Saudi Arabia: Reading Tea Leaves

 

Photo Credit: Bahrain Ministry of Foreign Affairs

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Let me mention four posts that I did recently on energy issues:

There were four main ideas that came out of those articles:

  • Saudi Arabia would allow the price of crude oil to fall to hurt competitors/rivals, particularly Iran.
  • The price of crude oil would stay near $50/barrel.
  • Lots of overlevered companies dependent on a high price for crude oil would go bankrupt.
  • But bankruptcy would happen to fewer, and more slowly, because of all the private equity wanting to buy distressed assets.

All that said, my view has changed a little recently. I could be wrong, but I think that the ceiling price for crude oil may be $70/barrel for a few years, with the average remaining at $50. I believe this because I think the Saudis are more desperate for cash than most believe.

Here’s my reasoning:

  • First, you have them selling off a 5% interest in Saudi Aramco. When you need money, there is a tendency to sell high quality easily saleable assets, because they will sell for a high price, and with little fuss. Admittedly, they aren’t rushing to do it, which weakens my point. My view is that you would sell off lesser things that aren’t core, rather than complicate life by selling off a portion of a top quality asset.
  • Second, they are seeking loans, and considering selling bonds.
  • Third, they are considering decreasing the subsidies that they give to their people. I think this will be very difficult to achieve politically.
  • Fourth, when the amount of Saudi holdings of US Treasury bonds was announced, it was lower than many expected, at $120+ billion, which only covers a little more than a year of their budget deficits, which was $98 billion last year.
  • Fifth, and most speculatively, I wonder if many of the US Treasury holdings have been pledged to cover other debts. No proof here, but it’s not uncommon to use highly liquid assets as collateral for privately contracted debts. That may explain the musing by some that there had to be more US Treasuries there… but where are they?

What this implies to me is that Saudi Arabia is now little different than most of their associates in OPEC. Their financial situation is tight enough that they must pump crude oil without respect to the strategy of holding crude oil off the markets to get better prices. It’s not just punishing US shale oil production and Iranian crude production — the Saudis need the money.

If the Saudis need the money, and must pump, then OPEC lacks any significant coalition to raise prices. Prices will rise with growth in demand, and cheap resource depletion… but as for right now, there are enough barrels to come out of the ground below $70.

The Saudi need for money is a much simpler explanation than trying to knock out US shale oil, or gouge the Iranians, because it has the Saudis acting directly in their own interests, and it fits the price series for crude oil better.

PS — One more note: this is mildly bearish for the US Dollar as the US does not have the same dedicated buyer of US Dollar assets as it once did. I say mildly bearish, because most of the damage is already past.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.