Saudi Arabia May Have Just Shot Itself in the Foot

Another Saudi official is trying to downplay the kingdom's expanding deficit - as their problems get worse...

On Saturday, Foreign Minister Adel al-Jubeir maintained that the current situation was manageable. He was speaking at a conference in Manama, the capital of neighboring Bahrain.

The situation, of course, has been sparked by two Saudi-led decisions within OPEC. The first was to defend global market share by keeping production high (a move made last year while Americans were sitting down to their Thanksgiving turkeys). That started a downward slide in global oil prices.

The next move involved Riyadh opening the spigots on production, further exacerbating the pricing decline.

At the time, I noted the Saudis had no choice, given events unfolding elsewhere in OPEC.

Today, I'll show you why the wealthiest OPEC nation's situation has gotten worse - and look at the two recent developments that could accelerate the problem...

All OPEC Members Have Taken a Hit

OPEC members may be selling 40% of the world's oil requirements, but they also must import just about everything else they need domestically. That requires an increasing amount of hard currency - especially since populations are rising fast, while average ages are declining to the low 20s or even beyond.

So a country like Saudi Arabia, even with its vast raw material and hard currency wealth, has its hard currency revenue exposed in trade taking place outside its borders. In a low price environment, Saudi Arabia will consistently generate lower revenue in foreign sales while its required foreign product purchases will disproportionately increase in cost.

Because the cartel members are all dependent upon oil sales and run undiversified economies, the almost 60% collapse in crude prices hit every one of them hard. Defending market share is one thing, but rendering budgets inoperable is something else altogether.

Those least able to withstand the lowering revenue from crude sales simply sold more of it into the international market, further depressing oil prices and extenuating a downward pricing cycle.

OPEC members like Venezuela, Nigeria, Libya, Ecuador, and Iran are experiencing significant financial constriction. Each of these nations requires a crude oil price of well more than $120 a barrel to arrest a spreading fiscal paralysis.

But crude trades in London today at less than $50.

Having lost effective control over the pricing mechanism within OPEC, Saudi Arabia has taken a lesson from the pages of the "if you can't beat them, join them" book ...

Saudi Arabia Is Losing Billions on a Weekly Basis

Since the Saudis must import the bulk of their consumer products, they are rumored to be losing billions in hard currency exchange weekly. That's why even the most solvent OPEC producers - Saudi Arabia, Kuwait, and the United Arab Emirates (UAE) - are experiencing budget deficits.

Now, they are nowhere close to "bake sale" territory. Recent estimates put Saudi's cash war chest at around $669 billion. As officials are wont to declare, they can run a deficit for decades.

But not at projected rates.

A deficit run by a rentier state (which takes profits from raw materials but provides little in the way of value-added development) tends to accelerate regardless of whether the country has the means to offset it with forex moves. A vicious cycle emerges well in advance of any threatened default or currency collapse.

And two recent decisions made by Riyadh accentuate the kingdom's quandary...

First, Riyadh began withdrawing investment from foreign asset funds.

Global oil sales are denominated in dollars. A producer like Saudi Arabia must stabilize what otherwise would be too much hard currency from flowing back into the domestic economy, thereby subjecting the local currency to bouts of debilitating inflation. This is accomplished by investing the money outside the country and then repatriating investment proceeds over time or using it to purchase equipment or other essential imports outside the country (capping the circulation of hard currency within the country limits the inflationary impact).

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On the other hand, withdrawing outside funds means only one thing. The hard currency is required to address foreign exchange concerns.

Second, Riyadh has returned to the global capital markets by issuing sovereign paper after years of staying away. The Saudis used to tout the strength of their economy by refusing to draw from debt markets.

Not anymore.

It's another indication that even the normally revenue-heavy OPEC leader has to watch its exchange balance. This has hardly gone unnoticed in the market.

Standard & Poor's cut the Saudi credit rating from "AA-" to "A+" last week and said it was retaining a negative outlook. As expected, the Saudi Finance Ministry was quick to issue a strongly worded reaction, maintaining that the S&P move was "reactionary," driven by "fluid market conditions rather than economic fundamentals."

Nobody in the business really buys that view. The Saudi "economic" perspective has little going for it other than the global selling of oil. Little else is produced there, and the service industry is largely provided by foreign nationals.

The Saudi Problem Is Long Term

Until a higher (and more resilient) pricing floor can be commanded for crude, the Saudi situation will not improve.

Now, the environment is hardly better in non-OPEC major producers like Russia, where many of the same problems earlier on pummeled the ruble.

In the United States, where increasing shale and tight oil volume has profoundly changed assumptions about worldwide available reserves, the situation is different. The American market is populated by private producers, not state-controlled companies. There, a market really can develop and regulate the trade.

The Saudis are certainly not a basket case, and their access to oil sale revenue will continue unabated. But the attempt to diversify the economy is still languishing, and that will become more problematic the longer low oil prices remain.

Crude below $50 a barrel is a short-term consideration. The more fundamental Saudi economic problem is not. I'll be monitoring the situation and keeping you informed as this situation plays out.

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About the Author

Dr. Kent Moors is an internationally recognized expert in oil and natural gas policy, risk assessment, and emerging market economic development. He serves as an advisor to many U.S. governors and foreign governments. Kent details his latest global travels in his free Oil & Energy Investor e-letter. He makes specific investment recommendations in his newsletter, the Energy Advantage. For more active investors, he issues shorter-term trades in his Energy Inner Circle.

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