Brent price has rallied from $23 a barrel in April to $36 a barrel on Thursday -- about 56% from the lows when the WTI May contract fiasco took place.
Rather than it be a case in perpetuity, it just suffered a triple whammy of too much supply. OPEC+ nations were pumping at the max, just as demand collapsed during the coronavirus lockdown. In addition, those factors were exacerbated by a lack of storage available in Cushing, Oklahoma.
It was a one-time thing and academics got overly bearish and predicted the same fate for the June WTI contract, as well. What most tend to forget about the commodity markets is that they have a natural way of sorting itself out via pricing mechanisms. It is one of the markets not manipulated by the Fed -- not yet, at least -- so when there is too much supply, prices fall precipitously until that supply is shut off and meets demand, and vice versa.
This all happens within a few days or weeks as the system is very intelligent. The victims, of course, are the producers. They need to shut off their production to balance the market. The U.S.' weekly oil inventory data shows that U.S. domestic oil production fell from highs of 13.1 thousand barrels per day (mbpd) down to 11.5 mbpd. But according to more on-the-ground models, that number is closer to 9.8 mbpd, as about 3 mbpd of U.S. oil production has been shut off. Prices below $35 a barrel WTI are unsustainable for U.S. shale to keep producing in any of the basins. As supply fell, the pressure on storage eased, as well. The June oil price rallied and got many caught short as they expected June to trade negative like the May contract. That's Sod's law.
Who are the biggest losers from this price scenario? It would seem Saudi Arabia and the U.S. would be hurting the most here. The former suffered a similar fate back in 2014 during the first price war. Both times their strategy of flooding the market backfired, given the resilience of U.S. shale and the subsequent bounce back. In 2014, they had record high foreign assets of $737 billion in August 2014. It moved from a budget surplus to a then-record high deficit in 2015 of $98 billion and spent at least $250 billion of its foreign exchange reserves over that period. During the 2014 to 2016 oil price war, OPEC member states lost a total of $450 billion in oil revenues, according to the International Energy Agency.
This time around, Saudi Arabia did benefit form undershooting its Russian partners in pricing their oil at a steeper discount to China. Its shipments more than doubled to China in April to 2.2 mbpd and those to India at 1.1 mbpd. What they lost in price, they tried to make up for it in volume, but it was not enough. This was one of the reasons they had to take initiatives outside of the oil sector to diversify.
Prior to the coronavirus demand collapse, the fiscal break even for oil was around $80 to 85 per barrel. Brent. Sure, their cost of production is in the single digits, but they had ambitious future spending plans. This is why we saw the value-added tax increase three-fold and government employees' salaries cut. Last year, $62 billion was spent on weapons, ranking fifth in the world in military spending. This is about 8% of Saudi Arabia's gross domestic product, more than U.S. even, at 3.4%, and China at 1.9%. This, too, could be at risk given the pressure on foreign reserves.
The Saudi riyal vs. dollar peg has been in effect going back to 1945, between the U.S. President Franklin D. Roosevelt and the Saudi King at the time, Abdul Aziz. A number of independent analysts are predicting that its overall gross domestic product could shrink by more than 3% this year, whilst the budget deficit could widen to 15% of economic output. It is said that around $300 billion is needed to defend this peg. According to even the Saudis' own figures, the Kingdom's foreign reserves fell by just over about $27 billion in March. This is a full 5% decrease from just the previous month, and the total reserves figure now stands at just $464 billion, the lowest level since 2011. If we see an additional 5% reserves drop for April and May, foreign exchange reserves could hit $418 billion. If the minimum of $300 billion is indeed right, that only leaves about $118 billion in surplus reserves for "other" spending. They have already tapped into the debt markets twice this year and borrowed a total of $19 billion from local and international investors.
The peg is not just about the oil price priced in dollars. The relationship goes a lot deeper. It encapsulates the arms exchange with the U.S., the promise of security in the region, circling back to the purchase of U.S. Treasuries. If the peg does indeed break due to domestic pressure, that would be an unwind 75 years of relationship and send the region into turmoil. If the ultimate "NOPEC" -- No Oil Producing and Exporting Cartels Act -- bill is passed, that would mean the end of sovereign immunity and a potential lawsuit. So many dominoes could fall with just one move.
The oil price has rallied as OPEC+ cut about 10.7 mbpd along with U.S. shale closing about 3 mbpd as demand recovers as economies reopen. But will that be enough? This all depends on the demand outlook for oil. There is a lot of oil that needs to be soaked up before we see higher sustainable prices; they are just trying to normalize right now to find the right level of equilibrium. The longer oil prices stay lower, the more the peg gets under serious pressure. Needless to say, it can have far reaching consequences.
