For all the trial balloons that were being floated through recent days, mostly by lower level oil officials around the globe talking up the prospects of an OPEC meeting and a crude output cut, the public responses from the two pivotal oil powers, Russia and especially Saudi Arabia, have been skeptical to lukewarm at best.
There is nevertheless little to dislike in weak hands being flushed out to cover shorts or perhaps even a turn towards a modestly bullish sentiment. Indeed, the last few days have seen a pick up in the market buying insurance against the possibility of a sharp upside move in prices.
*** Against that backdrop, we want to reinforce our strong sense that there is already a very subtle but crucial shift in Saudi oil policy thinking and tactics underway. While Saudi policy makers see little immediate need to pivot away from their maximum output and market share strategy, they are more than willing to commit to a credible output agreement if they truly believe it will underpin a market recovery; and, most crucially, if they trust the other key oil producers — read Russia — to abide by the terms of collective actions on output. ***
*** So in that sense, the recent string of trial balloons are small scale but important steps to an expanding sequence of trust-building measures among oil producers like Mexico, Iraq, and the Gulf states, with offers of output cuts to follow over the next few weeks. But ultimately, the moves and counter moves must build towards an essential working trust between Riyadh and Moscow. Importantly, this trust-building extends beyond the oil market itself, but critically, in the upcoming Syria peace negotiations that got off to a wobbly start today as well. ***
*** This will be a long process, more likely than not to take weeks if not months. The developments in Geneva and on the ground in Syria could play a potentially significant role in the efforts among the oil producing states in the run up to a meeting between OPEC and non-OPEC oil producers by the time major maintenance programs are underway in March. But it is our understanding the Kingdom, driven in part by its own domestic economic and political needs, is indeed seeking to stabilize oil prices, which they believe will probably rise to around the $45 a barrel level by year-end. ***
Small Trust-Building Steps
We have recently written on important steps being taken and considered by Riyadh to work behind the scenes with Iran to phase in additional Iranian barrels to minimize price dislocations (see SGH 1/21/16, “Saudi Arabia: Lending a Hand”).
It is our understanding something similar is being undertaken, or rather that the Saudis are willing to undertake something in a similar fashion, in a broader sequence of small steps that, if met in kind by the other pivotal players in the oil market, will in the end lead to an OPEC meeting and the foundations to an agreement on oil output aiming to drain the surplus of oil currently awash in the global markets.
The initial Saudi gesture is literally silence, refraining from the earlier harsh rhetoric of how much they are willing to see oil prices fall to $20 a barrel in the first phases of the oil price collapse in late 2014. No senior Saudi official has repeated such bellicose rhetoric recently, and their messaging and that of its Gulf allies has notably shifted towards their confidence or expectations of eventual higher oil prices and that current levels of around $30 a barrel are not realistic.
In one sense, it implies no rush to slash output or hurry to an OPEC meeting, but it also reveals more in what they are not saying. The same sort of reverse logic could be found in the skepticism expressed earlier today by officials from Russia’s Rosneft, the other key oil power. A lot would have to fall into place for an agreement on output, and it would be difficult in what remains of the winter, but the message to Riyadh was, we are listening.
Depending on whether the other oil producers follow in kind with suggestions of their willingness to trim or hold output flat, the Saudis could send a signal of their shift towards accommodating the others with verbal reassurances of support, or trimmed output in the seasonal arrival of maintenance programs. It could also come in the announcement of changes in the oil ministry. Ali al-Naimi, for instance, is still the nominal oil minister, and he has been seeking to retire for some time. But the announcement of his retirement, when it is made about the Saudi official most identified with the maximum oil output policies, we understand would be meant as a signal in the change in Saudi policy.
Other gestures could come from the Kingdom’s Gulf allies in a willingness to consider output adjustments. Iraq, while insisting it should not be part of any collective oil output cut, is still expected to play its part with the offer of a modest cut, but mostly in a commitment not to increase output or try to take market share from the Saudis.
Likewise, Iran is not expected so much to trim actual output as much as it is expected to slow the phasing in of its additional oil exports. Firm commitments would also need to come from the non OPEC producers like Mexico (whose President and oil minister were recently in Riyadh and who is in fact understood to be playing a trusted intermediary role between the Saudis and other non OPEC producers).
But above all, for there to be any deal to put a floor on oil prices, it will ultimately entail an understanding with the Russians. That will be immensely difficult in large part because the Saudis and most of OPEC have no faith the Russians will ever follow through with anything they promise. So more than anywhere else, small steps of trust will be essential.
It is thus interesting and potentially quite important that Deputy Crown Prince Mohammed bin Salman has come to see a good working relationship in the several meetings he has had in Moscow through last year with Russian President Vladimir Putin and Rosneft chairman Igor Sechin. It is also noteworthy that the Russian chatter of a deal with the Saudis did not include Sechin himself: the Saudis believe there is no agreement with the Russians without Sechin.
The Russian moves are expected to revolve around maintenance-driven cuts to output by March (which may be matched in kind by the Saudis). But it is also important to stress that the trust building between Riyadh and Moscow is not limited to oil output. It is in fact mostly revolving around Syria.
The prospects for the Saudi-supported rebel forces ground war to oust Syrian President Bashar al-Assad have gone from bad to worse since the Russians militarily intervened, providing crucial air support to what is left of the Assad army now fighting alongside Iranian and Hezbollah troops. Even if the rebel factions, under their umbrella High Negotiations Committee, do finally show up in Geneva as expected, they may not have much in the way of “facts on the ground” left.
The Russians also insisted recently on the Kurds to be included in the peace talks, knowing it would be a non-starter to the Saudis and especially the Turks. But if there are moves made by the Russians in the coming days on who is and isn’t at the table, it is likely to be met in kind by the Saudis, both in the peace talks, and in time we believe, in the oil market.
The Kingdom’s Domestic Political Pressures
Saudi Arabia is easily the most insulated economy to the near-term consequences of the dramatic free fall in oil revenues. Outside the Persian Gulf, every other major oil producing country inside and outside OPEC, and of course the oil shale producers across the US, are hurting badly in the lost revenues and widening budget shortfalls. Where the ultimate pain threshold is for those countries or shale producers is unclear, but it is certainly north of the Kingdom’s pain point.
But while the Saudis are in no particular rush, there are pressures inside the Kingdom that are pushing the senior Princes and policymakers towards a greater willingness to consider a new collective output agreement.
The domestic pressure is not necessarily all in the budget – they may not especially like it, but the Saudis can trim spending and draw on foreign exchange reserves for some time – nor is it due to speculative short term pressures on the Saudi Riyal’s peg to the dollar, as we have written several times before (see SGH 11/23/15, “Saudi Arabia: A Devalued Riyal Peg Highly Unlikely”). Rather, like China in some ways, the domestic political pressure is in the falling stock market and real estate prices.
The Saudi stock market, or Tadawul, is not really tethered too closely to the real economy, but it is to oil prices: oil prices are high, the stock market tends to do well, if prices fall, confidence in the stock market dampens. And when Iran recently came off the international sanctions in a setback to Saudi regional policies, the stock market fell nearly 8% on the news. The stock market swooned. The same logic of economics, wealth building, and political confidence plays out in the local real estate market, which has been depressed.
In many ways both the stock and real estate markets serve as useful political barometers to the Al Saud when the more traditional channels of dissent or unease — like elections for one — are denied and political expression is carefully monitored or repressed. And for all the talk of privatizing parts of Saudi Aramco or downstream petrochemical companies and utilities, the government planners will need robust, liquid and a confident local stock market.
To counter a downdraft in the economy and confidence, we understand the government recently “advised” the Saudi domestic banks to refrain from demanding more collateral on land and stock margin loans. It is our understanding that domestic political pressures are nevertheless still slowly rising (see SGH 1/15/16, “Saudi Arabia: Riyadh’s Strategic Gambit”).
But to support both will require broader policy moves, namely a confidence boosting effort to bring the collapse in oil prices to an end, and to show the Saudi public and business community anxious over strained relations with the Americans that the more muscular Saudi regional policies in confronting “Iranian expansionism” will soon be showing signs of success.