Oil markets have again started to make headlines in recent weeks with worries over a global supply glut seeing prices for both Brent and WTI plummet 31% since the beginning of October. Though the last couple of days saw some of those losses being clawed back following outages in the North Sea and expectations of production cuts by OPEC, most analysts remain bearish over the medium-term. Given oil’s centrality to the global economy, we took a step back to unravel and contextualize some of the shifts and dynamics that have been taking place in this strategically important commodity. This will be the first of a series of articles dealing with the primary drivers of oil markets in recent years beginning with Saudi Arabia.
Saudi Inc. - The Family Business
Any conversation about the state of oil markets should begin with the largest producer in OPEC, Saudi Arabia. A common misconception is that the Saudis are solely interested in a higher oil price, however this is far from the truth. While the Kingdom relies on Oil revenues for over 90% of its government expenditure and Oil exports make up 80% of the total net exports, it is far from being the Kingdoms primary motivator. In one of the most interesting and nuanced books on the subject aptly entitled ‘Saudi Inc: The Arabian Kingdom’s Pursuit of Profit and Power’, Dr Ellen Wald elaborates upon the often opposing forces at play when it comes to policy making and the royal families dynamic relationship with Aramco (the state-owned producer with a virtual monopoly in oil production). The leadership is motivated not only by long-term profit but also using the revenues and the company itself as a source of sustaining their grip on power. Unlike its western counterparts, Aramco is not encumbered by issues around quarterly earnings calls or sustaining a target share price, rather the goal is to sustain profitability over the long-run even at the cost of shorter term pain and support the house of Al-Saud on an inter-generational level.
A classic example of this was back in 2014 when then Oil Minister Ali Al-Naimi walked out of OPEC stating clearly that the regime wanted to increase production to full capacity despite oil prices being at cyclical lows. On face value this seemed to be a case of playing a zero-sum game, the logic went along the lines of ‘we might lose but others will lose more (i.e. since the Saudi’s have some of the lowest marginal cost of extraction in the world at less than $10 a barrel compared to US producers where the break even is $23). And while the gamble arguably didn’t pay-off as expected, a result of the lifting of sanctions on Iran and unprecedented increases in American shale production, this nevertheless illustrates the government's willingness to take high-stakes risks for longer term gains.
From a western perspective, this decision making process seems opaque and rather irrational but politics in Saudi has always been about two things. The first balancing the family’s interests and two, keeping a check on power. Ever since King Abdul Aziz reconquered his family’s stronghold of Riyadh in 1902 and the discovery of Oil shortly thereafter, the family has had to tread a fine balance between keeping western interests satisfied while maintaining a firm grip on a traditional society. In essence maintaining this balance has resulted in the pervasiveness of family and family members across all organs of the state (ranging from Defense to Commerce) while at the same time maintaining a close relationship with religious and conservative factions often referred to as the Wahabis. Wahabism is a particular strain of Islam that blurs the lines between radicalism and fundamentalist doctrines propagated and led by the other prominent Al Ash-Sheikh family, whose relationship with the royals is one of mutual dependence. They promote and give legitimacy to the political standing of the Al Saud’s in return for a free reign on political and social issues. And so despite periods of economic growth and huge inflows of wealth, in many ways society and politics in Saudi Arabia retains its traditional and tribal flavor, where ruthless pragmatism and familial loyalties trump all other considerations.
The history of Aramco is an excellent illustration of the above point. It was founded as an American company and bought back by the kingdom in stages during the 1970’s. However for almost all of its history, the operational and managerial aspects of the company has remained insulated from political interference. In fact for its first 8 years after acquisition, it was still registered in Delaware, and whilst this no longer is the case, the company’s management still see themselves as intensely American on par with Exxon, pursuing both vertical integration and value add-services in addition to primary production and extraction. To quote Dr Wald again, the attitude seems to be ‘they make us money and its well run, lets not touch it.’ But on production targets, the government uses oil rather as a tool for political purposes in conjunction with its regional foreign policy objectives and as a negotiation tactic with the Americans, best exemplified during the now infamous 1973 Oil Crisis.
So what does all this mean for Oil prices?
By now, we hope that it’s somewhat clear what the motivations are when it comes to the Saudi agenda. Their goal going into any OPEC meeting or thinking about Oil is not simply about fluctuations in price. So when trying to assess how they are likely to behave, it is perhaps more important to understand what the conditions they are facing at this point in time are and try to think about how they going to balance the priorities. The outcome is either an increase in production or scaling back.
From a purely economic standpoint, we would suggest that cutting production is the most rational move given the budget deficits the kingdom has run up since deciding to increase production in 2014.
While some of the associated problems were cushioned thanks to a recent crackdown on corruption. Which, though primarily motivated by a desire to consolidate power by the Crown Prince was also effectively an asset seizure of significant enough proportions to boost the budget. The one clear outcome of the move was to concentrate an increasing amount of power into the hands of the Crown Prince and the King’s favourite son Mohammad Bin Salman. So the answer to the question of what policy the Saudi’s are likely to take in the medium term lies with this relatively and until recently unknown 33 year old.
The curious case of MBS
When Mohammad Bin Salman or MBS was first appointed to the cabinet following his father's ascension to the throne, it hardly surprised anybody since he had been a close aide to his father when he served as governor for Riyadh province. However, things took a slightly different turn as he continued to assert himself in an increasing number of portfolio’s first being appointed to Defense and eventually deposing his cousin as Crown Prince (i.e. succession in Saudi has always been from brother to brother rather than to son). This assertion often came at the expense of other members of the family. In addition, his increasing impatience with trying to wean the Saudi Economy off its reliance on Oil, led to several ambitious moves including a vision 2030 plan and notable social changes including allowing women drivers and even cinemas in the hope of promoting tourism. Such moves though minimal by western standards signalled fundamental shifts and increasing royal assertion on the social life of the country seemingly at the expense of religious leaders.
Unfortunately for MBS, he has in recent times had to face the harsh reality that his forebears have been diligently trying to avoid for more than a century. You cannot liberalise an economy and expect societal and political norms to maintain status quo. The reason for the succession from brother to brother was to find ways around instability and the reason for stringent societal conditions was the price they paid for maintaining an authoritarian rule. While he had been given relatively free reign thanks to support from the White House with the administration preferring stability in one of the few allies in the region, he just may just have gone beyond the pale with the killing of Jamal Khashoggi at the Saudi Consulate in Istanbul.
The above incident puts MBS and Saudi policy in an unenviable situation. Firstly, he has very few allies internally thanks to his agenda and is evermore reliant on the patronage of the White House. And while it might make economic sense to curtail production, it is hardly advantageous for the Trump Administration who now have a leader that they have increasing leverage over and who will likely tow the line. This is probably the reason why both Trump and Pompeo wish to protect him despite raising the ire of Congress. His other alternative is to cooperate more closely with Russia and the Chinese who fortunately may not be as discerning or limited when it comes to allies. Either way, the Chinese as the one of the largest importers of Oil will also be putting pressure on the Saudi’s to at least maintain production. From a political standpoint it looks more likely than not that MBS will be motivated to either raise production (which would surprise and be more bearish on Oil) or maintain current levels (since the Russians as an Oil producing nation would want to cut production and maintaining the status quo satisfies or dissatisfies everyone equally).
The second and perhaps far-fetched alternative, is that the family and the King decide to take the more economic route. This might involve lowering the profile of MBS or even removing him completely from the picture. This would be a bullish signal for prices. Though far-fetched, in politics all is fair (even when it comes to family), the legacy must continue.
Markets & Commentary
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