We last wrote about oil on 23 April in which we said “With the best will in the World, OPEC and Non OPEC production cuts are barely making a dent in bloated stockpiles and there is a significant risk that price needs to correct further as the market rebalances, and further price declines would surely lead to bullish hedge funds capitulating, forcing price lower quite quickly.” The price of front month (June 2017) WTI was $49.62 at that time.
As at the close of trading last week, the front month (August 2017) WTI price had fallen to $43.01 and the net hedge fund long position had declined by just over a quarter. It’s nice to get something right in these markets!
Chart 1 – Front month WTI with 8 day moving average
The decline in oil prices is occurring at a time of some increased political uncertainty in the region and news this week that the young Prince Mohammed bin Salman has been appointed Crown Prince of Saudi Arabia. With the situation in the Middle East best described as “fluid”, the appointment of Mohammed bin Salman (MbS for short) brings with it a few interesting angles to consider.
First, MbS is taking a very hard line with Iran. The standoff between The Gulf Countries (lead by Saudi and orchestrated by MbS) and Qatar is part of the complex ongoing battle for supremacy in the Middle East, and it would appear that, post the Trump visit, the Saudi regime believes it has US backing to be openly more assertive, at the same time that the US is reversing course on the Obama negotiated engagement with Iran. We view the increasingly assertive move to isolate Iran as a potentially destabilising move for the region.
Second, Saudi has started to look seriously at reforming the country and reducing its reliance on oil since MbS was brought onto the scene a few years ago. Arguably the flagship piece of this reform programme is the upcoming Initial Public Offering of Saudi Aramco in 2018. It has been very clear that the Saudi/OPEC production cut last November was designed to help move the oil price higher in part so that the Aramco IPO valuation would be higher. The lower oil price is becoming a problem for the IPO process and therefore the overall reform programme.
Chart 2 – Saudi Reserves vs WTI Oil Price
Third, the powershift and appointment of MbS to Crown Prince appears to have been smooth so far, but risks do remain. The proxy war (against Iran backed rebels) in Yemen has been much costlier and long lasting than it should have been, and this was orchestrated by MbS and therefore risks been seeing as his failure. If public sentiment were to shift against this war at a time of economic difficulty at home (caused by the weak oil price), then it is possible that the conservatives will agitate against the young prince.
So, we have a new regime in charge in Saudi that needs to consolidate its power, and a nice policy success would certainly help. We also know that Saudi must diversify its economy away from oil to survive in the longer term. The investment needed for this comes from privatisations and reserves/revenues which are being depleted by the low oil price. We also know that Saudi are very keen to isolate Iran to increase regional power, and this battle with Iran (via regional proxy wars) is also draining their reserves (defence is a large and fast growing part of the Saudi budget). It would appear that something has to change for any sort of success to be more attainable, otherwise the risks of either a Saudi or a regional problem increase.
And the thing that needs to change to help Saudi is a higher oil price. Assuming that this is not achieved because of heightened supply concerns due to regional conflict, then we have to see further significant cuts to OPEC production, probably including Non OPEC countries as well. If Saudi fails to engineer a higher oil price, then we suspect that their finances will deteriorate much further and the young MbS will pursue even more aggressive foreign policies to deflect domestic criticism. Either outcome has importance for financial markets.
Perhaps we will see increasing jawboning in the weeks ahead about more OPEC production cuts. If so, they would have to follow through otherwise the market will lose complete faith in them. If this were to lead to a higher oil price, this would help inflation move higher (allowing more hawkish central bank policies) and help assets directly linked to the oil price. If OPEC does not cut further, then we have to suspect the oil price remains low enough to see further deterioration in Saudi finances.
We are open to both scenarios. We are modestly long of Canadian Dollars and Norwegian Krone in our portfolios which look cheap and would obviously benefit from a resurgent oil price. We are also short of Saudi Riyals. With the Riyal being fixed to the US Dollar, any devaluation will have to be politically sanctioned and would likely be from a position of weakness. This could be after a further drawdown in their reserves, and perhaps some backlash from Washington if MbS’ foreign policies prove to be one step too far.
Perhaps the biggest message we can leave you is that Middle East risks are on the rise, and there is no simple solution. Ordinarily, we would expect some sort of premium to be built into financial prices, and yet volatility remains low everywhere with the trajectory lower as well. Collectively, investors seem to be ignoring Middle East risks just as they seem to be escalating and perhaps becoming more intractable.
This is yet another example of investors collectively being asleep at the wheel. Low oil prices are bad for Saudi and regional stability. High oil prices are bad for developed central banks who will feel compelled to tighten policies, possibly hurting financial markets in time. So, investors had better hope that somehow the young prince keeps his nerve politically and engineers an economic revival with only modestly higher oil prices. We are fascinated by what seems to be an unsolvable conundrum and one being mostly ignored in mainstream markets.
Stewart Richardson
RMG Wealth Management
