Saudi Shakeup Sees Bin Salman Take Over

|
Includes: BNO, GZPFY, OGZPY, RNFTF, RSX, TOT, UUP
by: Tom Luongo

Summary

There is a new de facto king in Saudi Arabia.

Mohammad bin Salman is an aggressive actor behind many of KSA's recent moves.

Saudi Arabia is trapped between falling market share and an unsustainable currency peg.

The news came out last night that the succession in Saudi Arabia had been upended. Former Crown Prince Muhammed bin Nayef was removed from the succession and stripped of his titles, while the architect of Saudi's war in Yemen and diplomatic war with Qatar, Mohammed bin Salman, replaced Nayef. He now takes over as both Crown Prince and Minister of the Interior as well as his previous duties as Defense Minister and head of the economic council.

The far younger bin Salman, 31, has been consolidating power in Saudi Arabia for a while now. This move by King Salman, who is 87 and in poor health, effectively puts bin Salman in charge of the kingdom for the next two generations if it lasts that long.

The problem is that each of Bin Salman's big and bold maneuvers has fallen flat and placed the country in an even more precarious position than it was previously. He escalated the now stagnant war in Yemen as well as support for ISIS in Syria, and the latest move, the isolation of Qatar, has not progressed. Qatar has found allies in surprising places in Turkey, Iran and, by proxy, Russia. It is this attempt at forging a foreign policy independent from the Gulf Cooperation Council that precipitated the current conflict.

Bin Salman's Next Move

His time as Defense Minister has been marked by increased aggression and that should be our default position until events tell us otherwise. And that means ratcheting up tensions with Iran. We've gotten hints of this already with the attack on Tehran two weeks ago, which Iran claims was orchestrated by Saudi Arabia, and the counter-incident with an Iranian boat near the Saudi offshore oil fields which the Saudis say was launched in response by Iran. From my perspective, the attempt to isolate Qatar has already bogged down like the war in Yemen.

Saudi Arabia's government is facing an existential threat. Low oil prices are killing its economy. Its persistent budget deficit is the kingdom's Achilles' heel and its reserves are draining quickly. This is why bin Salman has pushed for the Saudi Aramco (ARMCO) IPO at a $2 trillion valuation, which Wall St. is having a hard time selling to investors.

It needs the capital injection to attempt any broadening of its economy. Bin Salman's Saudi Vision 2030 plan depends on maintaining a high enough oil price to fund it. This is a $373-billion project.

All attempts to prop up the price of oil have failed as the supply and demand mismatch continues unabated. Today's breakdown below $45 for Brent crude is technically quite bearish.

OPEC is not united on production cuts. In fact, OPEC production rose in May. Bin Salman's negotiations with Russia have led to tepid results. The only concrete agreement from Russia to limit production was by Gazprom Neft (OTCQX:GZPFY) saying it would cut production from legacy fields but not slow down new exploration activity.

Meanwhile, its enemies, namely Iran and Iraq, continue to ramp up new production. U.S. production is skyrocketing and there is little to nothing President Trump can do about it since he doesn't control the wildcat frackers out in the Permian Basin. The need then is to reinstate economic sanctions on Iran to limit the growth of its oil and gas sector and scuttle any major deals in the works, namely the big deal about to be completed with France's Total (NYSE:TOT).

So, Saudi Arabia's only real choice here is to consolidate power over the rest of the GCC countries and threaten war with Iran to keep an uncertainty premium over the price of oil.

The Float Problem

Remember, of the major oil producing countries, only Russia can handle a drop in prices back into the $30s. With the ruble floating freely while the Saudi riyal is pegged to the U.S. dollar, Russia can weather the current deflationary environment better than Saudi Arabia can.

Moreover, Russia continues to remove the dollar from its oil and gas trade. Gazprom and Rosneft (OTCPK:RNFTF) both do business with China in yuan. And both are working with the Chinese to build a new pricing standard for oil in yuan. Without a war premium, we have to accelerate discussing the deteriorating fiscal position of the Kingdom. Fitch finally downgraded it to A+ from AA- recently, after two years of double-digit budget deficits.

Unfortunately for bin Salman, Trump's pledge of support comes with the implicit guarantee of not breaking the currency peg and taking the GCC off the petrodollar standard. So many of Saudi's problems would be cured by free-floating the riyal, but that is not under contemplation.

Meanwhile, Qatar has been contemplating breaking its currency peg since it has a yuan clearing center in Doha. China has a lot to say about all of this since it is Qatar's largest trading partner and the 2nd largest consumer of Saudi oil behind Russia.

For now, investors need to be aware that with bin Salman, for all intents and purposes, in charge of Saudi Arabia, its policy will become more aggressive regionally. His history as Defense Minister tells us this. I personally discount the possibility of war with Iran in the near term because of the sincere mismatch between the military capabilities of the two countries.

Bin Salman is aggressive, but he is not stupid. However, I don't discount skirmish-level events that keep the markets on edge to try and keep the price of Brent Crude above $45 per barrel. I don't expect it to work. Any instability in this region will accelerate capital flow into the U.S. dollar and keep the pressure on oil prices in dollars. That's the key.

Given supply and demand fundamentals as well as a rally in the dollar, those will always, in the long run, overcome any negative headlines short of regime change which cannot be ruled out. That said, I also expect Bin Salman, now that he has consolidated power to step up pressure on Qatar to see how committed Turkey and Iran are to its defense.

For subscribers to my premium service, Stocks, Shocks & Rocks, I covered these issues earlier in the week.

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.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.