Saudi worries

Over the last eighteen months, Saudi Arabia’s foreign policy has become extremely assertive and has created major uncertainties for the oil market and the geopolitical situation in the Middle East. Both of these are of major significance for global financial markets.

In the second half of 2014, there was a major shift in Saudi policy with regard to the oil market. Stung by rapid growth in US oil output from shale oil deposits, which led to the US no longer being a net importer of oil, the Saudis refused to continue to act as the swing producer in the oil market in order to maintain an oil price above $100. They announced that they would continue to pump oil at full capacity in order to maintain their market share. With oil demand weak due to weak global growth, particularly in China, and supply plentiful, inventories have soared and the oil price has fallen to a level at which US shale oil is uneconomic. Prices below $60 will see exploration in the US shut down and development of existing discoveries discontinued, though this process has been slow due to US investors providing a lot of capital, both debt and equity, to US shale oil companies in the first half of 2015, believing that the oil price would bounce back towards $100.

For Saudi to maintain its share of the oil market, it was necessary for them to force the most marginal oil fields out of business – these were the US shale deposits, and Saudi continues to pursue this policy which will also maintain the US as a net oil importer. As a way of treating its historic key ally and protector, this was an aggressive decision by the Saudi government.

The financial market implications have been (i) major credit problems in the US high-yield bond market which had provided a lot of capital to the shale oil companies, (ii) massive cutbacks in planned capex spending by the major oil companies – should the oil price remain in the $30s almost all of them will have no sustainable earnings or dividends and (iii) the Saudi budget, which is based on the assumption of $100 oil has moved into an enormous deficit. In order to meet the gap of 15% of GDP in 2015, the Saudi government has drawn down from its sovereign wealth fund, which in turn has liquidated investments it held global financial markets. Other oil exporters have had to act in a similar fashion and some have dubbed this “Quantitative Tightening” as liquidity is withdrawn from financial markets in contrast to the “Quantitative Easing” employed by central banks in recent years, which has acted to support financial market prices.

Cynical political observers have long noted that when a government faces difficulties in its domestic economy, its politicians often discover an external enemy that needs to be confronted that also distracts the attention of its populace. It might be argued that the New Year’s Day decision of the Saudi government to execute Nimr Al-Nimr falls into this category.

Islam is divided into two key strands, Shia Muslims for whom Iran is the acknowledged leading force and Sunni Muslims for whom Saudi Arabia is the leading force, though Iran contains a minority of Sunnis and Saudi contains minority of Shias. This divide is at the very centre of unrest in the region as a whole. Nimr Al-Nimr was the leading Shia cleric in Saudi Arabia, and his execution for terrorist offences was interpreted as an attack on the Shia minority by the Iranians, which then led to an attack on the Saudi embassy in Tehran which led to the Saudis breaking off diplomatic relations with Iran. This heightens the tensions that already exist across the region. The situation is compounded by the number of different sides that exist in the region, where your enemy’s enemy may very well prove also to be another enemy to you rather than a potential ally.

This increasingly assertive Saudi government policy follows the appointment nine months ago of a new Crown Prince and Deputy Crown Prince, representing the appointed succession plan to the 80 year old King. Their more assertive policies are a break with Saudi tradition and may well indicate a new trend. Wars which lead to attacks on the major oil fields in the region have, on fairly recent history sent the world economy into recession very quickly.

Currently, most of the world’s powers have troops attacking someone in the Middle East region – the chances of a relatively minor event drawing in military forces of many countries is very real. Once again global geopolitics is centred on the region the oddity this time is that oil prices have fallen as tensions have risen.

A much less predictable Saudi regime is the last thing financial markets need when there are so many other factors causing uncertainty. For the investor, the best response is to build exposure to gold, which would perform well in the face of both the increased geopolitical uncertainty and greater uncertainties in financial markets.