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oil exporters have had to act in a similar fashion and some have dubbed this “Quantitative Tightening” as liquidity is withdrawn from financial markets in contrast to the “Quantitative Easing” employed by central banks in recent years, which has acted to support financial market prices.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.

Syria – Assad situation

Syria is a secular state, but the religious breakdown of the Syrian population is approximately 74% Sunni Muslims, 16% Shia Muslims, 10% Christian (source – CIA World Factbook).  However, the al-Assad family which has ruled Syria since 1971 are Alawites (one of the branches of Shia Islam), and government positions are mainly held by Alawites.  The Arab Spring – the movement across the Middle East which sought to overthrow long-established autocratic leaders – saw an uprising in Syria against the Assad government; this began in March 2011 and the ensuing civil war continues today, with the Assad regime determined to stay in power.  It has become a war between Shia and Sunni Muslims.  Both share many of the same beliefs, but the Sunni Muslims, who represent about two-thirds of Muslims in the Middle East region, believe in the authority of the Koran and the sayings and actions of the prophet Mohammed as the source of truth and wisdom, whilst Shia Muslims believe that Allah has appointed certain people from Mohammed’s descendants and that they possess special spiritual and political authority over their community.

The key allies of the Syrian government are Iran and Russia.  Iran is the largest Shia Muslim state and a neighbour, and is thus determined to ensure that Syria remains controlled by Shia Muslims.  Iran and Syria have been strategic allies since the Iran-Iraq War when Syria sided with Iran, sharing a common hostility to Saddam Hussein, as well as to the US and Israel.  For Russia, Syria is of geo-strategic importance as an ally, since the Syrian port of Tartus is Russia’s only Mediterranean naval base.  In the UN Security Council, Russia has consistently supported Syria against the imposition of UN sanctions and in providing arms to the government.

Saudi Arabia has been the biggest supporter of the Syrian rebels, providing finance and arms. Saudi is predominantly Sunni Muslim and its official form is Wahhabism, often described by critics as being “puritanical” or “intolerant”.  Both Iran and Saudi have aspirations to be seen as the leaders of Islam, and Saudi interests would be served by the rebels overthrowing the Assad government and installing a Sunni regime, thus gaining a new major ally and depriving Iran of the same.

Al-Qaeda is a terrorist Islamic organisation, which sees its targets as both any non-Muslim influence on Muslim countries (hence its attacks on the US and the UK), and any non-Sunni branches of Islam. They are widely believed to be very active in supporting the Syrian rebels with finance, troops and weapons.

Qatar is another Sunni-dominated Muslim country which has given heavy support to the rebels.  Qatar is a tiny country with huge gas reserves and is very keen to build a gas pipeline into Europe via Turkey. To get to Turkey, it must pass through either Saudi Arabia or Syria, and Saudi is currently blocking the proposals.  A more reliable and Qatar-friendly government in Syria would make a huge difference to its ability to supply gas to the European market.

Israel has little direct interest in the Syrian civil war other than to be very aware that should the US engage in military action, then it poses a very convenient and close target for retaliation by Syria.  It would though be more wary of a religious-led government in Syria than the current secular government.

In the initial stages of the Syrian civil war, the three Western permanent members of the UN Security Council, the US, the UK and France were generally sympathetic to the Syrian rebels, on the grounds that a minority grouping ran the country against the wishes of the majority grouping, which would not occur in a properly-functioning democracy.   However as time has gone on, the active support of Al-Qaeda to the rebels has limited the Western desire to take sides actively in the civil war, and instead seek to broker opportunities for peace.

About a year ago, President Obama warned Assad that he would regard any use of chemical weapons in the dispute as breaching a “red-line” for him, and would be unacceptable.  Last week the US announced that they were convinced such weapons had been used by Assad.

The US faces a set of very poor choices: (i) if it decides upon military intervention and this leads to the overthrow of the Assad regime, they are likely to find that Syria’s next rulers hate the US with just as much passion as Assad, and indeed Al-Qaeda supporters may well find themselves in power; (ii) if it decides upon military intervention and this does not lead to a change in the regime, then it will look weak and Assad will become a bigger hero in the eyes of many Arabs; or (iii) if it decides against military intervention, then Obama will have allowed Assad to cross one of his “red-lines” without incurring any serious consequences.  This will be noted and seen as weakness by Iran and North Korea where Obama has also set out “red-lines” over their development of nuclear weapons.

From its beginnings as an internal uprising during the Arab Spring to its evolution as a sectarian Muslim civil war, markets have taken little notice of Syria.  It is only now, as it nears turning into a proxy war between superpowers that the gold and oil prices have started to rise, and markets have begun to be wary.  The lack of public support in the US for military intervention is however likely to mean that Obama will not wish to get heavily involved in Syria beyond a round of air strikes at key Syrian targets.

We are not recommending any changes to portfolios in the light of the Syrian crisis – we expect tensions over the next few weeks, but in the end we believe that the US will not seek a deep involvement in Syria, as it has no major national interest in the outcome of the civil war and no clear objectives and strategy that would inform any deeper involvement.  However, should there be a clear escalation of US involvement in the conflict, the risks to the oil price and the world economy would become much larger.

The Falling Oil Price – mirror on China, geopolitical football or beacon of hope?

The oil price has fallen from $128 on March 1 to below $90 in recent days, but this sharp decline has received little news coverage.  There are good reasons from both supply and demand perspectives why this 30% fall has occurred:

On the demand side

  • Economic data since March have disappointed expectations, following a burst of optimism in January and February on the back of the ECB’s dramatic action to offer a trillion Euros of extra 3-year liquidity at the start of the year. However none of this liquidity made it into the real Eurozone economy – it went into the banking system and the banks used it to support the government bond markets in Spain and Italy as many other investors used the opportunity to exit from their Euro assets.
  • Austerity continues to drive the peripheral countries deeper into recession and the German economy has seen its export engine struggle as the rest of the world slows down.
  • In the US, the improvement in the labour markets that appeared to be taking place at the start of the year has stalled as austerity from the individual states, which are forced to run balanced budgets, has reduced domestic demand. Growth expectations for 2012 have been steadily reduced over the course of this year.
  • It is however the Chinese economy which is the key driver of oil demand, and although not clearly reflected in the official statistics, which are aggregated from local regions all keen to show themselves in a good light to the centre, there is increasing anecdotal evidence of a major slowdown in demand from manufacturing companies for raw materials with the appearance of large inventories of coal and copper within China, together with continued weakness in demand for electricity.

On the supply side:

  • Saudi Arabia has pumping record amounts of oil over the last three months and shown no sign of reducing this rate of production as the oil price has fallen  close to levels (generally assumed to be $80-90 per barrel), which make it difficult for them to balance their budget. They have declared this to be part of a policy aimed at helping the Western economies – closer to the truth might be that the American authorities have requested a much lower oil price, which would boost consumer disposable income and confidence and thus give more room for the Federal Reserve to ease policy and for Obama to win the election in November.
  • Oil production and exports from both Iraq and Libya have been expanding rapidly this year as calm has returned to these countries and with it a focus on rebuilding export earnings.

So weaker demand and increased supply have occurred together and prices have fallen sharply. For Western economies trying to deal with the after–effects of a major banking crisis, this is positive news.  Lower petrol prices leaves more money in consumer pockets to spend in other areas of the economy, at a time when consumer incomes are otherwise under pressure, and allows the Central Banks to be more relaxed about any inflationary pressures. Should Europe be able to find a way through its problems in the next few weeks, there may be scope for an equity market rally.

In the longer term, it should be noted that the USA is moving aggressively towards being energy self-sufficient). The new fracking technologies are significantly increasing the productive potential of its own gas reserves, which will, over the long term, ensure that it will not be dependent upon the Middle East for its energy requirements. Structurally this bodes well for the US relative to Europe and Japan, which will remain more beholden to political developments in those regions, and therefore for the dollar relative to the euro and the yen.