Riyadh’s oil price conflict

20 December 2011

As Saudi Arabia ramps up spending commitments in the wake of the Arab uprisings, the breakeven price needed to balance its budget is soaring, which puts it at odds with the global economy

Key fact

The breakeven price for a Saudi barrel of oil is expected to be about $90-95 a barrel in 2012

Source: Riyad Capital

Saudi policymakers will be in a bullish mood after winning the argument inside Opec at its 14 December meeting, setting a 30 million barrel-a-day (b/d) target that keeps output at three-year highs.

Yet not all is good. Saudi policymakers may be experiencing a sense of deja vu as they survey global oil demand. Three years ago, oil prices were surging: before the Lehman Brothers bankruptcy in October 2008, they had risen 38 per cent from the start of that year.

Saudi Arabia 2011 oil price requirements*
 ($bn)($ a barrel)
To cover current expenditure amounting to…12053
To cover current expenditure, plus capital spending of $70bn19079
To cover current & capital expenditure, plus a contingency reserve of $10bn20183
*=Opec basket price. Source: Jadwa

Fast-forward to 2011, and with the IMF forecasting a 31 per cent increase in prices from the start of the year while the fear of recession stalks the Eurozone economies it is eerily reminiscent of the gloom that followed the Lehman collapse.

Decisive impact

There are other parallels. Just as in 2008, the Saudi authorities are in the midst of a spending spree. Starting out with the two huge cash injections in February and March worth a combined $130bn, the government has lavished spending on its population in 2011. This was initially triggered by fears that the wave of regional protests could envelop the kingdom.

What appeared to be a one-off panic gesture is looking increasingly like a decisive turning point in long-term Saudi policy-making and the spending surge to ensure social peace could exert a long-term impact on Riyadh’s oil policy.

Like other major oil exporters, Saudi Arabia has seen its breakeven oil price (the price at which the government calculates a barrel of oil to keep its budget in surplus), trend steadily upwards and it is now approaching the actual spot market oil price. The traditional comfort zone between Riyadh’s preferred oil price – usually about $10-20 a barrel lower than the actual oil price – has eroded significantly.

If prices were to fall substantially for any length of time, this would likely involve reducing production

James Reeve, Samba Financial Group

The IMF estimates the breakeven oil price for 2011 at $80 a barrel for Saudi Arabia, a rise of $30 a barrel on the level three years ago. The Washington-based Institute for International Finance, for its part, estimates the breakeven Saudi oil export price rose from $66 a barrel in 2010 to $79 a barrel in 2011 and will rise further to $90 a barrel in 2012, but even these figures look conservative. The sheer scale of the kingdom’s spending commitments now necessitates a substantially higher oil price, say analysts.

“Saudi Arabia could sustain its fiscal position at prices well below current levels for many years,” says James Reeve, senior economist at the local Samba Financial Group. “However, it is fair to say it would like to see prices at about $100 a barrel.”

If that target appeared unachievable, the kingdom could look to work with partners in Opec to support prices. “If prices were to fall substantially for any length of time, this would likely involve reducing production,” says Reeve.

The London-based Centre for Global Energy Studies (CGES), chaired by former Saudi oil minister Riyadh’s Sheikh Zaki Yamani, estimates the Saudi breakeven price at about $90 a barrel, based on production of 9.2 million b/d.

Next year, with the 2012 budget increasing outlays, that price could be even higher.

“We expect the breakeven price for a Saudi barrel to go up. In 2012, the price will be about $90-95 and that is because there will be additional spending requirements next year,” says Khan Zahid, chief economist at the local Riyad Capital.

We [expect] the oil price to fall, primarily based on the assumption that … the Eurozone crisis [will] worsen in 2012

Khan Zahid, Riyad Capital

Although overall spending in 2012 will be lower than the previous year, due to the one-off royal decrees in February/March 2011 that mandated the $130bn of new spend, Riyad Capital anticipates a 7.4 per cent increase in budgeted expenditure to SR827bn. Some of the $130bn of off-budget spend will also be disbursed in 2012, adding further to state outgoings.

The inexorable rise in spending and consequent need to finance these increases through boosting oil revenues, has placed even greater emphasis on ensuring the oil market remains tight, while still ensuring high prices do not destroy demand. This is a balancing act Riyadh has carried off confidently over the past decade.

Higher breakeven prices are forcing the authorities to defend much higher oil prices. This entails maintaining a much closer watch on supply and demand during a period when the global economy is vulnerable and new supply sources are starting to re-emerge, notably the return of Libyan oil production, which was removed from the market for much of 2011.

Crude oil output

This partly explains the large fluctuations in Saudi oil supply witnessed in 2011. The kingdom hiked crude output by 500,000 b/d in November, hitting 10 million b/d, according to Petroleum & Mineral Resources Minister Ali al-Naimi. With its substantial cushion of spare capacity thanks to a production capability of 12.5 million b/d, Saudi Arabia has the means to bring new production on stream quickly – and cut this back equally as fast if necessary.

We expect [an erosion of oil demand] to be offset by sustained oil demand growth in emerging markets

James Reeve, Samba Financial Group

But the new-found affinity for high prices carries a price of its own. Riyadh may be growing structurally attached to a higher breakeven price to meet new spending commitments, leaving less room to moderate oil prices at a time when the global economy is vulnerable to commodity price rises.

Traditionally, Saudi Arabia has steered clear of overt price hawkishness, as part of a general strategy to maintain an equilibrium between supply and demand.

That now appears to be over. In an assessment from the CGES, the Opec Basket price averaged $94 a barrel in 2008, meaning crude oil costs accounted for just over 5 per cent of global gross domestic product GDP. However, at the kingdom’s breakeven price of $59 a barrel that year they would have accounted for just 3.3 per cent of GDP, leaving plenty of room for Riyadh to tolerate the lower oil prices the global economy needed. Three years on, says the CGES, the picture is very different. At the 2011 break-even price of $90 a barrel, crude oil costs would account for 4.4 per cent of expected global GDP, leaving much less room for manoeuvre.

Economic vulnerability

The end result, warns the CGES, is that the revenue needs of Opec producers such as Saudi Arabia are now pushing oil costs to levels that the global economy cannot tolerate. 

It may also be that the Saudi economy cannot tolerate it. The ostensibly comfortable Saudi fiscal position, with a likely surplus of SR226bn in 2011, according to Jadwa Investment, equivalent to a healthy 11 per cent of GDP – masks a deeper vulnerability. Government spending and domestic consumption of crude are rising far faster than overall oil output. In other words, the Saudi government will be unable to simply rely on cranking up production to boost revenues, especially if it is consuming a growing proportion of the crude it pumps.

Clearly, Saudi Arabia doesn’t want oil prices too high … but it [also] doesn’t want prices falling to fast

Paul Gamble, Jadwa Investment

State spending is unlikely to shrink anytime soon. The 2011 special spending commitments may have been front-loaded – with one-off hikes in public salaries and benefits kicking in straight away – but also contained within them are long-term commitments on investing in housing. These and other commitments could set the kingdom on an expansionary fiscal policy stretching out over several years.

Since hydrocarbon revenues account for at least 80 per cent of all state earnings, the kingdom looks destined to grow more sensitive to oil market developments. In June, Riyadh broke with the Opec consensus and hiked output by more than 1 million b/d, to ensure the markets were well served, but global demand in 2012 is too uncertain to justify another such increase. The likelihood remains that a global recession – in the context of reviving Libyan output – could trigger a significant fall in Saudi oil production.

Saudi Aramco is already pumping at record levels, indicating a still tight market with little excess supply. Al-Naimi surprised the markets in early December with news that the kingdom produced just over 10 million b/d of oil in November, the largest output since 1981, when it was forced to step in to provide extra barrels to compensate for shortages caused by the Iran-Iraq war.

Breaking the 10 million-b/d mark is a significant step for the kingdom and only explicable in light of the absence of at least 800,000 b/d of Libyan crude output, and resilient demand in Asian markets.

Indications of how nervous Saudi Arabia is about the impact of recession on demand will become clearer in the wake of the 14 December Opec meeting in Vienna, when member states agreed a supply policy after six months of drift, following the failure to reach consensus at the June ministers’ meeting. 

The public comments of senior Saudi strategists suggests an underlying confidence that the long-term global demand trajectory will work in the kingdom’s favour. Addressing a Riyadh energy forum in November, Saudi Aramco chief executive officer Khalid al-Falih pictured a bright future for the oil and gas industry, with demand set to keep increasing in line with the expansion of the global population. Asian economies would keep on growing, he said, which will support healthy prices in the long-term.

Far East dependence

The latent price hawkishness reflects the growing Saudi dependence on Asian growth. Over the past 20 years, Saudi exports to Asia have grown from one- third to two-thirds of total crude exports. China’s demand for oil has grown by an annual average of 500,000 b/d a year over the last five years. In fact, the International Energy Agency says 95 per cent of net growth in oil consumption is coming from China, the Middle East and the rest of Asia.

The jury is still out on whether China and other Asian economies can provide a counter-cyclical impetus to global oil demand and offset a flatlining Eurozone and still stagnant US. 

“We are expecting the oil price to fall in 2012 and that is primarily based on the assumption that we are going to see the Eurozone crisis worsen in 2012. There could be a series of severe crunches that they will be unable to do anything about on a sustainable basis,” says Riyad Capital’s Zahid.

There is a much-increased prospect of recession in the Eurozone area next year and maybe even in US. “Given all those things, there will be some impact on oil prices next year. We are looking at prices coming down from about $107 a barrel this year to $92 a barrel next year,” says Zahid.

The challenge facing Riyadh will be sustaining its social and capital spending initiatives in a context of subdued global economic growth. A return to the early-2009 situation – when oil prices sank to $37 a barrel in the midst of the post-Lehman recession – would be disastrous for the Saudi authorities given the scale of their spending commitments. 

Such a nightmare scenario may not transpire. Some analysts are notably more optimistic than sceptics such as the CGES about the strength of oil demand. Samba says, despite weakening global activity and trade, there is a consensus that oil demand will continue to grow reasonably healthily in 2012. In fact, the Saudi bank points out, that despite recent downward revisions to global demand projections, the incremental increase in oil consumption next year is projected by most major energy agencies to be higher in 2012 than 2011.

“Even if one assumes these projections are optimistic it seems clear that we are not heading towards a 2008-09 scenario when world oil demand fell and prices plummeted,” says a Samba research note on the Saudi economy released in November.

Credit squeeze

“Iraqi production does represent a risk to oil prices, though most commentators would probably see 2013 rather than 2012 as the year when it increases output significantly, although this is something of a moving horizon,” says Samba’s Reeve. “There is also clearly a threat from the erosion of demand, and a decline is already widely expected in the OECD [Organisation for Economic Cooperation and Development] in 2012. However, for the moment, we expect this to be offset by sustained oil demand growth in emerging markets, especially China, India and the GCC.” 

The big unknown is whether the Eurozone debt situation deteriorates leading to a serious credit squeeze, not just in the Eurozone, but more widely, with adverse affects on world trade and growth. “Under such a scenario, oil demand globally could stagnate. This is not our baseline scenario, which is for relatively healthy demand growth in 2012, but weakening fundamentals as supply revives [from Libya and non-Opec producers] leading to a weakening in prices to about $100 a barrel,” says Reeve.

Much thought will have to go into how Saudi Arabia calibrates any reduction in output with a returning Libya. “The Saudis obviously need to cut back a little bit to accommodate returning Libyan production, but it will still leave them about 800,000 b/d or so short compared with where they were in January,” says Leo Drollas, chief economist at the CGES. “That would be the sensible thing to do if they want to keep the price more or less where it is – but whether we consumers want it that high is another matter.”

Ideally, the kingdom would coordinate its output decisions with the other members of Opec. “The Saudis increased production by 1 million b/d or so to compensate for lost Libyan production and, as Libya comes back on stream, they will cut production. But they will do this carefully, adjusting for global economic conditions,” says Paul Gamble, head of research at Jadwa Investment.

The Opec agreement in mid-December to implement a 30 million b/d cap at least suggests greater coherence among its major oil producing peers, under Saudi guidance. However, if it met stiff resistance then it would probably reduce output anyway, with the support of Kuwait and the UAE, says Reeve.

The one negative side effect of cutting oil production is the loss of associated gas production at a time of rampant domestic demand for gas. However, the coming onstream of Karan gas since the summer of 2011, reaching more 400 million cubic feet a day (cf/d) and which will rise to a substantial 1.5 billion cf/d by June 2012, will relieve much of the pressure on associated gas fields. Any cuts would likely hit on oil fields that do not have associated gas production.

Balancing act

“Clearly, Saudi Arabia doesn’t want oil prices too high as this could help push a weak global economy into a serious bad patch, but at the same time, if it does hit a bad patch it doesn’t want prices falling too fast. It will play around at margins as to how it does this, but our view is that oil prices will come down next year,” says Gamble.

Saudi officials deny any shift in strategy over oil prices. They say the approach is the same as before: to ensure that the kingdom is able to influence global price setting and keep the market supplied, while ensuring prices are sufficiently high to support key economic policy goals.

The inexorable rise in that oil price comfort zone is nonetheless a growing challenge for Riyadh. A breakeven price nearing $100 a barrel may be welcome for Saudi budget setters looking to secure adequate funding for a raft of social and infrastructure spending measures, but it is far from ideal for a global economy whose fragility has been brutally exposed over the past year.

The possibility that Saudi Arabia is becoming structurally wedded to a high oil price is a clear danger for both consumers and producers, even if the multibillion-riyal fiscal surpluses are able to disguise it effectively for now.

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