Col­lat­eral dam­age takes toll

The West Australian - - WEST BUSINESS - Am­brose Evans-Pritchard Run­ning ev­ery­thing: Saudi Ara­bia's deputy crown prince Mo­ham­mad bin Sal­man in Paris. Pic­ture: Reuters

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.

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