Saudi Arabia doesn't seem to realize its stock market games this week will lead to its downfall

On Monday, Saudi Arabia’s Crown Prince Mohammed bin Salman, once affectionately known to American elites as “MBS”, cost stock holders about 8 per cent of our net worth over a gambit to boost oil production and flood world oil markets with crude — a move oil-producing nations have tried before, failed at, and will fail at again.

For all of the Wall Street carnage, we saw this only about five years ago. If not for the simultaneous worldwide furor over coronavirus, we’d probably remember it better, and we’d have understood faster that this is a tactic Saudi Arabia is employing out of weakness, not strength.

Put simply, Saudi Arabia needs expensive crude even more than the US-based fracking companies that spent Monday announcing cuts in their capital spending for this year. Its oil money is spent on social programs that keep the peace. By recent estimates, Saudi Arabia needs $80 a barrel oil to balance its budget and provide incomes for citizens not in the oil business. And as the scales fall from western eyes about MBS, we’re reminded that he’s a fairly basic Middle Eastern dictator — and that in that part of the world, welfare spending isn’t a luxury.

Spending to appease the masses is what keeps dictators like MBS on thrones — and out of ditches like the one where Muammar Gaddafi met his fate.

In other words, oil markets are about leverage, and who can out-wait whom. That’s a game where the Saudis have a weaker hand than they did in their 1970s heyday, the waning of which they have struggled for years to accept.

There are a few reasons for this.

The most obvious is that western economies, and especially the US, are way less energy-intensive than they used to be. And the energy intensity of the Chinese economy — the amount of energy needed to generate a given level of gross domestic product — is falling nearly twice as fast as the global figure, according to consulting firm Enerdata.

The one the Saudis will never escape is the one that’s coming: Demand for crude is due to enter a long period of secular decline.

Put simply, electric vehicles are coming, and they will change the Saudis’ world. According to Bloomberg New Energy Finance, electric vehicles will be cheaper than internal combustion engines within a few years, displacing 14 million barrels a day of crude oil demand by 2040. Regulators are confident enough of this that Britain has already set 2035 as the date when sales of new gasoline and diesel-powered vehicles will be outlawed, and then-presidential candidate Michael Bloomberg proposed doing the same in the US.

One thing electric vehicles have in common: They don’t rely on petroleum, the only product the Saudis sell. By the time EVs hit mass adoption, US electricity will be mostly renewable or nuclear (which is also carbon-free), up from about 40 per cent now and 30 per cent 10 years ago. In the US, almost half of crude oil use is for gasoline now, and a lot of the rest is for diesel and heating oil. All those markets will shrink sharply, then disappear slowly, and not just in America.

Just because the only tool the Saudis have is a hammer, doesn’t mean the only problems the world presents are nails.

In the meantime, US and Canadian-based fracking fills the gaps and sets the world’s oil price. Saudis may not like it, but it’s true.

US producers now supply about 13 million barrels a day, out of a world supply the US Energy Department puts at around 100 million barrels. The US, not Saudi Arabia, is now both the world’s largest and fastest-growing producer of crude oil.

The point of the Saudi gambit is to push prices higher — but as soon as it works, the plan creates its own failure. Brent crude tumbled on Monday, on the assumption that Saudis will try to set a price that only they and a few other Arab states can supply profitably. The Saudis take market share, and then jack prices back up. That’s a nice 1970s playbook.

The problem is, once prices rise, US frackers can get back in the game. The equilibrium price of oil is near the cost of production of the player whose barrels make the difference between an undersupplied and oversupplied market — and that’s the US. That price per barrel is somewhere in the $40 range, on average — some parts of North Dakota and Texas produce oil for the 20s, and others are more expensive. Oil production in Texas actually rose in 2015, the last time the Saudis tried their flood-the-market trick.

And that price will be set at a level that is above the Saudis’ price of producing crude — but below the price they need to pay for social peace and, in a new twist since MBS came to influence if not formal power (his father is still king), regional military adventures.

In the meantime, let’s not exaggerate the Saudis’ market power — or their staying power. Profits at state-run Saudi Aramco were down 18 per cent in the first nine months of 2019, to $68.2 billion. The company blamed this on lower oil prices, which tumbled all the way to $66 a barrel in the first half of 2019 from $69 the year before. The Saudi government just pushed them to the low 30s.

So, you tell me: The Saudis, with profits down 18 per cent and worsening through the year, cut the price of their product in half and hope, ultimately, to make the lost profit back by exploiting an oligopoly they no longer control. Press coverage of Saudi oil works on the assumption that the desert kingdom can produce for $10 a barrel or less, but that’s not what Saudi Aramco’s financials tell us. Neither did the $4.65 a share drop in Aramco’s stock price on Monday, as it got whacked like everyone else in the business.

Aramco’s full-year earnings report comes out March 16. The conference call should be fun.