A Critical Juncture for Saudi Arabia – Double Down or Act Rationally?

This piece is also available via my LinkedIn profile.

In a piece written this morning in Financial Times by Kings College Professor Nick Butler, the ensuing dichotomy of options for Saudi Arabia in terms of its role in the global oil markets is coming into focus. Their first option is to keep open the proverbial floodgates of production, hoping to metaphorically drown a number of weakly positioned and/or poorly hedged American shale producers; the second option involves Saudi Arabia coming to their senses, curtailing some production, and rising the tide for oil producers. Their are interesting points on each side.

As to Option 1 (doubling down), Butler notes that the shale producers in the United States are proving to be more resilient than perhaps the Kingdom expected them to be. Certainly, some companies have already filed bankruptcy, and others likely will in the coming months and even into 2016; however, there has not been anything resembling a crippling industry-wide impact. With depressed crude oil pricing, Saudi Arabia is finding it difficult to pay for costs to run the country, including social programs –  this could explain a round of lending that Saudi Arabia has undertaken very recently. As Butler observes, they may believe that more of the brunt of the pain would be borne by other players such as Venezuela, Russia, or Iran. The author opines that “[t]his hardline assertive approach…is not immutable,” stating that “the alternative is a more pragmatic view of Saudi’s true interests and a more realistic assessment of whether those interests are being well served by the current policies.”

Option 2 (acting rationally) involves the Saudis accepting that economic stability would better serve their long term interests, and would better aid in their efforts to maintain their current level of influence. The Saudis believed they could crush shale producers and frackers, and to a large degree they have thus far proven to have largely erred in this calculation. Butler intelligently observes that the current king is 79 years old, and current oil minister Ali al-Naimi is 80 years old – arguably they have become so used to the global economies and oil markets of yesteryear that they believe their influence is currently as strong as it was decades ago. If this is true, it is a miscalculation on their parts. The pragmatic approach, Butler argues, for Saudi Arabia would be to cut oil production by 1-2 million barrels/day, which would commensurately bring crude oil into largely rangebound $70-80 levels.

Ultimately, sustained depression of oil prices will cause political unrest, instability, and even potentially attempts of upheaval. The Saudis tried to execute their plan, and to a large degree it has not worked. Accepting the oil markets as they operate today would mean that their country, as well as other producer nations, stave off economic hardship and suffering, thereby mitigating any potential deleterious political or social consequences. If Saudi Arabia doubles down on their current practice, they may succeed in driving out of business a marginal number of American producers, but they will do so at great cost not only their own nation but to other OPEC nations.