When the second largest oil (NYSEARCA:USO) producer in the world still suffers from a budget deficit, you know current oil prices won't last for many years. HFI Research throughout this year have highlighted many facets of the oil markets not widely discussed by "experts" and analysts. One of those things is the focus on incentive alignment. After the Algiers meeting, our analysis of the OPEC discussion led us to believe that a deal was possible in Vienna at the end of November. Our forecast paid off with our largest holding, Gear Energy (OTCPK:GENGF) (GXE.TO) hitting a new 52-week high since we first wrote about it (Our analysis of the OPEC deal here).
Understanding the long-term trajectory of oil prices requires the analyst to understand the long-term drivers of demand and supply. Supply is far easier to forecast than demand as simple financial modeling can project out the various supply scenarios given a certain price outlook. Demand, on the other hand, is much harder as GDP, global credit cycle, technological disruption, price and other factors play a role.
So as we take a look at Saudi Arabia's 2017 budget, Saudi's budget deficit will decline to 198 billion Riyals from 297 billion Riyals in 2016. Saudi has made ways for cutting down its budget deficit from 362 billion Riyals in 2015 all the way down to 198 billion Riyals or the equivalent of about $53 billion.
The budget deficit in 2017 however continues to remain an issue for a country that's trying to wane itself off of oil in the long run. The deficit is forecasted to be 7.7% of GDP, and without either a substantial increase in oil prices or a substantial decrease in cost, Saudi won't be able to break even on its budget unless oil moves up to the high $60s/low $70s.
This presents an interesting issue for the global oil markets. Does Saudi's budget deficit signal that the second largest producer intends to push oil prices higher? Obviously, one player does not have the capacity to move prices for an extended period of time. Temporary supply cuts are exactly that, temporary. So the question is, what will continue to push oil prices higher?
Current OPEC and non-OPEC cuts for the first half of 2017 will bring down a considerable amount of surplus storage with HFI Research forecasting the surplus to completely go away by Q3 2017. Once that happens, global demand by the second half of 2017 will have already surpassed global supplies as we estimate that the current oil market is already 30k b/d undersupplied despite what IEA and other energy agencies have reported. Global storage has been in decline since March, and the trend will accelerate further going forward. Floating storage in Singapore has been in decline for the last two months, and will normalize by early next year. Brent and WTI spreads have also started to price in the rebalancing of storage for the second half of 2017. All signs point to higher oil prices in the next 12-18 months.
Despite Saudi's strong efforts in cutting its budget deficit, the economy will still be running a budget deficit at 7.7% of GDP. Oil prices will need to move higher for Saudi's 2030 vision to play out, and Saudi Aramco's IPO value will also be dependent on the price of oil at that time. With the second largest oil producer in the world's incentive aligned for higher oil prices, we think WTI will reach $60 early 2017 and $70 by Q3 2017.
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Disclosure: I am/we are long GXE.TO, GENGF.
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.
Additional disclosure: GXE.TO trades on the Canadian stock exchange.