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Saudis sticking to oil marketing strategy

Despite downturn, Riyadh is confident enough to play the long game

Crisis? What crisis? If Saudi policy makers are spooked by the sharp downturn in global oil prices, they aren’t showing it. The first action the newly crowned King Salman bin Abdulaziz took on succeeding his half-brother Abdullah in January was to spend a cool $30 billion giving subjects a two-months salary bonus. That comes just a month after the Saudi budget forecast a deficit of $39bn for 2015. For most Opec producers, especially those outside the Gulf, such largesse is unimaginable. But with about $750bn in financial reserves, the kingdom is not breaking sweat.

This is a far cry from the 1990s, when Saudi Arabia was last hit by low oil prices. Then, after many years of price softness, the kingdom began running budget deficits, saddling itself with a debt-to-GDP ratio above 100%. The Saudi financial cushion had all but eroded when prices dipped as low as $10 a barrel in 1998. This time around Riyadh is in far stronger financial fettle.

This confidence has infused the kingdom’s oil-price strategy, made implicit at the Opec meeting last November. Saudi Arabia would take its “hand off the tiller” for a while, to use the words of one senior ministry official who spoke on the eve of the meeting. The market would be allowed to discover its own price, balancing supply and demand in the process.

Energy strategy

Veteran oil minister Ali al-Naimi provided a glimpse into Saudi thinking at the beginning of the year, articulating the strategy primarily as a challenge to the status quo ante, in which “highly-efficient” Opec producers like the kingdom are required to reduce output, while inefficient ones can continue to produce. This, Naimi told industry newsletter MEES in January, was “crooked logic”, and took no account of the fact that efficient producers deserve market share. And if anyone had somehow missed the message, Naimi made it abundantly clear; if the price falls, it falls, and nothing can be done about it. But the rejoinder is crucial in explaining the prime motivator for the Saudi action. “If it goes down, others will be harmed greatly before we feel any pain,” he said.

Backing up those claims, Naimi contends that the marginal cost of Saudi oil is at most $10/b, which compares favourably to the marginal cost of US tight oil, claimed by some – though disputed by many – as being closer to $40/b.

Naimi still rules the roost in determining Saudi policy, but since the death of King Abdullah on 23 January, he now has a royal contender to think about in the form of the newly-promoted deputy oil minister Prince Abdulaziz – a son of the new king Salman.

Abdulaziz is considered bright and competent, and has been mentioned in dispatches as a potential successor to Naimi – though this is unlikely to transpire, as elevating a prince to oil minister rank would ruffle feathers among the senior ranks of the House of Saud. More importantly, Abdulaziz is understood to be less keen on the current no-cuts policy than Naimi – whereas Khalid al-Falih, Saudi Aramco’s boss and another contender to succeed Naimi, is considered on-side with the oil minister. If the strategy ultimately fails to deliver, that may play to Abdulaziz’s advantage, who would then be better placed to succeed to the top job, despite the drawback that is his royal lineage.

Whoever is in charge of oil policy over the long term, the latest shift in the kingdom’s strategy is a critical moment in the oil market’s history. “The Saudis have effectively surrendered any control over oil prices and that makes it the most important decision in the international oil industry since 1973 when oil producers realised they could determine prices themselves,” says Paul Stevens, a Chatham House associate fellow.

Even if it turns out not be as epoch-shaking as 1973, the Saudi policy is still a departure from its previous role as a market stabiliser.  Above all, the kingdom is implicitly making long-term market share, not short-term price, its priority. That means that other producers, those Naimi says are “less efficient”, will be left to do the cutting in a market that is oversupplied by as much as 1.5m barrels a day (b/d).

Something needed to be done. In the past five years, Saudi exports to the US fell from 1.5m b/d in 2008, to 1.2m  in 2014, according to the Energy Information Administration (EIA), the statistical arm of the US Department of Energy. While that is not a dramatic drop, it took place against a backdrop of steadily rising Saudi global crude exports over that period, which increased from 6.3m b/d in 2009 to 7.6m b/d in 2013. More recently, the Saudis have increased exports to the Asia-Pacific region. In 2013, that region accounted for 4.6m b/d of overall Saudi exports of 7.6m, according to Opec, while Asia accounted for 68% of Saudi crude exports in 2013 and the Americas only 19%.

The decline in US crude imports from the kingdom is a consequence of increased local and Canadian supply. Total US imports have declined sharply, from 9.6m b/d in 2009, down to 7.7m b/d in 2013, a year when it saw imports slide by a sharp 9.2%.

Thanks to the Motiva refinery, in Port Arthur, Texas, a 50:50 joint venture between Aramco and Shell, Saudi Arabia still has a guaranteed outlet for its heavy crude in the US Gulf. This gives it a slice of a market increasingly targeted by rival heavy-oil suppliers from Canada. But even with that buyer, supplies to the US have fallen in the past year. In April 2014, Aramco sold about 1.6m b/d to the US. In November, the most recent month with full data from the EIA, the figure was about 30m barrels, or just over 1m b/d.

Letting prices fall to force out some of this rival supply – in the US Gulf and elsewhere – carries risks for the kingdom. Despite a surge in the oil price in February, it remains 50% beneath the peaks seen in the summer of 2014. Market contango has spurred lots of traders to buy prompt oil for storage, too – meaning another price slide is plausible if demand doesn’t pick up sufficiently to drain those burgeoning stocks, or if storage rates keep rising to the point where the contango play is no longer profitable, forcing the spot market to retreat again to open that window.

Even more problematic is that no one knows yet where oil’s floor price is. Naimi suggested on 11 February that there were signs that higher-cost production was beginning to be shut in, but the evidence is thin. Despite sharp drops in US rig counts, output is still rising as producers there focus on higher-yield plays. The lower oil price is also likely to force down production costs, leaving the price at which US tight oil production continues to flow much lower than it was just a few months ago.

All this means that despite the recovery in February, the oil price could fall further – or simply take much longer to recover than Saudi Arabia expects.

The Saudis’ predicament partly reflects the pressures placed on the kingdom since the 2011 Arab uprisings, when the leadership pumped billions of dollars into the domestic economy to keep its restive youth off the streets. High oil prices let the kingdom pay for the largesse. Those same higher prices, however, dampened global oil demand growth and underpinned the growth in rival supply, from the Bakken to Iraq.

High oil prices could not survive weaker demand and rising supply. “Something had to give,” says Stevens, “and the result has been since June 2014 rising oversupply reflected in increasing stocks of crude oil. Stock levels in the OECD are pretty much full which means as supply increases you either put it into floating storage or you have to sell it.  And the only way you can sell is by lowering the price.”

Saudi revenue will now fall steeply. Riyadh-based Jadwa Investment predicts oil-export income will drop to $214bn this year, down from $270bn in 2014 and $323bn in 2013. To plug the gap, the kingdom may draw down on its reserves – or, as Naimi said, run a deficit. Citigroup expects sharp cuts in state spending this year, as slumping oil prices start to bite. The bank says real expenditure in the kingdom would decline 17.8% in 2015 to $241bn, leading to a non-oil contraction of 5%.

Saudi Arabia’s robust foreign reserves – net foreign assets at the Saudi Arabian Monetary Agency stood at $736bn at end-November 2014 – provide it with a cushion that no other Opec producer, bar Abu Dhabi, can match. It is also substantially higher than the $463bn in foreign assets that it boasted the last time oil prices plummeted, in early 2008. Most of these reserves are invested in low-risk US dollar assets such as US Treasury bills, and provide for at least three years’ import coverage. However, if it did come under sustained pressure from low oil prices, the reserves would eventually erode as they did in the late 1990s. Liquidating these treasuries would have other consequences for the Saudi economy – and for the US treasury – reducing investor confidence.

Whether oil prices recover by then is debatable. In theory, lower prices will force more costly-to-produce oil offline, forcing buyers back to the Gulf’s big suppliers. For those who put their faith in that basic economic theory, some signs of it working are already visible. In mid-February, the International Energy Agency said that while global demand in 2015 would rise by 0.9m b/d – a number unchanged from its earlier forecasts – falling non-Opec output in the second half of the year would lift the call on Opec’s crude to 30.2m b/d.

Saudi Arabia, however, won’t be the only Opec producer hoping to regain market share as demand for the group’s crude rises. Iraq and Kuwait continue to price their oil competitively and have big output growth plans. An easing of sanctions against Iran would push more of its oil into the market, too. Peace in Libya – a distant prospect – would do the same.

How long will Riyadh stick to the policy? Despite the change in Saudi leadership, there is unlikely to be an imminent shift. Naimi said in January the price could go to $20/b without testing the kingdom’s resolve. Some analysts close to the Saudi oil ministry, however, still say November’s Opec decision reflecting a tactical – not strategic – move by the Saudis: not a new laissez faire marketing policy, but a way to tell others in the group and some outside it (Russia and Mexico, for example) that the kingdom would not shoulder future cuts on its own.

For sceptics like Stevens, the Saudi stance underlines the futility of Opec’s attempts to control the market. “Opec has become irrelevant in terms of the oil market,” he says. “Even if it tries to get control, would they get unanimity? And more importantly, would anyone believe them? Do they have any credibility in controlling what is a huge amount of oversupply? Opec’s obituary has been ready many times before, but this time it’s very difficult to see what role it can play.”

Saudi Arabia’s commitment to the policy should be visible in its production numbers. Although the kingdom has shown no willingness to tap about 2.5m b/d of spare capacity it could draw on, production has been high by historical standards. Jadwa projects full-year average production in 2015 at 9.6m b/d, declining to 9.4m b/d in 2016. Short of an unexpected leap in global demand, those are hardly the kind of output figures that will drain the market of its excess oil, or return oil prices to a more comfortable $100/b level.

It will leave Saudi Arabia relying on its formidable financial strength. For now, there are few threats to the country’s bank balance. Until those less-efficient producers begin curtailing output and global inventories start emptying, the market will not regain the levels seen last year. Everything is in the timing of the market’s turn. The longer the slump lasts, the bigger the questions facing Saudi Arabia and the architect of its new market strategy, Naimi.

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