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Saudi’s oil price gamble exposes fragile finances

**Written and disseminated to select contacts on March 25, 2020**

 

WHAT YOU SHOULD KNOW

Saudi Arabia’s finances risk becoming seriously impaired if oil prices remain lower for longer, with the state budget and balance of payments deficits virtually unfinanceable at $30/b in 2020. The massive cuts to spending needed could lead to political and public discontent, especially at a time when progress on Vision 2030 goals is slow and unlikely to deliver on its economic objectives in the ambitious time frame.  

 

WHY THIS MATTERS

State finances: Saudi Arabia’s economic health is intricately linked to state oil giant Aramco’s profitability; the company accounts for three-quarters of the country’s annual revenues. Earlier this month Aramco announced a 21% decline in annual profit – missing analyst forecasts – and disclosed plans to cut capital expenditure in 2020 in view of market conditions and the coronavirus outbreak.

  • If oil prices average just $30/b in 2020, overall government earnings (royalties plus income tax) from Aramco could fall to SAR91.3bn ($24.3bn) from SAR518.2bn ($138.2bn) (see Table). The company may cut expenditures further to provide higher revenues, but if it wants to maintain current operations as well as fund future expansion plans, spending cuts will need to be limited. Aramco could draw down its cash holdings of $47bn to transfer to government coffers but this may damage its global reputation. Aramco has $12bn in bonds outstanding, issued last year to massive global demand. Plans for an international IPO listing remain on the table. With oil prices at $47/b, Aramco royalties and taxes to the government would fall to SAR231bn ($61.6bn).
  • With oil at $30/b, the budget deficit could rise to 22% of GDP. To plug this, the government’s cash reserves may fall by 50% while foreign and government debt could rise to 39% of GDP from 26%. About $30bn in external borrowing and $150bn in asset drawdowns will be required, depleting the state’s foreign assets significantly. At $40/b, external borrowing of $20bn will be required to cover a budget deficit of 16.3% of GDP.
  • Despite a significant increase in Saudi bond issuance globally in the last five years, the highlight of which was Aramco’s $12bn sale in 2019 eliciting orders of over $100bn, borrowing under current market conditions will be challenging. Global investors are always going to relish the prospect of high yield, relatively low risk issuance from the GCC, but current volatility and the flight to safety attitude of most investors will mean Saudi Arabia can expect to pay a bigger premium to attract demand.

 

Response & reaction: Under both oil price scenarios above, government revenues will be significantly depleted requiring both a fiscal and political response, the latter likely to include tough new austerity measures which will be unpopular, especially as many in the kingdom are beginning to express frustration at the limited progress towards meeting economic development targets set out in Vision 2030 – overseen personally by MbS.

  • Vision 2030 is critical to creating jobs for millions of young Saudis who would otherwise need to be employed by the public sector, weighing on government finances. Maintaining the social contract will be key to securing popular support for MbS, especially among the demographically important youth population. Therefore, he will need to weigh any deep austerity measures, such as job or salary cuts, with the risk of possible social instability.
  • Saudi Arabia is hoping that the economic and financial pain they inflict on the Russians will force the latter back to the negotiating table. This is a dangerous gamble. Much like the unintended consequences of the kingdom’s war on Yemen or support for the US against Iran, its “flood the market” production policy could harm its own finances more severely than the damage to the Russian economy.

 

BACKGROUND

Global oil prices have fallen approximately 60% since January.  Prices crashed 30% in a day after Saudi Arabia announced a massive increase in production following an OPEC+ meeting in Vienna on March 6, during which assembled ministers failed to reach agreement on further output cuts. Oil prices were already under downward pressure amid falling Asian demand and the spread of COVID-19. Russia argued that further cuts would support high-cost oil producers globally, such as US shale players, and would lead to further erosion of market share for the lower-cost producers, such as Saudi Arabia and Russia. Following Russia’s rejection of the agreement, the Saudis returned to their 2014 policy of maximising production, flooding the market with cheap oil, leading to a price war from which neither party is expected to emerge unscathed.

Saudi Arabia’s gamble could either bring Russia back to the table or risk a lower-for-longer price scenario which would have more durable repercussions for both the long-term viability of the Saudi economy and the global market.

 

 

Rachna Uppal | Senior Analyst Business & Finance | r.uppal@castlereagh.net

Forecasts provided by Fareed Mohamedi, Senior Advisor to Castlereagh Associates and Managing Director, SIA Energy International

 

 

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