Saudi’s Oil Price Attack: Market Share, or Political Play?

Earlier this year, the Xchanging Political Risk team was very pleased to be able to host Professor Gavin Don, founder and CEO of Newsbase Research (NBR) at a seminar in our office. Professor Don, Visiting Professor of Finance at Edinburgh University, gave a talk on the topic “Saudi’s Oil Price Attack: Market Share, or Political Play?” based on deep analysis conducted by NBR using their proprietary Oil Forecasting model and algorithms.

NewsBase informs companies and governments what’s going on, why, and what will happen next in the global energy industry. NewsBase was established in 1995, and now serves over 21,000 readers in 86 countries.

After a brief explanation of the history of the Newsbase Group and the evolution of NBR, Gavin set out the issues: Saudi has attacked the oil price, driving crude prices down by as much as 70 % in the 24 months from June 2014. Why? NBR had initially read this as an attack on US “tight oil” growth and indeed in 2014 had correctly forecast the initial Saudi attack on crude prices for that reason (the graph at Figure 1 shows the rapid growth in tight oil production that might have fed that motivation) but the Saudi attack has persisted far longer than necessary to achieve that objective.

Figure 1. The growth in tight oil, 2010 – 2014

Gavin started by explaining the Equilibrium Theory pricing model that feeds NBR’s forecasting process. In contrast to classical economics, the Theory states that prices will remain stable so long as the flows of supply and demand are roughly equal. Trend oil prices will only change when a Disequilibrium occurs (i.e. over- or under-supply), with the rate and level of price response depending on the size of the Disequilibrium and the length of time it persists. Prices will stabilise at a new price level when Equilibrium is restored. Gavin and his colleagues believe that the Saudis discovered Equilibrium Theory at the turn of the millennium, and has been using what he called Saudi’s “swing bubble” to manage the oil price since then, including the “psych spike” that was the subject of NBR’s 2014 prediction, and which was aimed at persuading investment managers to divert funds away from tight oil towards other less volatile investments.

However, the Saudi attack has persisted beyond what was necessary for that initial objective, so Gavin explored a number of alternative strategies.

The first thesis was that the Kingdom of Saudi Arabia (KSA) is defending its market share, supported by rhetoric at a number of OPEC summits. Gavin dismissed this on the grounds that market share economics do not work in the oil industry. In most other industries an aggressive competitor can destroy competition and then retain its increased market share through brand loyalty. However, in contrast to other industries, whilst discounting prices may kill competitors, it does not kill reserves, which will be exploited by a new operator when prices rise again. A market share strategy would also be contrary to Saudi’s “equilibrium management” strategy, which is aimed at maximising NPV.

The second thesis was that the continued price attack has been a part of the larger “cold war” between Sunni and Shia Islam, and between Saudi and Iran, which Gavin described as “the Islamic Civil War”, with the KSA attempting to undermine the expected bonanza caused by Iran’s return to the world’s oil market, and in turn undermine Iran in the proxy wars in Syria and Yemen. However, again the economics do not support this. The USD 10 – 12 bn per month of damage the price attack is inflicting on the Saudi sovereign wealth fund far outweighs the USD 4.3 bn per month cost that pushing oil from USD 100/bbl to USD 30/bbl inflicts on Iran. And in any event, the ending of sanctions has released up to USD 125 bn of previously frozen foreign currency reserves to Iran which is a far greater prize to an economy that is only 25% dependent on oil (as opposed to the KSA’s 75%).

The third thesis was that the attack is part of wider geopolitical competition with Russia. During 2015, the Russians intervened in Syria to save a collapsing Syrian army, protect the Assad regime (a key ally) and in turn secure their strategic naval base at Tartus. This was contrary to the Saudi policy of regime change to remove the Alawite Assad dynasty, and at the same time reflective of a nascent alliance between Russia and Iran. Was the attack aimed at Russia’s budget and dollar reserves? Russia is certainly experiencing budgetary pain due to the low oil price, in addition to Western sanctions following Putin’s intervention in Ukraine. However, if there is one thing that history teaches us, it is that Russia has an extraordinary ability to endure pain, and the Russian military remains heavily engaged in Syria with no sign of any change in this policy in view. Accordingly, if this was the reason for the KSA’s attack, it has failed and should be abandoned. Gavin also concluded that Russian budgetary pain would have been a “nice to have”, and not the sole reason for extending the price attack.

The fourth thesis was that the intention was to wean the Saudi population off oil and state subsidies. Deputy Crown Prince Mohammed bi Salman recently unveiled a radical USD 2 trn “Vision 2030” which aims to diversify the economy away from dependence on oil. However, if this is the rationale for the attack, it is causing serious economic self-harm, with the Saudi Sovereign Wealth Fund burning at a rate of USD 10 bn to USD 12 bn per month as a result of the low price of crude.

Gavin’s conclusion was that eventually physics will prevail with the volume of capital expenditure cuts in the industry resulting in a sustained Positive Disequilibrium returning in 2017 to 2018.

The floor was then opened, and a fascinating Q&A session followed. One of the attendees reminded the room of veteran former Saudi oil minister Sheikh Yamani’s observation in the 1990’s when fuel cell vehicles were first being mooted: “The Stone Age didn’t end because the world ran out of stones”. He followed this with a question as to whether the real strategy was to produce at all costs now in the light of the Paris agreement and the rise of electric vehicles and in anticipation of future demand destruction. Gavin thought not in the light of the level of auto industry investment in conventional power systems and the long lead time on infrastructure development required for EVs and FCVs – to illustrate this, a newly constructed engine production line will be expected to operate for 20 years. 

So, the internal combustion engine will be with us for a good while yet. Another question was whether the Chinese economic slowdown had caused any additional damage to the price of oil. Gavin said no, and pointed out that the Chinese growth rate has slowed, growth has not stopped, and that in fact demand for oil increases in a rebalancing economy.

All in all, this was a great event that we at Xchanging were privileged to host, and I should conclude by expressing our particular thanks to Professor Gavin Don and his colleagues Andrew Langlands, Bill Perceval-Maxwell and Chris Moghtader.

 George Johnston is the Chief Adjuster for Political Risk and Political Violence at Xchanging Claims Services. In addition to delegated claims handling services, his team provides market claims coordination services to the Political Risk and Political Violence markets. This article is also published on the Xchanging web site at https://www.xchanging.com/blog/2016/10/05/political-risk-and-energy-market-seminar-saudi-oil-price-attack-market-share-or.