Taking Stock Of Oil As Saudi Arabia Ushers In A New Era

Taking Stock Of Oil As Saudi Arabia Ushers In A New Era

As anyone who follows markets is well aware, oil prices have been a key determinant of broad market sentiment since late 2014 when the Saudis moved to drive the US shale complex out of business and secure geopolitical leverage by dealing a death blow to a petrodollar system that’s underpinned decades of US financial hegemony and, ironically, served the kingdom very well over the years.

Although the drawdown of Saudi Arabia’s FX reserves isn’t as large a concern vis-a-vis rising yields on core paper (notably US Treasurys) as China’s massive reserve liquidation, Riyadh’s efforts to offset lost crude revenue by tapping their rainy day fund have contributed to a phenomenon that was already in motion: the end of what Deutsche Bank dubbed the “the great accumulation.”

For years, central banks had steadily accumulated trillions in US Treasurys that could be used to safeguard their countries’ respective financial systems (and budgets) in the event some calamity befell them. Then, two things happened: 1) commodity prices - already under pressure - fell to 21st century lows last year in the wake of crude’s dramatic plunge, and 2) China moved to a new FX regime which, contrary to what you might have heard, actually gives the market less of a role in determining the yuan’s exchange rate, not more.

Those two events conspired to put enormous pressure on EM currencies and subsequently, on EM reserves. Here’s a chart from Deutsche that shows the trajectory going forward assuming the run rate returns to where it was last autumn:

The worry was essentially that EM reserve liquidation would simply offset asset purchases conducted by developed market central banks and that the deflationary impulse playing out across the globe would undermine the effectiveness of those asset purchases leading the likes of Mario Draghi and Haruhiko Kuroda further down the quantitative easing rabbit hole.

While it’s not clear the extent to which Deutsche Bank’s “quantitative tightening” has exerted any kind of upward pressure on core paper yields, what does seem apparent is that the rout in oil prices and concurrent downturn in commodities has rendered QE largely ineffective when it comes to boosting DM inflation and/or growth. Put simply: if this was working, the whole of Europe plus Japan wouldn’t be monetizing every asset that isn’t tied down and they wouldn’t be sitting on negative interest rates either.

That’s part of the reason why January was such a harrowing month for stocks. Investors seemed to be concerned that oil - which fell to $27 at one point - was contributing to central banks’ inability to get things moving again and that the monetary gods were about to run completely out of ammunition.

Meanwhile, traders were also becoming increasingly concerned that the high yield market might simply implode should a wave of bankruptcies in the US shale space trigger a rush to the exits into a thin secondary market where, thanks to the post-crisis regulatory regime, Wall Street might no longer be willing to take inventory onto its books in a pinch.

Oil has of course bounced back into the $40s since January’s ‘crude’ carnage and pushed above $46 last week as wildfires threatened some 1 million b/d of production capacity in Canada’s beleaguered oil patch and the absolutely absurd political situation in Libya looked set to spiral further out of control.

All of this is set against the backdrop of the failed talks in Doha, where Saudi Arabia’s 30-year-old deputy crown prince Mohammed bin Salman “unexpectedly” torpedoed a plan that would have seen Riyadh, Moscow, and others freeze production - albeit at record levels. The problem: Iran wasn’t on board and as I’ve discussed at length lately, the Saudis are perfectly willing to endure more pain and more gaping holes in the budget if it means keeping Tehran from reaping an even larger windfall now that the country has come off sanctions and expects to ramp production all the way up to 4 million b/d at least by H1 2017.

(Chart: Barclays)

“Saudi Arabia’s oil politicization derailed the Doha talks,” reads an excerpt from Iran Petroleum, a publication distributed by Tehran’s oil ministry. “Saudi Arabia will be the main loser in the price war,” the ministry continues.

It’s hard to argue with that, and the Saudis know it, which is why a sea change is taking place in the kingdom. The country’s insistence on using its sway over oil prices as an instrument of foreign policy has ultimately forced the kingdom to accelerate long overdue economic reforms designed to reduce the country’s dependence on oil. Whether or not the plan - which involves taking part of Saudi Aramco public in what may well end up being the largest IPO in history - is too little too late remains to be seen. Here’s Barclays on “Vision 2030”:

Commercial objectives dominate at a country level, no longer just at Aramco’s level. The Vision 2030 plan has other notable goals outside of those focused on reforming Aramco. Lofty goals include “a new city dedicated to energy,” a plan to double gas production, to construct a national gas distribution network, and to “gradually liberalize the fuels market” to “guarantee the competitiveness of renewable energy.” Even if these goals are not achieved, the long-term direction has a clear implication: more oil for exports.

I bring all of this up because on Saturday, the Saudis replaced powerful oil minister Ali al-Naimi with Saudi Aramco chairman Khalid al-Falih. Although the move was telegraphed and although  Falih is generally expected to stay the course in terms of avoiding production cuts in order to “preserve market share” (Riyadh doesn’t like admitting it’s using oil prices to play politics), this is still an important transition and does raise significant questions.

“Mr. Naimi, known in oil industry circles as a technocrat’s technocrat, appeared to be losing his grasp on power when a meeting of major oil producers aimed at reaching an output-freeze agreement collapsed less than a month ago,” WSJ wrote over the weekend, before quoting one of Naimi’s assistants as saying that “we all knew after the Doha meeting that it was only a matter of time before he [was] gone.” Here’s a bit more from The Journal:

“Naimi knows OPEC‎ and OPEC knows him and any change will present another problem for OPEC ministers,” said John Hall, chairman of Alfa Energy and a longtime OPEC watcher. “To understand the new direction that will undoubtedly arise from the new leadership of the Saudi ministry will take time.”

Mr. Falih is an experienced oil executive, leading the state oil company for years, but he hasn’t attended an OPEC meeting and doesn’t have the long-term relationships with other countries that Mr. Naimi did.

Mr. Falih will have to navigate a landscape of increased competition from Iran, Saudi Arabia’s main rival for power and influence in the Middle East.

“Our main competitor is Saudi Arabia,” said an Iranian OPEC official in Tehran. The dynamic between Saudi Arabia and Iran “has always been political. It will remain political.”

In short, it would appear that the market will need to try and negotiate whether the potential for further tension among OPEC members attributable to the absence of Naimi outweighs the fact that Falih will likely stay the course on production when it comes to crude prices. “Saudi Arabia will maintain its stable petroleum policies,” Falih said in a statement. “We remain committed to maintaining our role in international energy markets and strengthening our position as the world’s most reliable supplier of energy.”

Oil was notably higher early Monday as traders seemed to be: 1) betting that production lost to the Canadian wildfires won’t come back online for some time despite expectations for rain and shifting winds; 2) reading data on rising Chinese crude imports as a sign of continued strong demand; 3) utterly confused about what’s going on in Saudi Arabia. “Investors might do well to resist any temptation to trade on the Saudi Arabian government shake-up and economic overhaul as a game-changing development,” Bloomberg wrote this morning, adding that “this is neither bullish nor bearish for oil.”

Here’s Barclays take on the outlook for prices.

Given recent developments and further baseline data revisions, we slightly alter our price forecast higher for the year and expect 4Q prices in the $50 range. Although the balance looks weaker in Q4 than in the past (we no longer forecast a draw), the softer balance is a product of higher OPEC output and results in less spare capacity as the market transitions to an even tighter balance in 2017. In the short term, we think the market is due for a downward correction in May, but prices are likely to average in the mid $40 range in Q2 as transport demand keeps prices supported in June and July.

Of course at the end of the day the fundamentals remain largely the same. “The supply demand discrepancy is little changed from the forecast in January,” the bank adds.

Right. Trade accordingly.