Here's Why Saudi Arabia Will Continue Pumping Oil

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Includes: OIL, USO
by: Ryan Edward

Summary

Saudi Arabia continues to pump near-record supplies of oil despite lower prices.

With Iranian production set to rise after sanctions are repealed, Iran is set to challenge Saudi Arabia for regional influence.

Low prices help limit Iran's regional influence.

History has proven that Saudi Arabia is willing to withstand years of budget deficits to maintain its political power in the Middle East.

Many expect oil to move higher over the long-term, but it's not entirely clear when this will be. The biggest factor will be a return to normalcy on the supply side. While demand for oil is continuing to grow (roughly 1% a year), it's not fast enough to erase one of the biggest oil gluts in decades. Relief for energy investors will only be found when suppliers cut production drastically to balance the market.

Unfortunately, one of the biggest producers in the world may not stop pumping anytime soon.

Many today talk about OPEC's diminished power in the oil markets. Controlling over 80% of global reserves however, OPEC still has incredible clout over supply. Saudi Arabia comprises almost 25% of OPEC's oil portfolio, equating to nearly 20% of all oil in the world. That's bigger than every country outside OPEC combined.

Controlling almost 20% of global oil reserves, Saudi Arabia has a unique ability to control the market's supply, something it has shown willingness to do in the past to stabilize prices. The recent crisis, however, has brought about a previously unknown version of Saudi Arabia, one unwilling to reduce supply to balance a massively over-supplied market.

This week, oil continued its 70% tumble over the past 18 months, touching under $30 a barrel. Still, Saudi Arabia refused to cut supply at the previous OPEC meeting, believing it has the money and the patience to take market share by outlasting every other global supplier.

First, a bit of history. Following Ayatollah Khomeini's revolution in 1979, oil-rich rulers across the Middle East spread weapons and cash throughout the region, seeking to become the dominant influencer. This event is still one of the key contributors to unrest today, as Saudi Arabia and Iran were two of the biggest entitles vying for power over the area. Today, the two oil-rich theocracies, one Shiite and one Sunni, are vying for regional dominance yet again.

Many argue that the Saudi Arabia will be forced to bring balance to the market by cutting supply, abandoning the current strategy of gaining market share. What does Saudi Arabia have to gain from keeping prices low? Politically, a lot.

Saudi Arabia has plenty of reasons to limit Iran's regional power. As one of the more stable and wealthy countries in the Gulf, Saudi Arabia is the defacto leader and influencer in the area. So, while economics and fiscal analysis may indicate that Saudi Arabia will start to act more rationally regarding supply, don't be surprised if they keep prices low, crippling Iran's economic benefit from repealed sanctions.

With sanctions set to be lifted, Iran is ready to receive hundreds of millions in additional revenues to fund whatever they please. According to a recent note from Oppoenhiemer's James Schumm: "Though low oil prices hurt Saudi Arabia, they negatively impact Iran in a much greater way and it crimps Iran's ability to fund sectarian uprisings in Saudi Arabia's backyard."

Many other countries in the area have been unable to fully realize the value of massive oil reserves due to inefficient production or lack of transportation infrastructure. While Iran's reserves are the closest in the area that can compete with Saudi Arabia, economic sanctions have crippled their ability to monetize it. With sanctions ready to be lifted, Iran is about to gain a critical ability to influence the region in ways Saudi Arabia wouldn't prefer. Recently, Saudi officials announced that the kingdom will sever all diplomatic ties with Iran and told all Iranian diplomats to leave within 48 hours. Saudi Arabia's foreign minister revealed that it may take further steps against Iran, stating that they "are looking at additional measures to be taken if it [Iran] continues with its current policies."

To maintain power and prevent an Arab uprising at home, Saudi royalty must keep the country's powerful extremist Sunni clerical establishment on its side. Keeping oil prices low helps limit Iran's benefits from repealed sanctions, as increased oil exports will be considerably less valuable. This wins big points at home, while also ensuring Saudi Arabia's dominant position as chief regional influencer.

More important than a few years of oil income is maintaining domestic social order and regional power. Many analysts point to Saudi Arabia's massive budget as proof that it can't continue its current policy for long. At last check, the country needed at least $100 oil to balance its budget. This thesis, however, may be misguided.

In reality, there is no reason to believe that Saudi Arabia is unwilling to withstand years of budget deficits. After piling up reserves during oil last bull run, the country has amassed foreign reserves equal to its GDP. To plug the budget gap last year, it spent roughly 20% of those reserves, indicating that it has roughly four years left before trouble even begins to brew. Even then, the country still has 2.6 million barrels a day of spare oil production capacity to fire up.

Plus, we have hard historical evidence proving that Saudi Arabia is willing to run deficits for years. After building up reserves during the oil bull market of the 1970s, it posted deficits every year from 1983 to 1998 until things stabilized. Once they did, Saudi Arabia reverted to budget surpluses for the next 15 years.

When dealing with issues as important as regional and domestic stability, don't be surprised to see history repeat itself.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.