Saudi Arabia is in a serious jam. So much so that their internal political structure could collapse. Not right away, not next week or next month, but in the next few years if the global forecast for oil futures contracts stays so incredibly depressed.
It seems strange to think Saudi Arabia could collapse when they are sitting on huge amounts of cash. They have hundreds of billions in net cash on the balance sheet and arguably have the ability to leverage that cash (by taking out new debt against it). This is like a guy with a huge pile of cash in the bank and pristine credit to boot. He can borrow a lot of money at a reasonable APR and then use his cash flow to pay back the debt service, thus leveraging it multiples beyond the base amount.
So technically Saudi Arabia has a couple trillion in buying power if they leverage their, say, unencumbered $600 billion or so to the absolute available hilt. But at the same time, the world is watching what's happening with oil. And if the house of Saud leverages its cash and oil prices stay incredibly low for years… then what? Major geopolitical crisis. The House of Saud destroyed. (We aren't even thinking about Venezuela or Iran at moment - the first is already in flames and, as a country, is starting to resemble post-Katrina New Orleans.)
This is all happening because oil prices are collapsing. But it's no longer just the front month oil contract dropping into the low $40s per barrel. It is oil contracts many years out forecasting the pain of extended low prices, trillions of dollars potentially lost. The Saudis have been pumping like crazy - recently approaching all-time records:
Saudi Arabia has told Opec it has raised crude oil output to the highest level on record, as the country prepares for the return of regional rival Iran to international markets and for peak summer demand.
In the monthly oil market report published by the oil producers' cartel on Monday, Riyadh self-reported crude oil production of 10.6m barrels a day in June, an increase of more than 200,000 b/d on the previous month and its highest level since records began.
If Saudi Arabia keeps increasing production at this rate, it could, by the end of the summer, be the first country to pump 11m b/d of crude since the former Soviet Union.
And even with all that pumping, the Saudis have been borrowing money. They recently went into the credit markets for $27 billion…
Why does a country with nearly $700 billion in reserves - and lots of that as straight liquid assets - need to worry about borrowing? Because of the fears and concerns as described earlier in this piece. They may need to make that cash pile last a long, long time - so they have to start leveraging it NOW (and have zero back-up options in a world of super-cheap oil)…
…the decision to ride out a sustained period of lower prices has put a huge strain on the finances of major oil exporters, including Saudi Arabia which requires an oil price of $105 a barrel to balance its budget.
The kingdom has drained $65bn of its fiscal reserves to maintain government spending since the oil price plunge began. Sama currently has $672bn in foreign reserves, down from their peak of $737bn in August 2014.
The plan to resort to capital markets, if confirmed, demonstrates the priority Riyadh is placing on maintaining government spending, despite the pressure cheap oil is putting on its budget.
The monthly bond issuance plan would only cover part of the deficit…
You better believe they put a priority on "maintaining government spending." That's the only thing that holds the political structure together. Saudi Arabia has no industry of consequence other than oil and gas, and the oil revenues pretty much pay for everything…
Ambrose Pritchard makes the case for why the Saudis are dead in the water (and Bank of America says that OPEC is "dissolved"):
If the oil futures market is correct, Saudi Arabia will start running into trouble within two years. It will be in existential crisis by the end of the decade.
The contract price of US crude oil for delivery in December 2020 is currently $62.05, implying a drastic change in the economic landscape for the Middle East and the petro-rentier states.
The Saudis took a huge gamble last November when they stopped supporting prices and opted instead to flood the market and drive out rivals, boosting their own output to 10.6m barrels a day (b/d) into the teeth of the downturn.
Bank of America says OPEC is now "effectively dissolved". The cartel might as well shut down its offices in Vienna to save money…
~ UK Telegraph, Saudi Arabia may go broke before the US oil industry buckles
The Saudi "oil war" completely failed, Pritchard argues, because the US frackers are like cockroaches - too hard to kill off.
The problem for the Saudis is that US shale frackers are not high-cost. They are mostly mid-cost, and as I reported from the CERAWeek energy forum in Houston, experts at IHS think shale companies may be able to shave those costs by 45pc this year - and not only by switching tactically to high-yielding wells.
Advanced pad drilling techniques allow frackers to launch five or ten wells in different directions from the same site. Smart drill-bits with computer chips can seek out cracks in the rock. New dissolvable plugs promise to save $300,000 a well. "We've driven down drilling costs by 50pc, and we can see another 30pc ahead," said John Hess, head of the Hess Corporation.
It was the same story from Scott Sheffield, head of Pioneer Natural Resources. "We have just drilled an 18,000 ft well in 16 days in the Permian Basin. Last year it took 30 days," he said.
And not only are these frackers hard to kill, they are even harder to wipe out. Because if you kill one weak fracker, the infrastructure is still there for a stronger player to swoop up the busted credit obligations… and then keep pumping… and there may be a LOT of oil to be pumped:
Until now, shale drillers have been cushioned by hedging contracts. The stress test will come over coming months as these expire. But even if scores of over-leveraged wild-catters go bankrupt as funding dries up, it will not do OPEC any good.
The wells will still be there. The technology and infrastructure will still be there. Stronger companies will mop up on the cheap, taking over the operations. Once oil climbs back to $60 or even $55 - since the threshold keeps falling - they will crank up production almost instantly.
OPEC now faces a permanent headwind. Each rise in price will be capped by a surge in US output. The only constraint is the scale of US reserves that can be extracted at mid-cost, and these may be bigger than originally supposed, not to mention the parallel possibilities in Argentina and
Australia, or the possibility for "clean fracking" in China as plasma pulse technology cuts water needs.
Mr. Sheffield said the Permian Basin in Texas could alone produce 5-6m b/d in the long-term, more than Saudi Arabia's giant Ghawar field, the biggest in the world.
And now we see a deep and possibly fatal flaw that runs through the majority of OPEC nations - they don't have anything else BUT oil.
Whereas the US economy is so strong and diverse, that the fracker industry can take large amounts of pain (because of the credit strength behind it)… and even if the current wave of frackers goes bust because their debt deals were uneconomic, current creditors take haircuts but new management comes in and simply continues to deploy the existing technology and assets.
Think of diverse economic strength as an "industry turbulence buffer." The US can withstand wild swings in oil prices and its oil industries will hang tough. Saudi Arabia and others, meanwhile, have zero turbulence buffer. Too much volatility, or too long a period of depressed prices, and their bank accounts go empty and their political structure disintegrates.
Oil, oil and more oil. Kill the current set of fracker cockroaches, more come out of the walls, with stronger backing. And these are robo-cockroaches that get stronger and smarter every month (in terms of finding ever greater efficiency in oil extraction techniques).
So the Saudis are doomed then? That is what long-dated oil contracts running out to 2020 suggest. Not even the Saudis can run huge government deficits at 50% funding for an indefinite period.
But hold on, what if Jeremy Grantham is right?
Jeremy Grantham is the famous founder of Grantham, Mayo Von Otterloo (GMO). In a GMO quarterly letter last year, Grantham called US fracking "the Largest Red Herring in the History of Oil." He starts by admitting fracking is an impressively massive red herring:
First, let us quickly admit that U.S. fracking is a very large herring. Its development has been remarkable. It will surely be seen in the future as a real testimonial to the sheer energy of American engineering at its best, employing rapid trials and errors - with all of the risk-taking that approach involves - that the rest of the world finds so hard to emulate. Similarly, it will always stand out as remarkable proof that, so late in the realization of the risks of climate change and environmental damage, the U.S. could expressly deregulate such a rapidly growing and potentially dangerous activity…
And then he drops the bomb: Fracking is not sustainable, and in fact has an extremely short shelf-life. The whole shale boom, if Grantham is right, will eat itself in a matter of years:
It is one of the ironies of this complex oil system that despite this unexpected gush of U.S. oil and the ensuing impressive current drop in oil prices, nothing that really matters in the long term is changed by U.S. fracking…
Because fracking reserves basically run off in two years and can be exploited very quickly indeed by the enterprising U.S. industry, such reserves could be viewed as much closer to oil storage reserves than a good, traditional field that flows for 30 to 60 years. Fracking oil reserves could consequently be treated as our emergency reserve. In real life we are using it up as fast as we can.
So if Grantham is right, the Saudis have a shot at surviving the fracker menace… because the frackers, for all their technological ingenuity, will simply deplete a limited life resource and their production will fall off a cliff by 2020.
Let us say, hypothetically, that Grantham's viewpoint is correct and that, for all their technological advances, the US frackers are simply accelerating the rapid depletion of a finite resource. If this is the case, the Saudi "grit their teeth and hold on" strategy still wins. The Saudis use debt leverage to maintain their dwindling cash reserves… and fracking output goes into a waterfall decline upon hitting the end of a 2 to 3 year lifespan… and then the price of oil goes back to $150 per barrel, or higher, because the "red herring" is gone… and the Saudis are laughing again.
So we don't really know who will be alive in 2020. On the one hand, it is plausible that the Saudis (and many other one-trick-pony oil producers) simply experience political turmoil and internal collapse - like a string of Venezuelas, with increasingly dark geopolitical consequences. On the other hand, it is possible that the Saudi cash pile - extended with leverage - has enough juice in it to cover the three-to-five year window in which fracking production tails off (as Grantham clearly expects).
These pathways also diverge between, say, oil at inflation-adjusted multi-decade lows in 2020, the Middle East "back to Bedouin" scenario… or oil at new all-time highs in 2020, both inflation-adjusted and nominal, as OPEC comes roaring back with a vengeance and the frackers quietly exit stage right.
Nobody can say the world is uninteresting…
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. I have no business relationship with any company whose stock is mentioned in this article.