oil would average $58.14 in 2015 and $65.65 in 2016. The EIA currently estimates Brent prices will average $54.40 and $59.42 in 2015 and 2016 respectively, and the EIA is likely to reduce its estimate as Brent as of September 9 was $50.63 and CME Brent crude futures currently show prices staying below $56 in 2016.
In addition, the Saudi government’s capability to compensate for the crude oil export revenue loss will diminish. It is on track to use $100 billion of its currency reserves to maintain 2015 government spending—$229 billion—at 2014 levels (the quarterly run rate is ~$25 billion). Since Saudi currency reserves, unlike the UAE’s and Kuwait’s sovereign wealth funds, do not generate a meaningful return, they will steadily deplete without inflows from budget surpluses and current account surpluses (both turning negative this year and in coming years with lower for longer crude prices).
The currency markets sense the squeeze. Against the backdrop of low crude prices, pressure on the Saudi economy, and currency depreciation in many emerging markets, the Chinese August 11 decision to devalue the Yuan led to a sharp spike in bets against the Riyal/US$ peg in futures markets. Related: Oil Price Recovery Seems Far Away As U.S Stockpiles Increase
Speculation the Saudis will be forced to abandon the peg caused Saudi Central Bank Governor Fahad Al-Mubarak to reaffirm publicly on September 6 the Saudi commitment to the peg—and central bankers defending a peg or fixed exchange rate is never a good sign.
A Toxic Global Crude Market to 2020
Absent a change in course by major oil exporting countries—individually or collectively—the pressure on crude oil prices will be intense and unremitting. The following table modifies Table ES.1 Global Balances in the IEA’s recently published Medium-Term Market Report 2015 for oil public summary. The sixth row, Implied OPEC Spare Capacity, shows that OPEC’s spare capacity, compared to the implied global net crude import market (row 4), remains considerable through 2020:
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The Saudis and their fellow OPEC members will be forced to compete ferociously against each other and against non-OPEC crude exporters, including Russia, Canada, Brazil, and Mexico. As the IEA’s Medium-Term Market Report 2015 for oil states:
“And with oil down more than 50% from its June peak, OPEC’s battle for market share may only just be starting. OPEC, along with rival producers outside the group, has been targeting energy-hungry Asia… Through its monthly formula prices, Saudi Arabia has sought to price its oil ever more competitively, leading other Middle East producers to follow suit.”
In response to the perceived growing threat to their market share, the Saudis could have pursued (at least) four different strategies.
First, they could have reprised their traditional role as swing producer and reduced output to accommodate the major sources of growing output (the U.S., Canada, Iraq, and potentially Iran).
Second, they could have maintained their 2014 crude export volumes (6.56 mmbbl/day) and let their share of global exports decrease over time.
Third, they could have maintained their export market share against various benchmarks (e.g. global output or global net export estimates).
Fourth, they could have sought aggressively to expand their share of the export market.
The (simple) scenarios in table below attempt to project what these strategies would have generated from 2015 through 2020 in net export revenue and calculate the loss in net export revenue against Saudi estimated 2014 net export revenue ($218.6 billion), were it generated each year over the same period. The uncertainty on demand, supply, and prices, given uncertainty on potential policy changes, threats to production, global economic growth rates, the impact of changes in output and demand on prices, etc., mean the scenarios should be considered with several grains of salt. Related: Is OPEC Too Big To Fail? Not Anymore
The scenarios incorporate the following assumptions:
- Base case: 2014’s 6.56 mmbbl average daily exports, average OPEC basket price of $96.27 (netting $91.27 net of $5 production cost) generating $218.6 billion annually through 2020.
- Steroid 1 and Steroid 2: aggressive increase in exports (and increase in market share), starting from 2015’s estimated 6.94 mmbbl/day (10.21 mmbbl/day output including the Neutral Zone, minus 3.27 mmbbl/day consumption); continued competition keeping prices at $46.40 in Steroid 1, while in Steroid 2, Saudi exports squeeze out other exporters and permit an annual $5 increase starting in 2016.
- Static 1 and Static 2: Exports kept at 2014’s 6.56 mmbbl/day average through 2020, prices drop, but fall modestly to $90 ($85 net of production costs) or to $80 ($75 net), the levels Saudi officials said were manageable for a few years (Saudi Oil Strategy: Brilliant Or Suicide?).
- Traditional 2.5% and 5.0%: Reprising their swing producer role, the Saudis cut exports by 2.5 and 5.0 percent annually from 2014’s level, supporting $95 ($90 net) $100 ($95 net) prices respectively.
- Global output growth: Export growth is linked to IEA projections of global output growth (see table drawn from IEA Medium-Term report above), reducing the rate of growth in output compared to the Steroid scenarios, lessening pressure on prices, and permitting prices to average $70 ($65 net).
- 10 percent discount rate for NPV calculations (although strategies vary in risk).
The following table, ranking the scenarios in terms of total revenues and total NPV revenues, indicates that Static 1 would perform the best through 2020, while Steroid 1 and Steroid 2, which project continuing 2015’s aggressive export growth strategy, the worst (see table in Supplemental Data at end of article for annual volume amounts for scenarios with varying annual output).
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The following table displays the estimated losses in total revenues and total NPV revenues for each scenario compared to the Base Case. The absolute losses in total revenues would be substantially greater for Steroid 1 and 2.
Diversifying the Saudi economy away from dependence on crude output and crude exports, as reflected in Saudi economic plans, has been and continues to be a priority focus of Saudi economic policy. The current Saudi approach seems to undercut this priority in at least two ways: it reduces the volume of funds available to finance diversification, without substantial borrowing, and thereby, in the long term, increases Saudi dependence on crude oil exports.
Presumably, the Saudis are evaluating the impact of their change in policy (and its actual implementation) on this and other economic priorities and will decide how to proceed. The evaluation will not necessarily be straightforward: each potential strategy has advantages and disadvantages, risks and rewards. Among those discussed in this article, for example, both Traditional strategies 2.5% and 5.0% generate more revenue over the 2015-2020 for economic priorities compared to all but one strategy, but the Saudis (rightly) may fear that sacrificing output in the medium-term, for higher revenues now, might lead to long term reduction in output and therefore ultimately to lower total revenues. On the other hand, were Steroid 1 and/or Steroid 2 to cripple competitors in the long-term, suffering substantial revenue losses through 2020 might be worth the severe damage to the Saudi economy—if, and it’s a big if, currency reserves and borrowing could replace the lost revenue and fund major economic priorities.
Of course, the negative impact of any strategy could be mitigated through a binding agreement on production cuts with OPEC members and other major national oil producers.
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By Dalan McEndree for Oilprice.com
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