The Fuse

Saudi Arabia’s Strategy Working, But Economy Is Hurting

by Matt Piotrowski | September 15, 2015

Lower Saudi production is mainly because of fluctuations in domestic demand rather than any change in tactics.

Following steady increases in output since last November’s OPEC meeting, Saudi Arabia’s production has fallen to its lowest level in six months. But that doesn’t mean the kingdom is giving up on its policy of sacrificing higher revenues for market share.

Output averaged 10.26 million barrels per day last month, according to the latest OPEC’s Monthly Oil Market Report (see table below), based on Saudi Arabia’s direct communication to the organization, down from 10.36 mbd in July and the record 10.6 mbd seen earlier in the summer. The lower level is mainly because of fluctuations in domestic demand rather than any change in tactics.

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With the latest reports from the Energy Information Administration (EIA) and the International Energy Agency (IEA), among others, showing that U.S. production is starting to take significant hits amid lower prices, possibly losing .5 mbd or more, pundits have claimed that the Saudis are ‘winning’ in their efforts to rebalance the market by curbing supply growth elsewhere and not giving up market share. Even though Saudi Arabia can ride out the low price environment better than others (see Venezuela, Russia, Brazil, Mexico, North Sea output, and U.S. shale), it is still seeing a good bit of pain, and needs to diversify its economy by boosting the private sector and creating jobs for a growing workforce.

The kingdom was able to implement its strategy of holding onto market share instead of throttling back production to prop up global prices because of the strong economic and fiscal positions it established during the extended period of high prices. It has substantial reserves being held in banks and holds the ability to issue new debt in order to keep spending high, even as oil prices are roughly half the levels reached in mid-2014.

Economic and fiscal pain

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The Saudi government is now running a very large budget deficit as a result of keeping spending high despite lower oil revenues. As prices averaged above $100 per barrel, the KSA’s fiscal breakeven price soared as the country sought to simulate other sectors of its economy and boost domestic confidence in the economy. In 2010, it was just under $70, but for 2014-15, it rose to well above $100, according to The International Monetary Fund (IMF), which says that the budget deficit will be 20 percent of GDP this year, versus just 1.6 percent last year.

It’s obvious why the lower oil price is having such a significant impact on the economy and the country’s budget: The oil sector makes up more than 40 percent of GDP, while about 85 percent of export revenue comes from oil, along with over 90 percent of fiscal revenues.

To bridge the gap between spending and revenues, Saudi Arabia can tap the substantial deposits in its banking system, so right now the OPEC producer remains in a relatively comfortable situation.

To bridge the gap between spending and revenues, Saudi Arabia can tap the substantial deposits in its banking system, so right now the OPEC producer remains in a relatively comfortable situation.

It can also issue new debt instead of cutting back on spending. The country’s central bank, the Saudi Arabian Monetary Agency (Sama), began issuing debt in July, the first time since 2007, with plans of $5.3 billion in bond sales to local banks each month. The country still has ample amounts of foreign assets, though they have dropped by $76 billion from the peak last year to $661 billion in July.

But it can’t go on like this forever if oil prices stay where they are. “A strong and sustained fiscal consolidation is going to be needed,” said Tim Callen, IMF Mission Chief to Saudi Arabia, in a video released on the Fund’s website last week. “If this doesn’t happen, then the fiscal buffers that have been built up will be eroded quickly.”

The Saudis also have an advantage with its healthy banking sector. Part of this is due to the central bank tightening regulations on the country’s financial institutions so they do not take on too much risk.

Getting the economy back on track, and diversifying it along the way, is important in keeping the kingdom’s 31 million citizens (up 23 percent in just a decade) content. Saudi Arabia could very well see instability if economic demands aren’t met. A major challenge is the explosion in the workforce population: From 2014-2020, some 1.8 million new people will need employment, putting pressure on the government to spend to create enough jobs in non-oil sectors.

Holding onto market share

The Saudi strategy of holding onto market share is working, with output reaching record levels this summer and exports to the Asia-Pacific region holding steady during the first half of the year.

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The kingdom’s exports declined throughout the summer, falling from a peak of 7.5 mbd in April as a result of higher domestic demand, but even as production has downticked, exports have rebounded to current levels of 7.2 mbd (see graphic below from ClipperData). The continued high level of exports signal that Saudi Arabia has indeed held market share but has not been able to increase its exports since April’s peak even with demand rising, a sign of how strong competition is from other producers.

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The competition could ratchet up a notch during the fourth quarter and into next year. Added pressure from Iranian volumes hitting the market, along with price cuts from other producers, will force the Saudis to be extra vigilant. “There are signs that OPEC producers are aggressively marketing their crude, and the Saudis are not swaying in their conviction to keep output high despite lower prices,” said Matt Smith of ClipperData.

OPEC pegs the call for its crude—the amount of oil from the cartel needed to balance the market—at 29.3 mbd for 2014, a .1 mbd bump from last month. For next year, the call is at 30.3 mbd, up .2 mbd from the previous report and up 1 mbd from this year’s levels.

Demand for OPEC’s crude is expected to rise next year, another sign of how the Saudi strategy has worked in carving out market share as others have to cut back.

If OPEC’s forecast is realized, this would be a major development: Demand for its crude will rise, another sign of how the Saudi strategy has worked in carving out market share as others have to cut back. Retreat among some shale produces in the U.S. and weakening supply outlooks in other non-OPEC producers mean the Saudis have an upper hand right now, even though it is taking some hits along the way.