14 months ago, Saudi Arabia had a plan.
That plan involved deliberately suppressing the price of crude in order to bankrupt the US shale complex and put pressure on the Russians who were still clinging to the notion that Bashar al-Assad would remain President of Syria.
Preserving crude market share and securing the “ancillary diplomatic benefits” (to quote The New York Times) of lower oil prices has proven to be a trickier proposition than Riyadh originally imagined.
Not only has Moscow refused to relinquish Assad, Russia is actually pumping crude at record rates as the country’s fragile economy remains resilient even as the budget deficit looks set to balloon to its second widest level in two decades. Meanwhile, US production has managed to survive the rout thanks to forgiving capital markets drunk on ZIRP Kool-Aid.
And while the party is well nigh over for uneconomic US producers, the damage has been done for Saudi Arabia. A year of depressed crude prices blew a giant hole in the kingdom’s budget and although things are set to “improve” in 2016, the deficit is still projected at around 13% of GDP.
Riyadh has been forced to overhaul the welfare state by cutting subsidies for everyday Saudis, a move which may ultimately foment social unrest and the war in Yemen (which is headed into its second year) is a further drain on the country’s depleted coffers.
The Saudis are of course armed with a sizeable war chest. SAMA reserves amount to some $630 billion.
But as large as that sounds, it could all be gone in a matter of years depending on how long the kingdom intends to keep up the war of attrition with US production and the shooting war with the Houthis in Yemen. Throw in the fact that the Iranians are hell bent on boosting supply by a million barrels per day by the end of the year, and you have a recipe for continuous budget bloodshed in Riyadh.
As if plugging the yawning budget gap and maintaining subsidies for the kingdom’s oppressed masses weren’t enough of a threat to the SAMA reserve treasure trove, Saudi Arabia is also determined to defend a three-decade-old dollar peg for the riyal.
Last August, we noted that the market was beginning to speculate that the peg would fall and subsequently, quite a few analysts and commentators began to ask how long the Saudis would be willing to keep the SAR tethered to a soaring dollar.
Well don’t look now, but Saudi Arabia just banned banks from selling options on riyal forwards.
“Saudi authorities ordered banks to stop allowing cheap bets on a currency devaluation, according to five people with knowledge of the matter,” Bloomberg reported this morning, adding that “the directive applies to local banks and the Saudi branches of international banks, the people said.”
With riyal forwards hitting record highs above 900 points, SAMA had apparently had enough. “[Their] motive is to kill this speculative activity over the sustainability of the riyal peg," Apostolos Bantis, a credit analyst at Commerzbank AG told Bloomberg by phone.
The peg “has served Saudi Arabia well [and] remains appropriate given the structure of the economy,” Masood Ahmed, director of the Middle East and Central Asia department at the International Monetary Fund said, earlier this month. "Saudi Arabia has adequate buffers to maintain this peg," he added.
Perhaps. But one thing policy makers should have learned after watching Greece unravel last summer is that capital controls almost always backfire. Once the market (not to mention the populace) senses panic, it's all downhill from there and make no mistake, there's blood in the water here (pardon the mixed metaphors). For those curious to know how long the SAMA piggybank lasts under $30 crude, recall the following graphic from BofA which looks at the cash burn under different scenarios for budget cuts and borrowing:
As for what happens if (or perhaps "when" is now the more appropriate term) the peg does fall, we close with the following bit from BofAML, who calls the breaking of the riyal peg the "number one black swan event for the global 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.
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.