Will Saudi Arabia’s Riyal Peg Crash Crude Oil?

What a crazy couple of months!

Stock markets have been on a roller coaster ride.

Lithium’s in a bubble.

Gold’s staged a classic bear market rally.

And oil punters have enjoyed huge gains.

There’s plenty to talk about. But let’s stick with crude oil today.

The bulls are back

Brent crude, the international benchmark, is trading higher, at US$48.79 per barrel. It’s up 75% from its low of US$27.83 per barrel on 20 January.

West Texas Intermediate (WTI), also known as US crude, is trading higher at US$48.45 per barrel. It’s trading at a seven-month high, up 86% from its low of US$26.05 per barrel on 2 February.

The upwards momentum looks good. But can crude jump above the US$50 per barrel level?

It would be a feat…

The last time Brent closed above the psychological level was in early November. In WTI’s case, it was early October. If crude closes above this target on a weekly basis, I’d expect to see a few more bullish forecasts.

Goldman Sachs, a major global investment banking firm, made the switch from bearish to bullish last week. According to investing.com:

Goldman Sachs said in a note to investors that it sees a re-balance in energy markets in the second half of the year pushing prices to near $50 a barrel. The forecasts reverse a call from earlier this year when analysts from the influential Wall Street bank noted that global oil prices could touch down to $20. Analysts from Goldman Sachs cited increase demand in India, China and Russia for the reversal.

I don’t agree with Goldman’s view. I believe that, while crude could jump a tad higher in the short term, this is just another bear market rally. To understand why, let’s turn to Saudi Arabia.

The decline of Saudi Arabia

My colleague Callum Newman, Editor of Cycles, Trends and Forecasts, talked about oil geopolitics in Friday’s Money Morning. It was a great piece of work. I’d like to revisit Callum’s punchline today:

The bigger point in all this is about Iran’s resurgence. This has entirely changed the geopolitical scenario of the world. Most likely, Iran will become the dominant regional player. One can only wonder what the Saudis will make of that.

Callum, there’s no need to wonder…

Saudi Arabia’s dominance is already over in the Middle East. But, like all declining empires, it is trying to hang onto power for as long as possible.

When the country nationalised its oil industry in 1980, it changed the world forever. At the time, the government purchased Aramco (formerly an Arabian-American oil company), renaming it ‘Saudi Aramco’. Previously, the oil industry was dominated by Western majors such as ExxonMobil [NYSE:XOM], Chevron Corporation [NYSE:CVX] and BP [LON:BP].

Saudi Arabia became a powerhouse in the 1980s and 1990s. OPEC, with the Saudis at the helm, was faced with lower demand and higher supply from its competitors. The Saudi’s response was to ramp up production, crash the crude price, and wipe out its competitors.

It worked like a charm!

Saudi Arabia tried to repeat history in 2014/15. Unfortunately, due to technological advancement, it didn’t work. While hundreds of US shale companies have gone under, many have survived. Technology has improved well efficiencies and reduced costs.

With the Kingdom running out of ideas, it’s turned to drastic measures…

What the mainstream won’t tell you

Recently, Saudi Arabia unveiled plans to sell 5% of Saudi Aramco. This values the company at roughly US$2 trillion — more than any other oil company in the world.

The question is: Why would the country want to sell its national champion, and at record low crude oil prices?

Deputy crown prince, Mohammed bin Salman — second in line to the Saudi throne — sold the official message to Bloomberg:

The kingdom can live in 2020 without any dependence on oil…The Saudi addiction to oil has disturbed development of many sectors in past years.

We plan to set up a US$2 trillion sovereign wealth fund… part of its assets will come from the sale of a small part of Aramco.

Titled ‘Saudi Vision 2030’, the plan includes regulatory, budget and policy changes. The Kingdom hopes to be less reliant on crude over the next 15 years.

Of course, there’s more to the story.

Saudi Arabia is in a bind. It depends on oil for around 80% of its budget needs. For this reason, expect the country to ramp up production significantly this year. It needs all the money it can get its hands on…

See, massive civil unrest is building in the country. During the years of higher oil prices, the Kingdom controlled its people through lavish subsidies. According to parliamentmagazine.eu:

Energy subsidies alone make up about a fifth of Saudi’s GDP. Declining revenues from declining oil exports will translate in the kingdom’s decreased capacity to keep a lid on rising domestic dissent.’

Putting that into perspective, about a quarter of Saudi Arabia’s population is in poverty. At the same time, the youth unemployment rate stands at roughly 30%. Remember, these are ‘official’ numbers. The true numbers are likely far worse.

Here’s the catch…

There’s a civil war brewing.

When the crude oil price crashes, Saudi Arabia’s economy should turn upside down. When this happens, if history is a reliable guide, there will be blood in the streets.

The budget situation gets worse.

The peg…when will it break?

The Saudi riyal is pegged to the US dollar. In other words, the currency is stabilised for confidence measures. Of course, given the strength of the US dollar — the world’s reserve currency — it costs money to prop up the riyal.

Bloomberg wrote recently, ‘PointState Capital’s Zach Schreiber calculates that with oil at $50, Saudi Arabia will burn through $80 billion to $100 billion in foreign-exchange reserves per year. The country has “two to three years of runway before it hits a wall.”

Schreiber — who made US$1 billion betting against oil two years ago — believes Saudi Arabia’s breakeven cost is around US$90 per barrel. Of course, this factors in the budget subsidies and peg-stabilisation costs.

Still, Schreiber’s forecast is probably a bit too generous.

The Kingdom is fighting a costly war in Yemen, which it can’t afford. I doubt this is included in the breakeven price. And what if crude re-tests the previous low in the US$20 per barrel region? There’s a good chance it will.

The country’s in deep financial strife…

I wouldn’t be surprised if the peg breaks this year. When it does, it will prove the country’s lost control of its budget.

There will be chaos across financial markets when it breaks. Remember, when Switzerland ditched its franc-euro peg last year, its currency soared by 30% in the minutes after the decision. Of course, when Saudi de-pegs its currency, it will crash…perhaps by 30% against the US dollar. Remember, it’s the weaker currency.

Being a weaker currency, Saudi Arabia will probably have to produce more crude to pay the bills. This could crash the crude oil price, with more supply flooding an already oversaturated oil market.

Indeed, this should prove Saudi Arabia’s no longer the major influence in the Middle East. After all, at the end of the day, money equals power.

If you want to know more on this story, check out Resource Speculator. I wrote about crude’s outlook in detail last week. Find out more by clicking here.

Regards,

Jason Stevenson,
Resources Analyst


Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read. Money Morning Australia is published by Port Phillip Publishing, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.


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