While arguments have been made in the past that oil prices have to spike eventually, it’s not entirely clear when this will be. The biggest factor will be a return to normalcy on the supply side. While demand for oil is continuing to grow (roughly 1% a year), it’s not fast enough to erase one of the biggest oil gluts in decades. Relief for energy investors will only be found when suppliers cut production drastically to balance the market.
Unfortunately, one of the biggest producers in the world may not stop pumping anytime soon.
Many today talk about OPEC’s diminished power in the oil markets. Controlling over 80% of global reserves however, OPEC still has incredible clout over supply. Saudi Arabia comprises almost 25% of OPEC’s oil portfolio, equating to nearly 20% of all oil in the world. That’s bigger than every country outside OPEC combined.
Despite Saudi Arabia continuing to pump near record levels, many analysts have pointed out that this is increasingly unfeasible due to a deteriorating fiscal situation. To break even, Saudi Arabia’s government needs oil to be over $100 a barrel, a far cry from today’s close of under $35. Last week, Saudi Arabia announced a sharp reduction in its 2016 budget to control a worsening deficit, which is steadily draining the kingdom’s financial reserves.
The argument is that the country will be forced to bring balance to the market by cutting supply, abandoning the current strategy of gaining market share. What does Saudi Arabia have to gain from keeping prices low? Politically, a lot.
In a recent note to clients, Oppenheimer's James Schumm:
“We have long believed that the Saudis are driving oil prices lower to inflict pain on Iran. Any collateral damage to US shale producers is a secondary or tertiary benefit. Though low oil prices hurt Saudi Arabia, they negatively impact Iran in a much greater way and it crimps Iran's ability to fund sectarian uprisings in Saudi Arabia's backyard. Essentially, they are forcing Iran to choose between higher oil prices and the economic prosperity that comes with it, and the desire to foment Shia uprisings in the Middle East. In essence we believe Saudi Arabia and Iran are fighting a war without tanks and jets but one with oil prices.”
Saudi Arabia has plenty of reasons to limit Iran’s regional power. As one of the more stable and wealthy countries in the Gulf, Saudi Arabia is the defacto leader and influencer in the area.
Many other countries in the area have been unable to fully realize the value of massive oil reserves due to inefficient production or lack of transportation infrastructure. While Iran’s reserves are the closest in the area that can compete with Saudi Arabia, economic sanctions have crippled their ability to monetize it. With sanctions ready to be lifted, Iran is about to gain a critical ability to influence the region in ways Saudi Arabia wouldn’t prefer. Recently, Saudi officials announced that the kingdom will sever all diplomatic ties with Iran and told all Iranian diplomats to leave within 48 hours.
So, while economics and fiscal analysis may indicate that Saudi Arabia will start to act more rationally regarding supply, don’t be surprised if they keep prices low, crippling Iran’s economic benefit from repealed sanctions.
