Saudi Arabia’s misjudged gamble on oil

In 1986 the Saudis opened the spigot and sparked a four-month, 67% plunge that left the price of oil just above $10 a barrel. That led to the economic slowdown of the industrialised economies worldwide The US oil industry collapsed, triggering a quarter-century of production declines, and the Saudis regained their leading role in the world’s oil market. This time it is different and it is likely Saudi Arabia will suffer most.

An Alarming Forecast

On 14 August the 20-day average of the contract price of US crude oil (West Texas Intermediate WTI) for delivery in December 2020 was $63.28 a barrel. This implies a drastic change in the economic landscape for the Middle East and petro-states.

A Saudi Gamble

In November 2014 Saudi Arabia stopped supporting prices and opted to flood the market and drive out rivals at a time when there was already a glut with more oil circling the oceans than users wanted to buy (Market chokes on glut).

It seemed that the main target of the Saudi action was the US shale industry which was perceived to be high cost and would not survive an oil price nearer $50 than $100. If that was the aim, the Saudis misjudged badly. One Saudi expert was quoted in the Daily Telegraph as saying, “The policy hasn’t worked and it will never work.”

US Shale Frackers

The problem for the Saudis is that they are mostly mid-cost, not high-cost. Constant technical developments drive down costs and IHS (a data analysis co) sees reductions of 45% this year. John Hess, Hess Corporation, said, “We’ve driven down drilling costs by 50% and we can see another 30% ahead.” Many over-leveraged wild-catters may go bankrupt but the wells, technology and infrastructure are there and stronger companies will mop-up on the cheap. Every rise in the oil price will increase production immediately.

Saudi Arabia Beached

It relies on oil for 90% of its budget revenues. Citizens pay no tax on income, interest and dividends and subsidised petrol costs 12 cents a litre. The IMF estimates that the budget deficit will reach 20% of GDP this year. The fiscal breakeven for oil is $106. Currency reserves will be exhausted by 2020. The Saudis are trapped. The government may slash investment spending but in the end it must face draconian austerity.

So What?

Draconian austerity will fuel an increase in Shia unrest, will encourage more terrorist attacks from ISIS and will bring greater instability to the Middle East. A worst case would be a rear-guard action by the House of Saud and a situation somewhat similar to Syria today (2015). This may be the prospect that will trigger a worldwide stock market crash.

Robert Bewell

About Robert Bewell

Retired Branch Principal & Wealth Manager - Raymond James, Hitchin. Robert has a positive view on risk management and volatility and an enthusiasm for both fundamental and technical analysis. Robert retired in 2016 after more than 30 years in the financial industry. He co-founded the Raymond James, Hitchin office with his daughter Susie, who is now joint branch principal with Faye Silver. Robert lives in Letchworth with his wife Jane and enjoys the company of his daughters and grandchildren.

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