The Saudi-Russia Factor In Crude Oil

by: Ivan Martchev

Given the historic summit between Saudi Arabia and Russia in early October - with the first-ever case of a sitting Saudi king visiting the Kremlin - one cannot help but notice the bid under the price of oil as the two countries are constantly in a tight race for the spot of #1 global producer. The Russians have come a long way since crude oil production imploded after the collapse of the Soviet Union and they are making their presence felt on the global stage both geopolitically and in the energy markets.

Russian Crude Oil Production versus Saudi Arabian Crude Oil Production Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The Saudis have finally realized that they will have to deal with Vladimir Putin. The fact that they signed a memorandum of understanding for the purchase of a highly advanced S-400 air defense system shows a key turning point in Saudi-Russia relations as the desert kingdom had previously sourced most of its defense purchases from the United States and the United Kingdom.

It has to be noted that Moscow is a top supplier of advanced weapons systems to Iran, which has long been challenging Saudi Arabia for dominance of the region. I would not be surprised if in due course Russia emerges as a mediator in the long-standing Saudi-Iranian conflict as they have made the strategic decision that the Middle East is very important to their national interests.

It had been a while since I had looked at the detailed maps (from the Institute for the Study of War) covering the Syrian conflict, as I had seen multiple headlines that the "tide had turned" against ISIS.

I had to look hard to find ISIS-controlled territories on the map. They had practically disappeared. And it's the Russians who get the credit, after they decided to intervene in late 2015.

Territorial Control in Syria Image

The oil market has definitely taken note of this Russian geopolitical maneuvering and so has the Russian ruble, which has a notorious correlation to the price of crude oil. (The Saudi riyal probably would have matched the Russian ruble if it were not pegged.) Saudi Arabia and Russia are similar in the way crude oil composes a disproportionate contribution to their government budgets and overall economic growth.

This Russian ruble volatility disproportionately affects the performance of Russian investments listed on foreign exchanges. Not only are Russian ADRs skewed towards energy and the materials sectors but they get more significant currency translation than your average ADR, given how volatile the ruble is.

Russian Ruble versus Crude Oil Price Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Still, I am wondering if this is not a dead-cat bounce in the price of crude oil as it tends to have negative seasonality in the fall and winter months. We did not get a seasonal rebound in the spring and summer months, so I am not quite sure how we will get a price spike in crude oil when seasonal demand is weak, geopolitical risks notwithstanding. There is no doubt that a warming of Saudi-Russia relations is a positive in the long term for crude oil prices, but in the short term there are serious risks that remain.

The #1 Risk to Crude Oil Prices Remains China

The #1 risk to crude oil prices remains China, which is not in a particularly stable economic situation. In fact, with China being the #1 consumer of oil, I don't think that any Saudi/Russia handshake can keep the price of oil up if the Chinese economy delivers a hard landing.

Iron Ore versus Crude Oil Price Chart

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

The significant price declines in crude oil and other key commodities in the 2014-2016 period coincide with the downshift in economic growth in China. Recently, the price of iron ore has again dramatically weakened while crude oil has rebounded. I know that key commodities are not perfectly correlated, but they do give us an independent indication of how the Chinese economy is performing. I have never been fond of official Chinese economic statistics that frankly can be "cooked." This is why when I see prices of key commodities - where China is the #1 global consumer - weaken, I take notice.

I am of the opinion that Chinese authorities pulled out all the stops to stabilize the Chinese economy for the 19th Congress of the Chinese Communist Party (CCP) that opens tomorrow (October 18). I do not think that the Chinese authorities can plug the air of a credit bubble in the Chinese economy that has already popped. What we see in China today is a temporary stabilization due to the CCP Congress, but later they may face a hard landing due to years of rising debt levels that are not sustainable in the Chinese economy.

In a strange way, the price of crude oil has been caught between warming Saudi-Russia relations on the supply side, and a Chinese economy (in a not-too-stable condition) on the demand side. In the short term, demand side shocks could have a disproportionate effect on prices, particularly in weak demand months.

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