Thursday, November 5, 2015

Oil and the Saudi budget

POST NUMBER 5 - Oil and the Saudi budget

The name of this blog is The Commodity Strategist, so I plan to concentrate on longer term issues instead of reacting to news coming off the tape. However, there were a few pieces of news on the oil front that that do have longer term implications. So here's my take:

There's a widespread view in the oil markets that Saudi Arabia is playing a game of chicken with various higher cost oil producers, especially the US shale industry. The theory is that the Saudis will overproduce to keep the price low enough that shale goes broke and then raise the price again. And if the low price hurts Russia and Iran, so much the better.

This really underestimates the Saudis. They have been in the oil business for a long time and have seen many cycles. I'm sure they realize that they cannot keep the price of oil above its long run supply cost for very long. If they do, it winds up crashing, just like a year ago. If OTOH they cut production unilaterally to support the price, world production will continue to increase. In the limit, their production goes to zero. Not good!

So I'll bet that they see sub $75 prices as a steady state. This should be enough to curtail a lot of high cost production - as it has already. They do have a major problem though. In the last few years, Saudi government spending has exploded. That's what happens when the government is taking in a gazillion dollars per year with $100 oil.

Saudi Government Breakeven Oil Price

2010       $69   / bbl.
2014       $106 / bbl.

The increase in government spending was pretty much broadly distributed: education, social services, government payrolls, defense, air conditioned soccer stadia, gold plated Mercedes, etc.

The information we have gotten recently is that they are getting serious about reducing spending. The 2015 budget was originally set at $229 billion. With that level the IMF is forecasting a $107 billion deficit. So far the Saudis have said they plan to cut investment by 10% (that includes the stadia and gold plated Mercedes) and to borrow another $27 billion.

All parties know that this won't be enough to stabilize the financial situation. The good news for them is that there are some almost painless cuts that can be made. Most obvious is the subsidy for gasoline. The UAE has recently eliminated this. It's easy to do with oil prices already low enough that it won't result in a huge extra cost to consumers. Some commentators have said that cutting back on payrolls and social services will make the population restless, but I see no actual evidence of that.

The budget path the Saudis take has long run implications for oil. If they continue on the path of right sizing their government spending, it means we are in for a long period of oil price stability at around these levels. In this scenario my feeling is that the price will slowly climb to maybe $65 in 2015 dollars, but it won't be quick enough to make a trade. This is bullish for most world economies since they will not have the price instability to upset planning.

OTOH, if they do not do this, there will be trouble down the road. They can finance things as is by drawing down reserves and foreign assets. They can also ramp up their borrowing; I'm sure the long-only geniuses who bought the subprime paper will gladly buy their's also. The result: wildly fluctuating oil prices, an eventual default and probably a turn for the worse in the middle east (yes, that is possible).

NEXT POST - Who's the Sucker Now?

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