The oil gambit

The biggest black swan event of the year is most certainly Saudi Arabia’s hike in oil production, which has thrown the international oil markets in disarray. Officially, it was a move to consolidate market share. Unofficially, it was a tool to pressure Russia to ditch Assad in Syria.

So how is Russia doing?

Some of us may recall that Saudi Arabia has tried this experiment before, with great success. The Saudis upped production in 1985 from two million to 10 million barrels a day. They had exactly the same excuse: protecting market share. Behind closed doors, there was a secret handshake with Ronald Reagan to bankrupt the Soviet Union. The USSR was one of the world’s largest oil producers at the time and their primary source of foreign income virtually evaporated overnight. Within five years, the empire was finished.

Today, however, it’s a very, very different story. As expected, recession has set in and unemployment and inflation are growing in Russia. Living standards are declining for the first time in 15 years. Oil and gas, together, provide about half of Russia’s state revenue, and the government is cutting spending and benefits. Pensioners don’t get free rides on the metro anymore.

The Russian spirit is thriving though. Oil production is increasing in Russia, with output breaking post-Soviet Union records. This year, for the very first time, it became China’s largest oil supplier, beating out Saudi Arabia.

As Nietzsche remarked, “He who has a why to live can bear almost any how”. The Russian narrative is all about Putin defiantly standing up to the thoroughly corrupt and imperialist Western order. With his interventions in Ukraine and Syria, Putin’s popularity at home just hit a high of almost 90 per cent, higher than it’s ever been in the 15 years he’s been in power. He’s also very popular abroad, architecting alliances and deals with major global players, right, left and centre.

Putin is likely not going away anytime soon. And, from the looks of it right now, neither is Assad. In fact, it looks as if this whole oil-gambit is backfiring in a big way.

The US itself is hurting deeply. In the last few years, thanks to the shale technology revolution, the US quietly became the world’s largest oil producer. But now, thanks to record low prices, it is far more expensive to get oil out of the ground in the US than in the international market. The shale boom has turned into a massive rout.

In October last year, there were 1,609 oil-drilling rigs operating in the US. Now, there are about 578, a 64 per cent decline. Ambitious projects are being abandoned. Shell recently invested heavily in setting up offshore drilling operations in Alaska, in the face of considerable opposition from activists and environmentalists. But it was the downturn in prices that forced it to scrap the project till at least 2020-30. Some of the biggest US oil producers have gone bankrupt and several more are reporting record losses. The US energy industry has laid off more than 90,000 employees over the last year and the cycle is still ongoing.

The shale industry is also deeply mired in debt. When the boom first began, companies borrowed heavily to expand operations and set up new rigs. Banks and investors were very keen on this new business when oil traded at $100 a barrel. Shale oil stocks surged. But now, companies are fighting for their very existence. Not only are interest payments on their loans eating away at what are suddenly precious small margins, but the banks themselves are tightening credit lines. Ratings agency S&P has downgraded credit ratings of almost half of the 105 US shale oil companies that it rates, and assigned 45 of them the dreaded ‘junk’ rating. Prominent hedge fund manager David Einhorn has called shale oil debt a big bubble due to burst any day now.

Saudi Arabia itself is not doing too well. Oil revenues account for half of the country’s economic output and 80 per cent of government income. The fall in revenues has led to a profound fiscal reverse in a region where grand surpluses have long been the norm.

To balance its budget, Saudi Arabia needs prices to be at $106 a barrel. This was the reason that S&P just downgraded Saudi Arabia’s credit rating a notch as well. An IMF report from October notes that low prices will slash $360 billion in earnings from the Gulf region this year. Furthermore, if prices subsist at $50 a barrel, some countries, including Saudi Arabia, will go broke in five years. Countries like Iran, Kuwait, Qatar and the UAE can hold out for much longer.

Saudi Arabia is also hurting from its military adventure in Yemen. Its military budget has gone up by a record amount of $80 billion in 2014, approximately 10 per cent of GDP and fourth highest in the world.

To plug the gaping hole in its budget, Saudi Arabia is tearing through its foreign reserves, drawing in some $70 billion from overseas assets. Surprisingly, it has also opted to go into debt. The government has issued sovereign bonds for the first time in almost a decade, worth about $4 billion, with strong indications of a lot more to come. Public spending is taking a hit. The government has paused new construction projects, delayed payments to contractors for six months, frozen new hiring and imposed bans on government purchases of cars and furniture.

The IMF has often suggested that Saudi Arabia saves money by slashing energy subsidies. In Saudi Arabia, drivers pay less than 10 per cent of European petrol prices and the kingdom pays about $3,400 per citizen to make this possible. Withdrawing these subsidies would be a colossal revenue stream but the government has always vigorously resisted the notion. Subsidies equate to a happy public, the argument goes and this keeps resentment at bay.

But now, subsidies are being seriously reconsidered. The government has just announced raising water prices for industrial consumption. And one can tell some desperation is in the air when a country like Saudi Arabia contemplates investing in renewable energy.

Published in The Express Tribune, November 26^th,  2015.

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