The Fuse

Saudis Playing the Long Game as Economy Sinks Into Recession

by Matt Piotrowski | October 11, 2017

The world’s largest oil producer and the leader of the OPEC cartel, Saudi Arabia, is now in recession as the economy contracted for two straight quarters in 2017. This development is ironic given that global oil prices have stabilized in the $50 per barrel range after falling dramatically from mid-2014 through early 2016. The country’s participation in the OPEC production cut is negatively affecting the economy despite the higher oil price. “The drag from oil production cuts will probably persist until the end of 2017 as Saudi Arabia continues to comply with the OPEC deal,” writes Bloomberg Intelligence.

Even though the OPEC strategy has increased prices, Saudi Arabia has had to contend with lower export volumes, and its production cuts have ceded market share to rivals, including the U.S. The oil sector has pulled down the entire economy, as the non-oil sector of the economy has seen only modest growth. However, despite the impact from the OPEC production cut and austerity measures, Saudi Arabia can ride out the current economic headwinds without having to switch oil market strategy or sink deeper into recession. That outcome, though, is not a certainty since there are factors that could further negatively impact the Saudi economy.

The country’s participation in the OPEC production cut is negatively affecting the economy. Even though the OPEC strategy has increased prices, Saudi Arabia’s production cuts have ceded market share to rivals.

After growing 1.7 percent in 2016, Saudi Arabia’s economy fell by 1 percent in the second quarter after shrinking by 0.5 percent in Q1. The International Monetary Fund (IMF) revised its 2017 GDP growth forecast down by 0.3 percentage points to just 0.1 percent total. The Saudi economy is not performing as poorly as other OPEC members, such as Venezuela and Libya, but it is facing stagnant growth while the rest of the global economy is set to rise by 3.6 percent this year.

Saudi Arabia, which relies on oil for 90 percent of its export revenues, pledged to take more oil off the market than any other producer involved in the OPEC/non-OPEC agreement, including Russia. Similar to past production agreements, the Saudis have felt the brunt of the cuts.

As a result of the Saudis’ cutbacks, they have ceded more room to their competitors, particularly Iraq, which is producing 150,000 barrels per day above its pledged output level. In the U.S., the cutback has been particularly impactful—the Saudis’ strategy has focused on reducing exports to U.S. customers, because inventory data in the U.S. is the most timely and visible in the world, and stock changes here have an outsized effect on global prices. Over the past month, imports from Saudi Arabia have fallen by 41 percent year-on-year to below 700,000 b/d. As Saudi Arabia has limited its sales to its American customers, Iraq has exported more to the U.S., and shale production has rebounded. In Asia, the competition is just as stiff, but the Saudis have not cut back as much to that region. Still, Saudi Arabia’s market share has been negatively affected. Iraq and Iran, both of which are producing above quota, have kept export volumes steady, while U.S. exports have increased market share in Asia.

IraqIran

Austerity, debt markets, & foreign reserves

From 2014 through 2016, the Saudis were able to avoid a recession by utilizing foreign reserves. They have continued to do so this year, but it hasn’t been enough to grow the economy. Since the third quarter of 2014, when prices began their descent, the Saudis have utilized about a third of their foreign reserves. In the past year, reserves have been reduced by 12 percent (although they rose slightly in June). However, they still have approximately $500 billion left. That large amount will help them mitigate the negative impact of oil prices and production volumes remaining at current levels, but its unclear for how long the current policy is sustainable.

SaudiForeignReserve

In the past year, Saudi Arabia has also tapped the international bond markets. This is symbolic of how much the country is struggling, but also indicates investors’ willingness to lend to Riyadh. The Saudi government is now running a very large budget deficit that reached 17 percent of GDP last year, and is set to rise further this year. Besides having to turn to debt markets, Riyadh has also implemented more austerity measures, adding to the economic contraction. The government, for instance, is reportedly planning to phase out gasoline subsidies to allow prices to be more in line with the international market. This move will likely increase domestic prices by 80 percent.

Besides having to turn to debt markets, Riyadh has also implemented more austerity measures, adding to the economic contraction.

The recession, along with the extended period of relatively low prices, provides even more motivation for the Saudis to reform their economy for the longer term. The price downturn has pushed Saudi Arabia to introduce its “Vision 2030” to become less oil dependent. The key for Saudi Arabia is to keep its economy from shrinking any further until it launches the Aramco initial public offering (IPO) next year, which should inject a large amount of capital into the economy.

Diversification efforts will take years to realize, however, leaving the Saudi government reliant on export revenues, foreign reserves, and international debt markets. Even more crucially, its economy will remain vulnerable to any declines in oil prices. It has been reported that the country is seeking a price of $60, but the oil market has not been able to break out to that level, even with the OPEC/non-OPEC agreement taking almost two million barrels per day (mbd) off the market.

If a situation similar to what happened in the 1980s emerges, the Saudi government would likely have to reconsider its strategy.

The big question going forward is at what point Saudi Arabia might have to switch its oil market strategy or fall into a deeper recession. If a situation similar to what happened in the 1980s emerges, the Saudi government would likely have to reconsider its strategy. Saudi Arabia cut output dramatically in the 1980s in an attempt to support prices, but it didn’t work. During the first half of the decade, the country’s production fell from around 10 mbd to 3.6 mbd, ceding market share to new non-OPEC producers and its rivals in OPEC. From 1981 to 1986, the price of West Texas Intermediate (WTI) fell from $41 per barrel to as low as $10.

But as of now, a price fall like the one that occurred in the 1980s does not appear likely. Oil fundamentals have tightened and global capital expenditures have fallen dramatically, setting the market up for higher prices early next decade. The production deal has held up with compliance remaining high, and the Saudis are committed to the current agreement despite having to take a large amount of volumes off the market and some producers cheating on quotas. Saudi Energy Minister has said that his country will do “whatever it takes” to drain inventories and increase prices. The Saudis continue to back up that statement. This week, the Saudi Energy Ministry said it would supply its customers with 560,000 b/d less than they need for November. Estimates put the country’s production for next month at 9.77 mbd, the lowest level since the beginning of 2015.

Given the Saudis’ determination to stick with the cut despite the loss of market share and the economic recession, it is apparent they can continue to tolerate low prices and they are willing to hunker down for the foreseeable future. The Saudis are playing the long game.

ADD A COMMENT