Two weeks ago, Morgan Stanley made a decisively bearish call on oil, noting that if the forward curve was any indication, the recovery in prices will be "far worse than 1986" meaning "there would be little in analysable history that could be a guide to [the] cycle."
As we said at the time, "those who contend that the downturn simply cannot last much longer are perhaps ignoring the underlying narrative that helps to explain why the situation looks like it does."
"At heart," we continued, "this is a struggle between the Fed’s ZIRP and the Saudis, who appear set to outlast the easy money that’s kept US producers alive." This is an allusion to the fact that the weakest players in the US shale industry - which the Saudis figure they can effectively wipe out - have been able to hold on thus far thanks largely to accommodative capital markets.
But persistently low crude prices - which, if you believe Morgan Stanley, are at this point driven pretty much entirely by OPEC supply - are taking their toll on producers the world over. That is, the damage isn’t confined to US producers.
In fact, the protracted downturn in prices is slowly killing the petrodollar and exporters sucked liquidity from global markets for the first time in 18 years in 2014. To let Goldman tell it, a "new (lower) oil price equilibrium will reduce the supply of petrodollars by up to US$24 bn per month in the coming years, corresponding to around US$860 bn" by 2018.
As Bloomberg noted a few months back, the turmoil in commodities has produced a "concomitant drop in FX reserves ... in nations from oil producer Oman to copper-rich Chile and cotton-growing Burkina Faso."
And don’t forget Saudi Arabia which, as you can see from the chart below, isn’t immune to the ill-effects of its own policies.
The financial strain comes at an inopportune time for the Saudis and indeed, as we noted when the country moved to open its stock market to foreign investment in June, "the move to allow direct foreign ownership of domestic equities [may reflect the fact that] falling crude prices and military action in Yemen have weighed on Saudi Arabia’s fiscal position."
"Our forecast is for Brent to average US$54 per barrel in 2015 [and] at this price, we expect total Saudi government revenues to fall by some 41% in 2015.[resulting] in [sharp] cuts to expenditures," Citi said at the time.
Now that Saudi boots are officially on the ground in Yemen (if only to provide "training") and now that it appears the Kingdom is prepared to step up its military efforts in Syria, the financial strain from lower crude prices looks set to drive the Saudis into the bond market. Here’s FT with more:
Saudi Arabia is returning to the bond market with a plan to raise $27bn by the end of the year, in the starkest sign yet of the strain lower oil prices are putting on the finances of the world’s largest oil exporter.
Bankers say the kingdom’s central bank has been sounding out demand for an issuance of about SR20bn ($5.3bn) a month in bonds — in tranches of five, seven and 10 years — for the rest of the year.
The latest plans represent a major expansion of that programme, which bankers believe could even extend into 2016, given the outlook for the oil price.
Saudi Arabia’s resort to further domestic borrowing highlights the challenges facing the region’s largest economy amid one of the steepest falls in the oil price in recent decades. Brent, the international benchmark, has dropped from $115 a barrel in June last year to about $50 this week.
Oil’s decline accelerated in November when Opec, the producers’ cartel, decided not to cut output, a major departure from its traditional policy of trimming production to prop up prices. Saudi Arabia said it was an attempt to defend market share against rivals such as the US shale industry.
But the decision to ride out a sustained period of lower prices has put a huge strain on the finances of major oil exporters, including Saudi Arabia which requires an oil price of $105 a barrel to balance its budget.
The kingdom has drained $65bn of its fiscal reserves to maintain government spending since the oil price plunge began. Sama currently has $672bn in foreign reserves, down from their peak of $737bn in August 2014.
The plan to resort to capital markets, if confirmed, demonstrates the priority Riyadh is placing on maintaining government spending, despite the pressure cheap oil is putting on its budget.
The monthly bond issuance plan would only cover part of the deficit, which economists estimate will reach SR400bn this year amid falling revenues and continuing high expenditure on big infrastructure projects, public sector wages and the continuing war in Yemen.
In case the irony here isn't clear, allow us to explain.
Saudi Arabia has effectively kept oil prices suppressed in an effort to wipe out the US shale industry which has only managed to stay afloat this long because Fed policies have kept monetary conditions loose and driven investors into HY credit and other risk assets. Now, Saudi Arabia is set to take advantage of the very same forgiving capital markets that have served to keep its US competition in business as persistently low oil prices and two armed conflicts look set to strain the Kingdom's finances.
Of course one option for keeping the cash drain to a minimum would be to avoid getting involved in multiple regional proxy wars - but where's the fun in that?