Most fundamental indicators are flashing bearish signals for oil. 1) Inventories are rising on a seasonally-adjusted basis. 2) Oil production continues to rise in Brazil, Kazakhstan, Libya and the United States, largely offsetting production cuts by the Organization of Petroleum Exporting Countries (OPEC) – which is itself showing cracks in its resolve to maintain production cuts. 3) Vehicles are becoming increasingly fuel efficient, dampening consumer demand for gasoline.
Despite all that, oil is not without upside risks. In our previous articles, we have discussed the possibility of instability in four major oil producers who have been hard hit by the collapse in oil prices and who lack substantial financial reserves, namely Algeria, Angola, Nigeria and Venezuela. Together, those four nations produce about eight million barrels of oil per day and related liquids, about two thirds as much as Saudi Arabia, the world’s top oil exporter. But what is going on with the Saudi economic landscape?
The Saudis are rapidly burning through their currency reserves (Figure 1) and are running a budget deficit of 7.3% of GDP. And, Saudi Arabia’s domestic and regional politics have taken some dramatic turns in the last few months. On June 21, King Salman replaced the next in line to the throne, Prince Mohammed bin Nayef, with his 31-year-old son, Prince Mohammed bin Salman. This change occurred two weeks after Saudi Arabia, the U.A.E., Bahrain and Egypt cut diplomatic ties with Qatar largely at the initiative of Prince Mohammed.
Qatar has been a thorn in the side of Saudi Arabia and Egypt for years. The two countries accuse Qatar’s Al Jazeera television network of fomenting unrest and being favorable towards the Muslim Brotherhood, an Islamist group in Egypt. More broadly, Saudi Arabia sees Qatar as being close with its regional rival Iran, with whom Saudi Arabia is battling regional proxy wars in Syria and Yemen, neither of which is going well.
Saudi Arabia’s beef with Iran reflects internal as well as external concerns. Most of Saudi Arabia’s oil is located in the eastern part of the kingdom, which is populated by a Shiite majority that is significantly less well off than its Sunni cousins in the rest of the country. As such, Saudi Arabia dedicates substantial resources to preventing unrest in its oil-rich but otherwise less-well-off Persian Gulf Coast.
Libya provides a hint of how sensitive oil prices can be to even small changes in supply. When the Arab Spring that began in late 2010 toppled the Gaddafi regime, Libya’s oil production fell by two-thirds from 1.8 million barrels per day to 0.5 million barrels, a drop equivalent to 1.5% of the world’s total supply. That comparatively small drop in production sent oil prices approximately 20% higher. However unlikely a similar production cut in Saudi Arabia might be, the fact that the country produces 12% of the world’s total oil supply gives an idea of the potential oil price shock if Saudi Arabia takes a strikingly different path in managing its oil resources.
The critical challenge for Saudi Arabia is its financial prospects in a world where a barrel of oil is $60 or less, perhaps much less, versus the heady days of $80-$110. Maintaining the standard of living in Saudi Arabia is a major factor in maintaining its financial stability. So far, the collapse in crude prices has deprived Saudi Arabia of revenues equivalent to 20% of GDP, yet despite some cutbacks in the public budget, the average Saudi citizen has been relatively insulated from the impact for two reasons: reduced FX reserves and increased debt being used to prop up the economy. Saudi FX reserves have fallen from $731 billion in late 2014 to $490 billion at the end of April 2017.
The rebound in oil prices from $26 per barrel in February 2016 to over $50 by early 2017 did slow the pace at which Saudi Arabia was burning through its currency reserves. In February 2016, when oil prices hit bottom, Saudi Arabia’s reserves were $131 billion smaller than a year earlier. One year later, with oil prices to around $50 per barrel, Saudi FX reserves are down by “only” $80 billion from a year earlier (Figure 2). One key factor to watch over the next few months: will the most recent dip in oil prices provoke a faster decline in FX reserves?
Saudi Arabia’s $490 billion in FX reserves will last the country about six years at the current rate of draw down. Letting the reserves fall all the way to zero, however, is not a realistic choice. Long before that, one of four things is likely to happen: more drastic budget cuts, a currency devaluation, sale of state assets or a major ramp-up in the level of debt. The first two choices are unpalatable as both contribute to the potential for unrest. Hence, the push to list state oil company Aramco and the necessity of increasing debt levels. Saudi Arabia’s ability to do these two things will play a key role in determining how long a day of financial reckoning can be postponed.
Saudi Arabia’s budget deficit of 7.3% of GDP sounds dire but it’s not. Just as the kingdom built up massive currency reserves during the good times that helped to weather the recent collapse in oil prices, the country spent most of the past 15 years paying down debt.
Back in 2000, the Saudis were deeply indebted. The Saudi government’s debt level was close to 100% of GDP after years of deficit spending to offset the collapse in oil prices in 1985 and 1986. By 2015, the government debt had been nearly paid off. Saudi Arabia’s private sector, however, accumulated debt over the same period, rising from 30% to nearly 50% of GDP. Since oil prices collapsed again in 2015, both Saudi public and private sector debt have risen. Public sector debt has gone from 2% to 13% of GDP, and private sector debt has increased from 50% to 68% of GDP. In essence, deficit spending by both the Saudi public and private sectors has kept GDP stable despite the crash in oil prices (Figure 3). Overall, debt at 81% of GDP is roughly double its recent lows but it remains far below the 2000 levels when it exceeded 120% of GDP and pales in comparison to debt levels in countries like the United States, Europe, China, Japan, South Korea and Canada where debt levels generally exceed 250% of GDP.
The Saudi’s can continue to raise debt for many years but the higher the debt levels, the less positive the impact they will have in terms of boosting or maintaining standards of living. The natural consequences of debt is that when debt levels are low, additional borrowing has a big impact on GDP because one entity’s spending or investing becomes income for somebody else. As debt levels rise, however, the impacts diminish as a larger portion of newly issued debt serves merely to finance existing debt. As such, the Saudi’s probably have at minimum two or three good years ahead of them in terms of the ability of increased debt to boost GDP and, given the low level of government debt, it will probably be more like five to ten years. That said, they know that this cannot continue indefinitely and hence the pressure to sell state assets.
The Saudi government has a magnificent asset: Aramco, almost certainly the most valuable corporation in the world. Opening Aramco to foreign investors could offset the decline in FX reserves and prolong the period during which Saudi Arabia can avoid a major economic reckoning. The problem is that Aramco’s valuation depends in no small part on the price of oil, the same commodity that is at the origin of the kingdom’s current financial woes. Moreover, before any initial public offering (IPO) occurs, investors will have to be reassured that Aramco can be disentangled from the Saudi state, which has used the oil company as a national piggy bank since the mid-1970s. Questions abound:
The idea is to use the proceeds from Aramco’s listing to fund a broad diversification of the Saudi economy. This is a tall order. Diversifying the economy requires more than just infrastructure: it requires an educated and competitive workforce that can produce goods and services of value for the rest of the world beyond oil. Can Saudi Arabia’s cosseted population compete in the international economy without massive state subsidies? Look at the political upheavals in the U.K. and U.S. where working class people have been sidelined by international competition and technological advances. At least most western workers never had an expectation of a high standard of living without working for it: the same may not be true in Saudi Arabia.
The kingdom seems to think that 5% of Aramco should be worth $2 trillion, but others value the firm at about 40-60% of that amount. If Saudi Arabia raises $1 trillion, that would be enough to offset 12-years of currency reserve declines at the current pace and should be enough to stabilize the economy and invest for the future. But will the efforts to revamp and reorient the economy away from oil be effective? As such, it’s tempting to view state asset sales as a means of clinging to the past by delaying inevitable and painful reforms rather than preparing for a very different future.
Overall, Saudi Arabia seems to have little immediate risk to its financial stability. It is a tall order to take a country that has relied on its oil wealth to manage its economy and transition it to an economy much less dependent on oil. What is clear is the kingdom appreciates the urgency and has made key changes designed to get the transition started. What is not clear is if the economy can be transformed in a stable manner given the timeframe provided by the financial challenges. This puts pressure on the Aramco sale to be successfully executed. Once the Aramco IPO is completed, what will be the future of Saudi Arabia as a swing oil producer? While not particularly probable, Aramco and Saudi Arabia might conclude that materially lower level of production and higher oil prices might be a better path for achieving 20-30 years of financial stability. That said, while the risks of supply disruptions in Saudi Arabia are relatively small , they will grow with time if economic reforms do not succeed, if oil prices don’t rebound and if the Aramco sale fails to generate the desired proceeds.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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