Back in 2015, veteran Saudi Oil Minister Ali Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:
“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”
As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4. But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand. And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:
“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”
Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.
Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:
- Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
- But its short-term need is to support prices by cutting production, in order to fund its spending priorities
The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past. It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.
The reason is that high oil prices reduce discretionary spending. Consumers have to drive to work and keep their homes warm (and cool in the summer). So if oil prices are high, they have to cut back in other areas, slowing the economy.
CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014
There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.
They were creating tens of $tns of free cash to support consumer spending. But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report. It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:
“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.”
SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS
Oil prices are therefore now on a roller-coaster ride:
- Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
- The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December
Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd). But as always, its “allies” have let it down. So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.
Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:
- Total US oil output is above Saudi levels at nearly 12mbd and forecast to reach 13.4mbd next year
- The reason is that US shale output has surged from less than 5mbd in early 2016 to 8.4mbd today
- Russia’s output is also above Saudi’s at 11.2mbd as it has cut output by just 78kbd versus its promised target.
Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds. As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.
But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.
Companies and investors therefore need to be very cautious. Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.
Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.
*Total cost is number of barrels used multiplied by their cost