It is no mystery that Saudi Arabia's oil export revenues and foreign reserves declined as oil prices fell this year. The most-recent print showed that foreign reserves fell by $14 billion in June and July after increasing by $32 billion over the previous 20 months. It is estimated oil export revenue have fallen from more than $600 million per day in October 2018 to $400 million in June 2019.
The last time we saw such rapid changes was in 2014, when export earnings fell from more than $800 million per day in April 2014 down to $300 million per day in February 2016. Common factor? Falling oil prices. Saudi Arabia is trying to diversify its national revenues away from oil into other sectors, but that will take time. In the meantime, it is still heavily reliant on the black gold.
Over the weekend in Saudi Arabia, King Salman replaced Energy Minister Khalid al-Falih with his son Prince Abdulaziz bin Salman, minister of state for energy affairs since 2017. This shakeup surprised most people, as al-Falih had done a tremendous job in coordinating OPEC cuts and getting Russia on board to broker a deal to cut oil output to support oil prices, forming the OPEC+ alliance.
Regardless of why, the main idea behind the reshuffle is to help the country get on track to maximizing their oil export revenue and successfully placing the IPO of its crown jewel, Saudi Aramco. The Kingdom needs higher oil prices to help pay for the government's ambitious economic programme to diversify away from oil; Vision 2030 plan. Whoever is at the helm of the boat faces the same problem, the delicate task of maximizing higher oil prices but without denting consumer demand at a time when the need for this fossil fuel is depleting on a long-term basis, given alternatives and natural substitution.
During the boom-bust cycles of 2014 and then again in 2018, Saudi Arabia has constantly struggled between protecting their market share by increasing production or cutting output to support the oil price. Oil accounts for 40% of Gross Domestic Product, 70% of government revenue and almost 80% of export earnings (source: IMF).
It is no mystery that they have one of the highest breakeven oil prices, given budget levels and ambitious spending plans for the future. Even though their cost of production is somewhere in the region of $9/bbl. (using 2016 estimates), the Kingdom needs Brent prices closer to $80-85/bbl. to break even. With Brent trading closer to $60/bbl now, that is a serious task.
Saudi Arabia still has about 13% of share of the global petroleum market, but it is no longer the "swing producer." Going back in history during times of boom and bust, changes in their energy policy caused a dramatic shift in prices. Today U.S. shale and Russia are at a level playing field to help sway the price based on supply levels. Thanks to innovative technologies, U.S. shale break-even price is around $45/bbl WTI -- and Russia is happy with $55/bbl Brent or higher. You can see the dilemma facing the largest OPEC producer now? Unfortunately, it will not be any easier for the new Energy minister to magically resolve this.
So much time is spent documenting academic reports generated by the IMF, EIA, and other governmental agencies to try and forecast the oil price. The most important factor missing in all these documents is the commercial angle, "demand" and "positioning" and how it changes given the macro economic landscape.
The year 2018-2019 has been a great example of the inefficiencies of these agencies to try and balance output by understanding what is really causing the price to rise and fall. Of course Trump has not made it easy, as he decides to change his foreign policy stance towards China and the rest of the world every second of the day.
Analysts are very good at using past trends to extrapolate a similar trend for the future, always giving demand a linear trajectory, then altering it after the fact. That is in essence the problem as demand never moves in a straight line. It varies based on economic cycles!
That is where OPEC and other government agencies would fare better to try and balance the market by understanding how the demand side is and can be effected. For that, one would need to hire Hedge Fund Managers and seasoned Macro oil traders as opposed to men in suits sitting in boardrooms regurgitating pamphlets heavier than most nightstands!
The oil price today will not only be influenced by its current demand/supply and physical market inventory dynamics but also where the dollar is headed, U.S. Fed central bank policy, U.S. Treasury market, U.S. recession vs. Trade War with China and other factors, to name a few. It is like a 10-D matrix moving dynamically day by day.
One thing is certain. The longer-term cost of production for oil is lower, given the many sources of oil and its abundance as demand has been growing on average 1.5% per year. When valuing oil companies that have been in perennial decline despite higher oil prices, this just shows the effect of discounting.
It does not matter what the spot price of oil is, it is where the long-term 10-15 year price of oil should be to back out an equity value for any oil company. Back-end oil prices are trading closer to $55-60/bbl and that will not change any time soon. No matter how much the Kingdom desires a higher oil price based on short-term factors, the valuation of its crown jewel Saudi Aramco will be predicated on that long-term price.
The risk is that prices fall even more if world does indeed go into a full-blown recession. We shall soon get the answer to see how the Fed reacts and whether Trump decides to structure a deal with China later this year.
If central banks wash the world with free liquidity and repeat past mistakes, asset prices can move higher. All this can happen merrily without any change in energy policy, as it is out of OPEC's hands for now.