Collateral damage takes toll
The hedge funds have taken their bets. The market is convinced that Saudi Arabia will ignore the revolt within OPEC at a potentially explosive meeting tomorrow, and continue flooding the global markets with excess oil.
Short positions on US crude and Brent have reached 294 million barrels, the sort of clustering that can go wildly wrong if events throw a surprise.
Speculators need to be careful. They are at the mercy of opaque palace politics in Riyadh that few understand. Helima Croft, from RBC Capital Markets, says the only man who matters is the deputy crown prince, Mohammad bin Salman.
The headstrong 30-year-old has amassed all power as minister of defence, chairman of Aramco and the top economic council. “He is running everything and it comes down to whether he thinks Saudi Arabia can take the pain for another year,” she said.
The pretence that all is well in the Kingdom is wearing thin. Austerity is becoming too visible. King Salman has frozen hiring and stopped public procurement.
The system of cradle-to-grave welfare that keeps a lid on public protest is unravelling. Subsidies are draining away. It will no longer cost 10 pence (21¢ ) a litre to fill a petrol tank. There will be a land tax. Yet these measures hardly make a dent on a budget deficit near 20 per cent of GDP.
The war in Yemen — Saudi Arabia’s Vietnam — grinds on at a cost of $US1.5 billion ($2 billion) a month. It is far from clear whether the Kingdom can continue to bankroll Egypt as Islamic State tentacles spread from the Sinai to Cairo suburbs.
The risk of a Saudi sovereign default has rocketed to 23 per cent, measured by credit default swaps. Riyadh’s three-month Sibor rate watched as a gauge of credit stress has spiked to the highest levels since the Lehman crisis.
The question for Prince Mohammad is whether it is worth pushing his oil strategy to the limit, even to the point of rupturing OPEC. “They want to prevent a horrible family feud breaking out into the open, but what will they do if countries threaten to revoke their OPEC membership,” Dr Croft said.
Venezuela’s president, Nicolas Maduro, says his country will layout plans for a 5 per cent cut in OPEC production, trimming global supply by 1.5 million barrels a day. For months he has been in despair, protesting bitterly as the Gulf strategy cuts off half his funding and drives the Chavista revolution into its final agonies. Yet all of a sudden he is strangely cheerful.
“There are going to be nice surprises in the next few days for the recovery of the market,” he said after visits to Riyadh and Tehran.
The veteran Saudi oil minister, Ali al-Naimi, says that nothing is pre-ordained before the meeting. “We will listen and then decide,” he said. He is certain to get an earful. Iran wants cuts of 1.7mbpf and a return to the agreed ceiling of 30m, targeting a price band near $US70.
Algeria, Angola, Libya, Nigeria and Ecuador all back variants of this position. Iraq is more complicated but it is bankrupt and is cutting vital funding for anti-IS militias. “They can’t even pay the salaries of the security forces,” said Dr Croft.
The Saudis are not going to back down or admit that their policy is engulfing everybody in an unwinnable quagmire, but they might catch the speculators off guard with a form of “forward guidance”.
They might try to set off a “short squeeze” by agreeing to an expert review of a $US70 price band.
The Saudi royal family itself is divided. Prince Abdulaziz bin Salman, the deputy oil minister and an elder son of the King, raised eyebrows last month when he warned the low oilprice strategy was dangerously misguided, leading to massive cuts in investment, setting the stage for a future price spike.
Some $US200 billion of projects have already been cancelled, mostly in ultra deep waters, the Arctic, and Canada’s tar sands. Spare capacity is down to a wafer-thin 2mbpd.
This is the stuff of nightmares. All it would take is an accident anywhere in the world to send prices through the roof. If the Saudis want to retreat tomorrow, this line of argument is a face-saving way out.
The scorecard for the Saudis a full year after flooding the market cannot be what they hoped for. Brent crude is still languishing at $US43, down from $US114 in mid-2014. OPEC’s annual revenue has dropped by $US550 billion. They have failed to curb output by Russia, now pumping near record volumes. The Kremlin has scorned repeated offers of alliance.
Saudi Arabia is discovering that its riyal peg is a trap. Bank of America says the currency peg is forcing the country to burn through reserves at a pace that may soon reach $US18 billion a month. The 12-month riyal forward contracts — watched for signs that traders are betting on a collapse of the peg — have soared to 650 from 13 points in June. “Saudi Arabia may face a critical choice: cut oil supply, or de-peg,” it said.
Russia is in deep trouble but ultimately it can always fall back on its industrial and scientific base, and it can feed itself. The Saudis are closing their last wheat fields for lack of water. This is not a duel they can win.
Yes, the Saudi strategy has finally begun to inflict damage on the US shale industry. IHS expects total US output to drop to 8.7mbpd by April 2016, a fall of 900,000bpd from a 43-year peak in April of this year.
It has taken longer than expected and the geostrategic cost has been higher. Fracking costs have fallen so far that the industry will probably spring back to life as soon as crude reaches $US55.
High-debt companies will fall like flies over coming months but the technology cannot be wished away. Bigger players with stronger balance sheets will take over. There is a loose parallel with the dotcom boom and bust.
Hundreds of the high fliers in the late 1990s went bankrupt: the information revolution scarcely missed a beat. Shale frackers will snap at OPEC heels for years to come. There is nothing the Saudis can do about it.