Saudi Arabia is hoping to break free from its dependence on oil. Can it do it? And what will that mean for the rest of us – and for the oil price? Matthew Partridge reports.
Over the past two years the oil market has been turned upside down. By summer 2014 oil prices had spent the best part of three and a half years above $100 a barrel. Almost everyone – analysts, economists, pundits, oil companies – expected it to stay that way. Yet within just six months, prices had halved.
After a brief respite and recovery in early 2015, a second slide saw both key oil benchmarks – Brent and West Texas Intermediate (WTI) – crash below $30 a barrel, levels not seen since 2004. Since the start of this year, prices have made another comeback. But can this rally last?
There are plenty of factors behind oil’s slide – from the glut of US shale oil, to concerns over Chinese growth, to worries about rate hikes in America. But the biggest factor is arguably the actions of Saudi Arabia. The wealthy oil state says it is planning for a future beyond oil. Is that possible? And what will that mean for oil?
This’ll hurt you more than it hurts me Saudi Arabia has huge influence on the oil market. It accounts for around a fifth of the world’s reserves, and its de-facto leadership of oil producers’ cartel the Organisation of Petroleum Exporting Countries (Opec) only increases its power. Between them, the cartel’s 13 members account for around 40% of oil production and 80% of proven reserves.
However, as advances in “fracking” technology have unlocked US shale oil, enabling America to become a top producer too, Opec’s grip on the market has slipped. After prices started to slide in 2014, most analysts assumed that Opec would slash production.
Instead, the Saudis raised output, against the wishes of many fellow Opec members. It seemed odd, but it was a simple recognition of reality – the last thing the Saudis wanted to do was to cut down on their own supply and encourage America to boost production further.
The decision has taken its toll on US shale producers, whose production costs are higher than the Saudis’. The number of crude oil rigs deployed in America is down by more than two-thirds from its peak, expansion plans have been mothballed, and several shale producers have gone bust (although the industry endures – as my colleague David Stevenson points out below).
But it’s not just about staving off Western rivals. Saudi Arabia sees itself as the centre of both the Middle East and the Muslim world. Iran strongly disagrees. This conflict has its roots in the centuries-old dispute between two different branches of Islam (Saudi Arabia is mostly Sunni, Iran mostly Shia), but has acquired a new urgency in the past five years, as a result of the “Arab spring”.
Neither Iran nor Saudi Arabia – both highly authoritarian – welcomed the pro-democracy protests that gripped the Middle East following the revolution in Tunisia in late 2010. But that didn’t stop them from exploiting the chaos in order to advance their own interests, resulting in a proxy war between the two across the region.
In Syria, Saudi Arabia has supported Islamist rebels against both Syrian dictator Bashar al-Assad, and the moderate Syrian opposition. In response, Iran has given Assad weapons and troops. In Yemen, Iran has backed the Houthi insurgency, which has driven the internationally recognised government from the former Yemeni capital, Sana’a.
In response, Saudi Arabia has bombed Houthi positions. So for Saudi Arabia, cheap oil is as much an economic weapon as a liability. Low prices might hurt Riyadh, but the Saudis hope that they will be more painful for Iran – which has recently re-entered the oil market after the US lifted sanctions against the country – and also Russia, which is friendly to both Iran and Assad.
Saudi Arabia’s game of thrones
A succession struggle has merely complicated things further. Last year, 80-year-old Salman bin Abdulaziz Al Saud became king, giving him absolute power. However, reports suggest he suffers from dementia and struggles to carry out even basic duties.
The official heir is the crown prince and interior security minister, Muhammad bin Nayef. However, analysts think he wants to pass the crown to his son, the 30-year-old deputy crown prince, Mohammad bin Salman Al Saud (normally the crown passes from brother to brother).
Prince Mohammad, currently the Saudi defence minister, is known for his aggressive anti-Iranian stance. Not only has he played a key role in Saudi Arabia’s Yemen campaign, but last month he overruled the Saudi oil minister to veto a deal that would have seen Opec producers join Russia to freeze production at January’s levels. Why the veto? Because the deal didn’t include Iran.
Meanwhile, a fortnight ago, the prince outlined a dramatic new economic policy that would see Saudi Arabia slash welfare spending, and end its “addiction to oil” by diversifying the economy. Mohammed has even promised to float a small stake in state-owned oil giant Aramco, and create a huge sovereign wealth fund. Most ominously for other oil producers, the report pledges that the reforms will go ahead, even if the oil price falls below $30, suggesting the Saudis are planning for prices to remain low.
Keep pumping oil to hang on to market share, while quickly diversifying away from a dependence on the stuff. It sounds like a good plan – on paper. But it’s unlikely to work in reality, says geopolitical analyst John McCreary of KGS NightWatch. The Saudis have been talking about diversification for nearly two decades now, but have made little or no progress. In 2005 the creation of a $100bn city, which was meant to turn the kingdom into a centre of finance and manufacturing, was announced.
Last year, the Saudi government admitted that the project would take a further two decades to complete, if it ever gets off the ground at all. One key issue is Saudi Arabia’s harsh religious laws. To become an attractive destination for finance and non-religious tourism – industries the country is keen to encourage – these would have to be toned down substantially. But that would mean confronting the powerful religious establishment, and that’s unlikely to happen.
For the last four decades or so the regime has operated under an implicit agreement, whereby it adheres to a harsh interpretation of Islamic laws in exchange for the religious authorities supporting the absolute monarchy and opposing anything that would diminish its power.
Easier said than done
So diversification is easier said than done. And the fact is that for all the bravado, cheap oil is playing havoc with the Saudi economy. Oil revenues account for 90% of government revenue, so falling prices have caused the deficit (the gap between annual income and spending) to explode to $98bn, equivalent to 15% of GDP.
The war in Yemen is also proving expensive. As for cutting spending – as many other, more stable nations have learned, budget cuts look good in theory, but getting them past a hostile population is a different matter. Saudi Arabia faces potential unrest from both its Shia minority and its youthful population, meaning that any attempts at austerity are likely to spark popular protest.
Tentative efforts towards modest tax rises and subsidy cuts have already proved extremely unpopular. The financial situation is so unhealthy that credit-ratings agencies recently downgraded Saudi bonds, while the international Monetary Fund warns that Saudi Arabia could conceivably run out of financial assets within five years. One sign of just how hard cheap oil is hitting Saudi Arabia comes from the construction business.
The Saudi Binladin Group, the largest builder in the country, fired around a quarter of its workforce – 50,000 workers. The staff were mostly expatriates from Asia, and the Binladin Group claims they were paid off in full, but there have been protests nevertheless, some of them violent.
Finally, Saudi Arabia’s policy of pushing down prices is alienating its Arab allies, including those in the Gulf. So despite the failure of the most recent Opec talks, there are plenty of reasons to think that Saudi Arabia could compromise in the near future.
Indeed, as Thomas Pugh of Capital Economics points out, the Saudis were among the first to raise the possibility of freezing output in the first place, so a complete Iranian freeze may not be the stumbling block most assume – instead, a smaller increase from Tehran may be a possible compromise.
So how high could prices rise if Saudi Arabia does agree to cuts? Most economists agree that the government needs prices to rise to around $100 a barrel to enable it to balance the budget. US shale oil means that seems highly unlikely to happen.
However, it’s plausible that we could see prices rise to around $60-$65, the level at which the majority of the US shale industry becomes viable again. Capital Economics expects a medium term price of $60 a barrel. We look at the best ways to play the oil market rebound below.
The best bets in the sector
If you’re looking for a direct “long” bet on oil, then an exchange-traded commodity fund such as ETFS Commodity Securities Crude Oil (LSE: CRUD) is one option. It is linked to the Bloomberg WTI index (so should rise or fall with the oil price) and has a total expense ratio of 0.49%.
However, direct bets on commodity prices are little more than speculation. A better strategy is to invest in beaten-down oil stocks. Royal Dutch Shell (LSE: RDSA) looks the most attractive of the UK oil majors. Shell refused to hedge its production when prices tumbled, but that means it stands to benefit all the more if prices continue to recover.
Meanwhile, the company has slashed both capital spending and operating expenses. It trades at 13.7 times 2017 earnings, and should be able to maintain its dividend at the current 7% yield. Rising prices should also help those explorers who can survive long enough to take advantage of the rebound.
James McKeigue notes that there has been a lot of interest in the gas and oil deposits in the Vaca Muerta deposit in Argentina, helped by government subsidies and heavy investment from international oil companies. One way to play this is via Andes Energia (LSE: AEN), though be aware that the company is not making any profits yet, so it’s a high-risk trade.
Finally, there’s state-owned Brazilian producer Petroleo Brasileiro (NYSE: PBR), aka Petrobras. Petrobras is a really risky play, due to the various corruption scandals surrounding the company and Brazil.
However, we expect the impeachment of Brazilian president Dilma Rousseff to act as a catalyst for a host of business-friendly reforms, among which is likely to be reform of Petrobras. This should enable the company to cut costs and debt. At the moment it trades at 6.7 times 2017 earnings and nearly a 50% discount to book value.
We’re on the bottom – now’s the time to buy
Oil prices could fall again – maybe towards $30 a barrel – but I think we’ve seen the bottom, writes David Stevenson. Managers are now launching funds to take advantage. Guinness Asset Management is in the early stages of launching a new oil and gas closed-end fund, for example.
Guinness has experience in the sector with its Global Energy Fund, but now it has recruited two exploration and production (E&P) experts from investment house M&G – Sachin Oza and Stephen Williams. The pair’s new fund will focus on smaller, listed E&P stocks.
The fund is built on an assessment of the top ten basins for oil and gas globally, and will have a strong African and Latin American flavour. The portfolio will contain around 30 stocks, and the managers will then try constructively to engage with the businesses, to encourage consolidation. You’ll need at least $100,000 to invest in it in the first instance, though it might become more widely available later.
If you like the idea but don’t quite have the capital to hand, there’s Riverstone Energy (LSE: RSE), which I own myself. Riverstone takes a private-equity approach to North America-based E&P businesses, as well as midstream sectors, and aims to back management teams with proven records.
Everything seems to be going to plan, judging by the most recent results, and the shares haven’t been hit as hard as those of most E&P firms. Numis reckons it’s currently trading at a discount of around 26% to net asset value (on a share price of 815p).
Riverstone focuses on big North American shale deposits. If Riverstone is right, then Saudi Arabia’s plan of sabotaging the unconventional oil and gas boom hasn’t worked. There’s been plenty of pain, but these huge reserves remain in business.
That would be terrible news for most Opec members, who’ve endured terrible financial stress backing a plan that hasn’t even achieved its key objective. The good news – potentially – is that Riverstone is still sitting on a fair amount of cash, which it can use to cherry-pick distressed assets – just 77% of its total funding of $1.3bn has been invested to date.
The bad news is that some of those distressed assets might actually be sitting on its balance sheet – it takes a while for bad private-equity decisions to work their way into the share price, so it’s almost impossible to work out whether Riverstone has a collection of prized assets, or overpriced stinkers.
Given the expertise of management and its past success, I suspect the former. So if you’re playing a big rebound in oilrelated equities, what better way than to invest via a fund with a chunky discount to net asset value, core North American assets and a pot of money to buy dirt-cheap assets?