As we noted recently, [11] BofAML fears "a depeg of the Saudi riyal is the number one black-swan event for the global oil market in 2016," adding that it is "a highly unlikely but highly impactful risk." Given the recent action in Saudi Riyal forwards - the market's best guess at where the oil-ruch nation's currency will trade in the future - the chance of the black swan 'de-peg' is its highest since 2002. Besides this morning's "whatever it takes" moment, which oil markets quickly shrugged off, amid heavy subsidies to keep the people calm and the costs of wars in Yemen (and more in Syria), weak oil revenues leave The Sauds with few options (outside of the load the nation with ever more debt program): It's either stop it with the whole flooding an oversupplied market strategy, or let the peg fall before reserves runs dry.
SAR Forwards indicate the highest de-peg conviction since 2002...
[12]
And notably, the de-peg is a lot more palatable than losing face and cutting crude production...
“It is a lot easier politically to implement a modest supply cut at first than allow for a full-blown currency devaluation."
As we detailed recently, BofAML [11] calls a Saudi de-peg the "number one black swan event for the oil market in 2016."
For oil, however, the most crucial point is what happens to Middle East currencies and in particular to the Saudi Riyal. In fact, Saudi Arabia’s FX reserves are still high and point to an ample buffer for now, but they have been falling at a relatively fast rate (Chart 21). However, should China allow for significantly faster FX depreciation than is currently priced in by markets, we believe oil prices could fall further. Naturally, the FX reserve drain on Saudi could accelerate to $18bn per month if Brent crude oil prices average $30/bbl (Chart 22), sharply reducing the Kingdom’s ability to retain its currency peg.
[13]
Saudi has been forcing prices lower by increasing production into an oversupplied market so far (Chart 23), and it also rushed to issue debt in its local market to fill a soaring budget gap. We have previously argued that Saudi Arabia’s surging output is responsible for almost half of the 520 million barrel global petroleum inventory build in the last 7 quarters. Can the government maintain this strategy of flooding the oil market? In our view, it is unlikely that Saudi leaders would want to exacerbate its ongoing reserve drain by pushing prices below $40/bbl. After all, pressure will quickly build on the riyal’s 30 year peg to the USD (Chart 24) if Brent crude oil prices keep falling. And frankly, it is a lot easier politically to implement a modest supply cut at first than allow for a full-blown currency devaluation. But a CNY meltdown could ultimately force Saudi’s hand.
[14]
In short, a depeg of the Saudi riyal is our number one black-swan event for the global oil market in 2016, a highly unlikely but highly impactful.
However, if Saudi cannot resist the gravitational forces created by a persistently strong USD and depegs the SAR to follow Russia or Brazil, oil prices could collapse to $25/bbl. Weaker commodity prices would in turn add more downward pressure on EMs (Chart 26). Thus, even if micro supply and demand dynamics are improving, the path for oil prices in 2016 will heavily depend on how the USD moves against the CNY and the SAR. Or on a Saudi supply cut.
And there you have it. It's either stop it with the whole flooding an oversupplied market strategy, or let the peg fall before SAMA runs dry. Bear in mind that it's not just falling crude, the peg, and generous subsidies that are weighing on the Saudis. There's also the war in Yemen and the prospect of a stepped up role in Syria.
Time to choose...
[15]
Charts: Bloomberg
