- Comprehending oil price movements in the post-Doha world requires a nuanced understanding of geopolitics.
- The escalating proxy wars between Sunni Saudi Arabia and Shiite Iran will go a long way towards determining crude prices in the years ahead.
- “Fundamentals” may ultimately become synonymous with “politics” and “war.”
On January 2, Saudi Arabia did something stupid: they executed prominent Shiite cleric Nimr al-Nimr as part of what amounted to the largest mass execution in the kingdom in around a quarter century.
To say executing Nimr was decisively foolish isn’t to say that Riyadh didn’t fully understand that they were stirring up a veritable sectarian hornets’ nest. The official excuse for killing the Sheikh was that he was a “terrorist” (he was accused of sedition among other things).
In fact, he was a political dissident and a leading figure in the anti-government protests that swept through the Shiite-dominated Eastern Province during the Arab Spring. Here’s a bit from The Economist that does a fairly decent job of hitting the high points in terms of the backstory:
A powerful orator, 54-year-old Sheikh Nimr emerged as a leader of protests that broke out in 2011 in response to the violent suppression of the pro-democracy movement in neighboring Bahrain. The island kingdom, whose predominantly Shia population is ruled by a Sunni dynasty, is linked to the Eastern Province by a causeway. In sermons Mr. Nimr did not only denounce the Bahraini clampdown, which was bolstered by troops from Saudi Arabia and other Sunni Gulf allies. He also demanded greater rights for Saudi Arabia’s own disenfranchised Shias, who have long complained of discrimination in government jobs and education.
“In any place he rules – Bahrain, here, in Yemen, in Egypt, or in any place – the unjust ruler is hated,” Nimr once said. “We don’t accept al-Saud as rulers and want to remove them,” he added, in case what he was trying to convey was in any way unclear.
The Sheikh’s execution sparked protests across the Shiite world, from Bahrain to Pakistan – and of course in Iran, the bastion of Shiite Islam where the Ayatollah promised “divine vengeance” upon the Saudis. Nimr was executed on a Saturday, and by the time the weekend was over, the Saudi embassy in Tehran was in flames (literally) and Riyadh had cut diplomatic ties with Iran.
“Ok, interesting, but what’s the point?” you might fairly ask. Look no further than the much ballyhooed meeting of 18 oil producing nations in Doha earlier this month for the answer.
As anyone who follows oil markets is acutely aware, Saudi Arabia refused to agree to any constraints on the kingdom’s production unless Iran agreed to freeze its own output.
What’s particularly interesting about the Saudis’ refusal even to freeze production at record levels is that the decision appeared to emanate not from Saudi Aramco, but from deputy crown prince Mohammed bin Salman, who, asBloomberg recently outlined, has consolidated power in the kingdom and is masterminding a push to diversify Riyadh’s revenue stream away from hydrocarbons.
“Observers saw it as extremely rare interference by a member of the royal family,” Bloomberg wrote last Thursday, before noting that “traditionally [the ruling family has] given the technocrats at the Petroleum Ministry ample room for maneuver on oil policy.”
“Extremely rare” – maybe. “Extremely unexpected” – hardly.
“Saudi tactics on the freeze appear to be a part of a shift in the kingdom’s oil policy,” The New York Times writes. “The Saudis, analysts say, increasingly seem to accept that they can no longer control oil prices through OPEC.”
In other words, if an unruly Russia and (down but not out) U.S. production are curtailing the cartel’s ability to function as a cartel, then the Saudis will simply resort to the next best option: using oil prices as an instrument of foreign policy to punish their bitter sectarian rival Iran. Here’s Deutsche Bank:
As it happened, the rift between Saudi Arabia and Iran proved to be the decisive factor, turning what might have been a symbolically positive event into a negative and casting a shadow over the potential for any agreement at the next scheduled meeting on 2 June. In other words, it now appears likely that both Saudi Arabia and Iran will maintain their incompatible positions.
To be sure, it was abundantly clear from the beginning that Iran was never going to agree to a production freeze. “They should leave us alone as long as Iran’s crude oil has not reached 4 million,” oil minister Bijan Zanganeh said last month, in response to pressure from other producers. “We will accompany them afterwards,” he added, referring to the point at which Iranian production reaches some 4 million b/d.
Here are two graphics, one from Barclays and one from Deutsche which should give you an idea of where Iran is versus pre-sanction production and versus the 4 million b/d target:
Put simply: Iran just came off international sanctions and is hell-bent on getting output back to (and above) pre-sanction levels. Just about the last thing Tehran wants to do right now is curb production just when oil revenues are set to quadruple or more by year end – especially if it’s the Saudis demanding said production curbs.
The problem for the Saudis is that the kingdom is facing an expected budget gap of some 13% in 2016. Not to put too fine a point on it, but that’s huge (although lower than the 16% hole Riyadh saw last year).
Cuts to subsidies orchestrated in part by the reform-minded deputy crown prince have helped, but as the red ink continues to pile up, the Saudis will either need to burn more FX reserves, drop the (heretofore sacrosanct) riyal peg, or else tap the debt markets.
As Citi recently put it, “GCC states have responded decisively [to falling prices] through surprisingly aggressive fiscal consolidation. On the expenditure side, spending rationalization has dominated via project cancellations/delays, efficiency drives and other penny-pinching measures.”
But that may not be sufficient for the Saudis or for the other Gulf monarchies.
Here’s a sensitivity analysis from BofA that outlines how long Riyadh can hold out under various scenarios of debt vs. FX reserve burn vs. oil prices (it’s a bit dated, but it illustrates the tradeoff quite well):
For now, the royal family is betting that they can diversify their revenue stream away from oil in time to avert going broke (and I mean literally going broke). Here’s Bloomberg:
On April 25 the prince is scheduled to unveil his “Vision for the Kingdom of Saudi Arabia. It includes the creation of the world’s largest sovereign wealth fund, which will eventually hold more than $2 trillion in assets. The prince plans an IPO that could sell off “less than 5 percent” of Saudi Aramco [and] the fund will diversify into nonpetroleum assets. The tectonic moves “will technically make investments the source of Saudi government revenue, not oil,” the prince says. “So within 20 years, we will be an economy or state that doesn’t depend mainly on oil.”
Even if you believe that (and you probably shouldn’t), 20 years is a long time – especially for a country that is spending rapidly on an ill-fated war in Yemen, a proxy battle in Syria, and the still astronomical cost of subsidies for the populace.
And here’s where it all comes full circle; the very real possibility of going bankrupt be damned, Riyadh would rather try to suppress Iran’s oil revenue by keeping prices at bay than it would buoy its own flagging fiscal position by agreeing to freeze output (and keep in mind, freezing output would hardly be a major concession considering production is running at a record pace).
As Reuters puts it, “Saudi Arabia would rather have a lower oil price and lower revenues for all producers, including itself, rather than reach a production agreement that would deliver increased income to its arch-rival across the Gulf.”
This goes far deeper than the kingdom’s spiteful war of attrition with the U.S. shale complex. This is a blood feud between Sunnis and Shiites.
What the mainstream press hasn’t done an ample job of highlighting is that the entire region is effectively embroiled in a sectarian war between Sunni Saudi Arabia and Shiite Iran.
The Saudi belligerence in Doha earlier this month and the execution of Sheikh Nimr al-Nimr in January are both consequences of the escalating conflict which also includes the war in Yemen (where the Saudis are battling Iran-backed Houthi militiamen), the five-year conflict in Syria (where Riyadh funds Sunni anti-Assad elements and Iran fights alongside their closest ally in the Shiite militia Hezbollah), and the protracted battle for Iraq, where ISIS (a group which, like the Wahhabist religious authority in Saudi Arabia, espouses a puritanical version of Islam) is at war not only with the Iraqi regulars, but with Tehran-funded Shiite militias.
In short: when you think about Doha and Riyadh’s refusal to curtail crude production, you must also think about Yemen, Syria, Iraq, and the protests that followed Nimr’s execution. That is, this is a perfect example of the intersection of geopolitics and financial markets (after all, crude is the most financialized of all commodities).
The longer the sectarian wars in Yemen, Syria, and Iraq drag on, the more contentious the political atmosphere between Riyadh and Tehran will become and in turn, the Saudis will increasingly look to suppress crude prices to minimize the windfall gain its regional rival can expect from ramping production.
It’s also important to understand Russia’s record production as a function of war and politics. Last year, it became reasonably clear that in addition to bankrupting U.S. shale, part of the reason Saudi Arabia chose to crush crude in late 2014 was to exert pressure on Moscow to give up its support for Bashar al-Assad in Syria.
That, as it turned out, was a disastrous gamble for Riyadh. Russia wavered for a moment, but within 9 months had not only invaded Syria on behalf of Assad (who, contrary to accounts you might read elsewhere these days, is certainly no human rights hero for “liberating” Palmyra and other captured cities from ISIS) but had also ramped up crude production to record levels.
While those two maneuvers have been variously pitched as a show of strength on Moscow’s part, they were actually incredibly myopic. Russia has made the exact same mistake as Saudi Arabia: they’ve contributed to falling oil when crude is the backbone of their economy, and they’ve spent heavily on a foreign war. Russia will end up just as broke as the Saudis over time if they continue to pursue this lunatic, masochistic policy path. If and when that happens, we shall see how long popular support for Vladimir Putin remains near 90%.
In an example of just how politicized this game has become, the IEA’s Neil Atkinson told CNBC on Friday that “in the post-Doha world, when we’re still in what is essentially a free market for oil, they (the Russians) will pump as much oil out as the market will absorb and the Saudis have said much the same thing.”
If you’re Vladimir Putin or King Salman, that’s just plain dumb. Riyadh will be roughly broke by 2019 or so at these prices and Russia isn’t doing itself or its allies in Iran any favors by continuing to pump.
In any case, some will undoubtedly argue that “fundamentals” will (eventually) trump politics in global oil markets. Last week’s price action is proof, they’ll say. Here’s Reuters for instance:
Brent gained about 5 percent this week and WTI nearly 9 percent. Crude is up more than two-thirds since its 2016 lows between January and February.
Strong gasoline consumption in the United States, increasing signs of declining production around the world, and oilfield outages have underpinned a return to investment in the sector, traders said.
“The current rally is driven by a market sentiment that is becoming more and more convinced that the worst is over and the global oil market rebalancing process is already in play,” said Dominick Chirichella, senior partner at the Energy Management Institute in New York.
All of that may be true, but it largely misses the point. Politics has become the key part of the fundamental picture. As Credit Suisse writes:
Saudi Arabia raises a bearish flag. We may find out more from MbS next Monday April 25th, but we think that markets will soon have to focus on Saudi Arabia upsetting the proverbial apple-cart in Doha. The specter of large slugs of new capacity coming online in Saudi in a few years and of Aramco selling some 0.35 to 1.2 million barrels a day more crude oil to any and all comers within months now looms over oil markets. As for Doha, it turns out that we should have listened more carefully to what Mohammed bin Salman told the world in an interview on Bloomberg on Friday 1 April and still more explicitly again on Bloomberg on Friday 15 April. No longer are Ali al-Naimi or MbS’ half brother the ones to negotiate with. All accounts of the meetings on April 16-17 tell the same story, that Russia, Iraq, Venezuela, Iran and everyone else were caught unaware when on Saturday MbS voided the carefully wrought ‘deal to freeze’ that they all thought they had come to Doha to sign.
Right. In other words: it’s not up to the oil minister anymore. This is now up to the royal family and the royal family is waging three proxy wars against Iran and one with Russia (although no one would dare admit the latter). It’s all political and these days, geopolitics is less and less about diplomacy and more and more about the use of force. In short, in the current geopolitical environment, there will be more volatility for crude and make no mistake, there will be (MORE) blood.
Those interested in the complete supply/demand picture should have a look at the following tables from Credit Suisse:
For what it’s worth, the managed money crowd is long – really long:
We’ll close with one last quote from Citi:
Doha confirms we are now in the new normal. But as the remarks of Saudi Deputy Crown Prince Mohammed bin Salman make clear, geopolitics extend beyond that internal OPEC scrap to the positioning of all three of the world’s oil superpowers: Russia, Saudi Arabia and the US. This new world oil order is one where zero-sum politics have moved from producer vs. consumer relations to producer vs. producer.