The Battle For Black Gold: Can Saudi Win?

In the ongoing “crude” war that is the talk of every boardroom in the Middle East, all eyes are very naturally on Saudi Arabia as it gears up for a battle with other oil producers.

At the moment, the Kingdom seems to have the upper hand. “Saudi Arabia and its GCC allies can win a price war against anyone, yet Citi believes that OPEC has yet to face up to the reality that lower prices are here to stay and the current slump in oil prices is not just a cyclical downturn,” Seth Kleinman, an analyst at Citibank, said recently.

Brent crude oil prices have shed around 60 per cent of their value since June, but OPEC countries led by Saudi Arabia have refused to cut production to support prices.

Saudi Arabia and it allies believe an OPEC cut would only help US, Canadian, Russian and other producers to mop up market share at their expense. Instead, in recent weeks, Saudi Arabia has cut its selling price for crude for its Asian and North American customers to hold on to its turf.

Citibank estimates Saudi Arabia’s breakeven price to be around $98 per barrel, but few doubt that the Kingdom will be unable to cope with a sustained period of low prices.

“The priority of Saudi Arabia is to protect its market share at a time of weakening demand. In the longer term, Saudi officials likely calculate that lower oil prices will drive economic growth abroad and boost demand for oil,” Torbjorn Soltvedt, principal MENA analyst at energy consultancy Verisk Maplecroft, tells Gulf Business.

Bank of America Merrill Lynch analyst Jean Michel-Saliba believes that while the country has enough room to accommodate budget deficits mainly through cuts in capital expenditures, the absence of domestic borrowing, and sustained large deficits would eventually exhaust government deposits at the Saudi Arabian Monetary Agency.

“Therefore, in our view there’s a strong domestic reason for Saudi Arabia to eventually attempt to stabilise oil prices at a higher level,” Michel-Saliba wrote in his end-of-year report.

“Government revenues in 2014 are likely to be just seven per cent higher than 2008 levels, while government spending is likely to be 100 per cent higher.”

But with all the major producers reluctant to cut output amid low global demand, most analysts think oil prices are heading south at least in the short-term. That leaves Saudi Arabia and other major oil exporters to contemplate other sources of revenues.

SLOW DIVERSIFICATION EFFORTS

While Saudi Arabia hopes to maintain its central role in global oil markets, the country has also looked to diversify its revenue stream, but that has not borne fruit quickly. “The pace of diversification has been relatively slow although the drive to boost non-oil sectors is gaining momentum,” Soltvedt says.

“Even if the ambitious targets set in the National Industrial Strategy 2020 are not met within the next five years, it is clear that the size of the industrial sector will increase markedly by 2020.”

In the meantime, high public expenditure and low oil prices will erode the country’s fiscal surpluses, according to ratings agency Standard & Poor’s.

“The economy is undiversified and vulnerable to a sharp and sustained decline in global prices, despite the government’s policy to promote non-hydrocarbon private sector growth,” S&P remarked.

However, the ratings agency adds that the economy is supported by the Kingdom’s very strong fiscal and external positions of as much as $775 billion, which would provide an ample buffer to withstand external shocks, including a drop in global oil prices.

That’s cold comfort for the Saudi equity market that has entered bear market territory as Brent crude shaved off $50 per barrel in five months.

“The outlook for oil prices is more uncertain than usual, and a sharper-than- expected drop in prices — particularly if unaccompanied by stepped up reform efforts at home — could trigger large capital outflows,” notes James Reeves, an analyst at Samba Bank.

While the 2015 Saudi budget is lower than 2014, authorities will be careful to ensure that they do not freeze investment opportunities. Indeed, Saudi has earmarked a public investment program that accounts for more than 30 per cent of all central government spending.

That provides the Saudi authorities with significant fiscal flexibility to react to the deteriorating terms of trade and government revenue. In addition, the opening up of the Saudi equity market announced last year could be a catalyst for non-oil sector growth.

“Financial market liberalisation – if realised on schedule for mid-2015 – would likely attract billions in additional capital,” Soltved notes. “However, such reform could expose Saudi stocks to increased short-term volatility. Authorities are expected to gradually open up the market by awarding licenses to qualified investors depending on the amount of capital they hold. It is also possible that the size of investments will be restricted through quotas, at least initially.”

As part of its diversification drive, the Kingdom has awarded contracts worth SAR950 billion in the past three and half years, with a special to focus to build out education, healthcare, transportation, housing, logistics, water and power sectors, according to NCB Capital. The government is also offering housing loans of at least SAR25 billion a year as the authorities hope to meet their target of building 500,000 housing units for its citizens.

The International Monetary expects Saudi GDP to grow 4.6 per cent in 2014 and 4.5 per cent in 2015 – among the highest growth rates in G20 nations. Indicators such as cement sales, the value of cash withdrawals from ATMs, point of sale transactions, the PMI, and private sector credit growth also point to strong growth in non-hydrocarbon real GDP in the first nine months of 2014.

But lately, the economy has shown signs of cooling. The non-oil PMI fell in October to 59.1 following a 39-month peak at 61.8 in the previous month.

ATM cash withdrawals were lower by 1.4 per cent year-on-year in October while point of sale transactions recorded a year-on-year growth of 10 per cent, the slowest since February. Cement production grew by 0.4 per cent year- on-year, but sales fell by 4.2 per cent year-on-year.

The country has also spent much of the past few years reforming the labour market to create more jobs for the young, local population, which is growing rapidly.

Wage reforms in the private sector, and an effort to remove illegal expatriate workforce in certain sectors has hurt companies and delayed some projects, but in the long-term it clears the way for the private sector to recruit more Saudis.

“To strengthen the regulation of foreign labour, licenses are being issued to mega- companies to allow them to manage the overseas recruitment process,” according to the IMF. “A scheme to provide retirement benefits to foreign workers is also being considered and could help attract more-skilled foreign workers.”

CHANGING OF THE GUARD

Beyond oil price volatility, there are greater challenges behind the scenes for the authorities to contend with.

The issue of succession remains an important one especially as the inevitable generational shift from the sons of King Abdulaziz bin Abdul Aziz Al Saud to his grandsons draws closer.

Although the Allegiance Council was established to ensure a smooth succession process, the ability of the system to overcome entrenched rivalry amongst possible contenders for the throne remains relatively untested. It is clear that the process could cause greater volatility. In March 2014, for instance, several prominent princes criticised the Allegiance Council following the appointment of Prince Muqrin as Crown Prince.

Such disagreements could lead to political paralysis at a time when Saudi Arabia is not only engaged in a price war with other major oil producers, but is also looking to influence political changes in Bahrain, Syria, Egypt, Iran and Iraq.

Another key structural change that’s often under-reported is Saudi Arabia’s rising consumption of its own oil – it’s most prized export commodity. While the Kingdom is the world’s largest crude oil exporter, it is also the seventh largest consumer of crude oil – and growing at a fast clip to accommodate rising population and economic growth.

Saudi Arabia consumed 3.5 million barrels per day in September, 7.3 per cent higher than September 2013, and the eleventh consecutive month of positive year-on-year demand growth.

“Strong gains were seen in the gasoil/diesel, LPG and residual fuel oil categories as additional demand emerged as industrial sentiment thrived,” said the International Energy Agency.

“Having likely risen by just over five per cent in 2014, the Saudi Arabian demand forecast for 2015 is for a slower gain of approximately 3.5 per cent, a decelerating projection caused by weaker economic growth resulting partially from lower oil prices.”

Higher domestic oil demand means Saudi Arabia loses the opportunity to export oil at market prices, and instead uses it domestically at heavily-subsidised rates, resulting in precious loss of revenues.

While Saudi Arabia will ride out the low crude price-environment with some discomfort, there are much larger structural challenges facing the economy that are expected to come to a head over the next few years. It’s unclear whether the Kingdom is ready for those changes.