Oil: A Strategic Underpinning to Higher Prices

Published on May 5, 2017
SGH Insight
Saudi oil officials are irritated but hardly panicking over the recent plunge in oil prices, attributing the drop to long positions being unwound among some hedge funds, and remain confident crude oil prices will rise back within the $50 to $55 per barrel target range.
Both Saudi Arabia and Russia are firmly committed to a six-month extension of the Vienna OPEC-non-OPEC agreement they believe is steadily working towards a crude oil supply and demand rebalancing.

Market Validation
(WSJ 5/11/17)
Oil Jumps on Confidence in OPEC Cuts
Crude futures gained on Thursday as investors became more positive that production cuts made by major oil producers are finally making a dent on global crude stocks.

Concern that these cuts weren’t reducing the global crude glut has put pressure on oil prices for several months. Oil prices hovered around five-month lows at the beginning of this week but have gained since data from the Energy Information Administration showed U.S. crude stockpiles dropped by 5.2 million barrels in the week ended May 5, far exceeding market expectations.

Saudi oil officials are irritated but hardly panicking over the recent plunge in oil prices, attributing the drop to long positions being unwound among some hedge funds, and remain confident crude oil prices will rise back within the $50 to $55 per barrel target range.

*** Both Saudi Arabia and Russia are firmly committed to a six-month extension of the Vienna OPEC-non-OPEC agreement they believe is steadily working towards a crude oil supply and demand rebalancing. Riyadh and its Gulf oil producing allies may also add some modest output cuts around the time of the May 25 OPEC meeting, with further cuts possible before year-end, if necessary. ***

*** Bolstering what it sees as an important strategic alliance on oil between the Kingdom and Russia, China has offered its full support, promising to purchase additional crude oil as needed to help bring oil prices back above $50, which it would put into its Strategic Petroleum Reserves. Chinese President Xi Jinping and Russian President Vladimir Putin will be meeting in Beijing in mid-May. ***

A “Tina Moment” for Riyadh’s MbS

In Saudi Arabia, the architect of the current Saudi oil policy, Deputy Crown Prince Mohammed bin Salman, gave a well-prepared interview on Saudi television last week, staunchly defending the current oil strategy and vowing to proceed with the 2018 global IPO of 5% of Saudi Aramco.

It cannot be overstated how crucial both are to the ambitions of the young Deputy Crown Prince to both consolidate his political power, to transform the Saudi economy by reducing its dependence on crude oil exports, and the means by which to realign Kingdom’s global alliances (see SGH 1/15/16, “Saudi Arabia: Riyadh’s Strategic Gambit”).

Any sustained downturn in crude oil prices would not only worsen the pressures on the Kingdom’s budget — most of the austerity measures introduced at the start of the year were reversed due to rising internal grumblings — but it would gravely wound the pricing and placement of the Saudi Aramco IPO.

In the television interview, the Deputy Crown Prince was impassioned in his defense of the IPO, asserting it will advance Saudi Arabia’s economic transformation by decades, and that his grandfather, King Saud bin Abdul Aziz, the founder of Saudi Arabia, would have wanted to privatize Aramco, the Kingdom’s crown jewel. For MbS, it was his “there is no alternative” or “Tina” moment.

Saudi Arabia, then, will stick to its output cuts and press its OPEC and non-OPEC partners to do so as well. The Kingdom, joined by the United Arab Emirates, could offer up a modest amount of further output cuts to follow an extension of the Vienna output agreement when the oil producers gather on May 25 in Vienna. Depending on how quickly the end to subsidized domestic energy and gasoline prices pushes domestic demand down, it may allow the Saudis to cut output even further later this year if needed.

And with the approach of the summer peak domestic demand season, Riyadh is likely to reduce its crude exports in any case, even if it loses (temporarily they believe) some market share to its rivals, like Iran and Iraq.

Beijing’s Support for Saudi-Russian Alliance

An especially important underpinning to the deepening alliance between Riyadh and Moscow oil policy is a new affirmation of support from Beijing in recent weeks. In a phone call between Chinese Premier Li Keqiang and Russian Prime Minister Dmitry Medvedev in March, the two agreed the then weakening oil price was the result of “US manipulation” and was not sustainable relative to “the further recovery of the global economy in 2017.”

Medvedev told Premier Li that Saudi Arabia and Iran both agreed with Russia on oil prices that should rise to $60 a barrel, and Li affirmed that China is willing to work with Russia and Saudi Arabia to maintain the relative stability of global oil prices.

President Xi, in his meetings last month with the visiting Saudi King Salman bin Abdul Aziz, committed China on two fronts in its relations with the Kingdom: first, that it would take a major strategic stake in the upcoming global IPO in Saudi Aramco, and; second, that China warmly supports Riyadh’s coordination with Moscow on oil policy and supports its objective to stabilize oil prices in the $50 to $60 per barrel target range.

To help meet that objective, Xi said China would be willing to consider additional crude oil purchases this year to take advantage of prices below $50 to add the crude to its Strategic Petroleum Reserves. China, in effect, could become something of a “buyer of last resort.”

President Xi will be meeting with President Putin in Beijing in mid-May, and among the issues on their respective agendas, they are expected to reaffirm their shared interests in stabilized international oil markets that reflects the upward growth expected in China and the global economy.

Russia Likely to be Aboard

Meanwhile, there is every indication that Russia will likewise agree to an extension of its near 300,000 bpd cut in output that it reached by the end of the current six-month period. In some ways its participation in the Vienna output cuts, even if its cuts only amounted to 300,000 bpd, was critical to the success in draining the supply gut so far, because without Moscow’s participation, the Saudis would not have reversed their previous market share strategy.

Russia’s continued participation is even more important in the next six-month extension, in large part because it will entail real production cuts whereas much of the prior 300,000 bpd in cuts was in fact mostly in maintenance shutdowns and the like.

But our sense is that Russian Oil Minister Alexander Novak will commit Russia to a six-month extension in Vienna later this month, with the firm backing of President Vladimir Putin.

Putin, it is believed, does not want any economic dislocations to get in the way of the upcoming presidential elections, and he has indicated the oil strategy being pursued with Saudi Arabia has proved its merits. What’s more, Russia does not want to jeopardize significant investment commitments by both Qatar and Saudi Arabia in the Russian energy sector.

There is some speculation of just a three-month extension or a longer nine-month extension to the Vienna output agreement. But it is our understanding the Saudis will press to stick to an extension for six months, primarily because it does not want the exemptions for Libya and Nigeria to become entrenched. The Saudis, as always, also want to keep rival Iran on a short leash with its commitment to go no higher in its production than 3.8 million bpd.

The Saudis are likewise betting the Iranians will be more cooperative at the Vienna meeting later this month with US President Donald Trump’s upcoming visit to Riyadh and to Israel, and all that it may suggest about the Saudi ambitions to bolster an anti-Iran alliance across the region.

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