Saudi Oil: Trading on a Loaded Proposition

Includes: BPT, USO
by: Follow My Alpha

The Saudi Arabian government has come out publicly recently, stating that it has the capacity and willingness to offset any potential oil disruption that is caused by the Libyan civil war. The OPEC leader believes that oil should not be trading above $100 (or, more realistically, it doesn’t “want” oil to be trading at such a high price) as it could slow down the global recovery. To be clear, the Saudis' best intentions are focused on one benefactor -- themselves -- because if the global economy does stall, oil prices will plunge, which spells out increased internal strife for them.

There is a real possibility that Saudi Arabia may not be able to truly deliver on its promise for some unknown reason soon enough or, worse, that it decides to renege on the pledge. Further, Saudi Arabia isn’t free of its own internal issues; things have only calmed down since the government unveiled a $36B social welfare program. The biggest dilemma that we see deals with the fact that having Saudi Arabia increase internal oil production from 9% to 12% of world distribution is not a real solution to the problem at hand. For these reasons we feel it’s time to be bullish on oil, given that the Saudi oil pledge looks like a loaded proposition regardless of whether they can or do offset any Libyan oil disruptions in the short term.

Internal Strife Exists in Saudi Arabia

In case anyone forgot, the Saudi people were ready to take to the streets just like in other volatile parts of North Africa and the Middle East not too long ago. What stopped them? About 36 billion reasons, in the form of a $36B social welfare program that King Abdullah offered his people to calm down. Yes, money talks, and it would seem it can even publicly quiet a whole country for the short term. This welfare program does little to address the issues of a Saudi economy that remains heavily dependent upon the energy industry and does little to effectively deal with its large population of unemployed youths.

We are now finally starting to find out that part of the reason oil production has slowed in Libya has more to do with energy companies shutting down facilities and extracting personnel than facilities actually being disrupted. Remember, when public protests and riots start breaking out in any country, it’s generally the poorest and hungriest that come out -- not the well-fed and well-to-do. At this point, Saudi Arabia may be quiet again -- but it has enough of an unemployed population segment that internal strife may flare up again. Should things get dicey in Saudi Arabia, we don’t think it’s impossible for oil production to somehow get disrupted for one reason or another.

Saudi Arabia Is Not UPS

If you have ever had anything delivered or sent to you by UPS, you can probably attest to its service and package tracking system ... so let’s be clear, then, that Saudi oil delivery is not UPS delivery. If Saudi Arabia pledges an increase in oil production, all we have is a verbal pledge. We don’t get to have satellites linking up in space with information being routed around the world in order to verify that what it says is happening is actually happening.

This makes us a little concerned about the current situation ... and investors in the Middle East feel no different, as Saudi Arabia’s benchmark stock index hit a nine-month low. This doesn’t sound too good, given that oil prices have continued to steadily rise little by little over that same period, prior to civil strife in the Middle East.

Investors are wondering how long Saudi Arabia is even willing to hold its production level at an elevated point of output. At some point or another, we feel that the Saudi government will renege on its oil pledge. The reason will likely be unclear and could have to do with internal or external pressures. Regardless, it doesn’t change our thought that at some point this will become a reality. What we care about is the end result, which likely means less oil in absolute terms for the world market and higher oil prices for everyone.

It needs to be clarified as well that not all oil is created equally. While an oil production increase on paper looks great, it may not really calm prices when one looks at the details of the situation. Saudi Arabian oil is actually considered sour crude, meaning it holds a high sulfur content, while Libya produces “sweet” crude, which is the exact opposite. Sweet crude is used to create products such as diesel and gasoline.

Further, a good number of European oil refineries are built to process sweet crude. With Europe already being adversely affected by Libyan supply issues, the idea of having the Saudis increase sour crude supplies does little to alleviate the situation. This means that even if Saudi Arabia can make the delivery, it’s still delivering the wrong package.

The Saudi Plug Is Not a Real Solution

While we applaud the Saudi government for coming forward and grabbing the oil bull by the horns (metaphorically speaking), it doesn’t change the fact that this is at best a “plug” and not a solution to the problem at hand. Eventually the Saudis are going to remember that they need to take care of number one first -- Saudi Arabia -- and that means cutting back its oil production to normal levels. If Libyan oil supplies resume somewhat quickly after this civil war, we feel oil prices should stabilize rather quickly as the “fear” will dissipate. On the other hand, if the opposite occurs, it doesn’t look good for stable oil prices.

The Saudi plug also doesn’t deal with the reality that it can’t just increase oil production every time one or more key oil producing countries have production issues and/or cutbacks. In addition, this Saudi move has set a dangerous precedent that could come back and bite it you-know-where later on. For the rest of the world, this means it better be ready for volatile oil supplies and pricing in the future.

The Call to Action to Make a Profit

Take on oil exposure and hold on tight for 2011. Oil in our opinion will likely remain at an elevated price level, stay volatile, and maintain the potential to go higher in 2011. We like the ETF United States Oil (NYSEARCA:USO) for broad oil exposure. Looking at other options and those more interested in yield, we think BP Prudhoe Bay Royalty Trust (NYSE:BPT) is a great name. For even more options, check out our earlier article here.

In sum, we think now is the time to take on oil exposure for 2011, and that it makes sense to buy on dips if an investor feels he has gotten ahead of himself for the immediate term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.