Saudi Arabia’s about-face

About a week ago, Saudi Arabia brokered an agreement among oil producing countries to cap their aggregate output of crude at 32.5 million barrels daily.  This will require daily liftings to be reduced by 1.2 million barrels.  Of that 1.2 million barrels in cuts, the Saudis themselves will account for 486,000, or just over 40%.

This Saudi decision flies in the face of the kingdom’s previous policy and its experience in the 1980s, when it repeatedly reduced production in a vain attempt to stabilize prices.  What happened back then?   …other OPEC countries, with more pressing needs for cash and with relatively short-lived reserve bases (so playing a long game made little sense, just as today), failed to make the output reductions they agreed to.  More than that, they boosted their liftings instead in amounts that more than offset the Saudi cutbacks.  So prices continued to fall, and for years afterward Saudi Arabia lost access to long-time customers.

Over the past two years, because of the bitter experience of the 1980s, Saudi Arabia has refused to reduce its output despite pleas from other OPEC members.  It  has even increased production a bit.

…until now.

What should we make of this about-face?

The superficial arithmetic for Riyadh is clear–reduce output by 5%; the price per barrel rises by 10% as a result; total revenue rises by 5%.  That’s assuming no cheating by other parties.  But in the case of every economically-driven commodities cartel, cheating always happens.  And the Saudis know that OPEC proved itself no different from other cartels 35 years ago.

 

What’s interesting about this case is that for us as investors situations like these, where we have imperfect information, arise more often than we would like to believe.  Rather than obsessing about what we don’t know in these cases, it’s important to see what conclusions we can draw from what we do know.

In particular:

–Saudi Arabia simply can’t have forgotten about its experience in the first half of the 1980s.  It must believe that eventually some parties will fail adhere to their production quotas.  But it must have some reason to believe that this won’t happen immediately

–it’s possible the kingdom thinks that with supply and demand are almost evenly matched, output reductions will cause the crude oil price to rise substantially.  The price rise will ward off cheating

–the Saudis must also think that what they’re doing now is a better strategy for them than that of pumping full-out and keeping prices low.  Why should this be?  My first thought is that Riyadh’s finances are not in strong enough shape to continue to endure $40 a barrel oil

–the Saudis must realize as well that $50+ a barrel will reinvigorate the shale oil industry in the US, capping any possible price rise.  On the other hand, keeping prices at, say, $40 a barrel won’t make shale oil go away.  The industry will simply lie dormant for a while, ready to spring to life again when prices are higher.  On the other hand, they may no longer believe that they can destroy the shale oil business forever by keeping prices low.  they may even fear that technological advances and cost-cutting will make shale viable at $40 if they are allowed to take place.  So, counterintuitively, the best strategy for combating the threat of shale may be to discourage the development of such new techniques by keeping prices higher

my take

Buy shale oil and monitor OPEC closely.

 

 

 

 

 

will OPEC cap its oil output?

…maybe, for a short while anyway.   Ultimately, no.

Will this move shore up oil prices?

…probably not.

Yesterday OPEC announced a provisionary agreement according to which the oil cartel’s members will limit aggregate output to between 32.5 million barrels per day and 33.0 million.  At the lower end, that would remove 750,000 daily barrels (or 2.3%) from OPEC production.  According to the Financial Timesvirtually all of the reduction would be by Saudi Arabia; other OPEC members promise only not to increase theirs.

Saudi Arabia has previously been dead set against any agreement of this type.  Why?   During the early 1980s oil glut, the Saudis sliced oil liftings from 13 million barrels daily to 3 million in a vain attempt to stabilize prices.  That effort failed because everyone else in OPEC cheated, boosting their output to fill the void.

That such cheating happens shouldn’t come as a shock.  It’s standard cartel behavior–and the reason most cartels fail.  The truly startling development in the modern history of commodity-producing cartels was the solidarity of OPEC in its formative years, when it was a political cartel opposing exploitation of third world countries.  It has lost its power as it evolved into the current economic one.

So, as I see it, there’s no reason not to expect widespread cheating again.

Another factor arguing against this agreement actually stabilizing crude oil prices is that OPEC doesn’t dominate world oil production as it did in the 1980s.  Four of today’s top six oil-producing countries (Russia, US, China, Canada) are not members of OPEC.  There’s every reason to expect that all of the four would boost output as/when prices start to rise.

 

To my mind, the real news the OPEC accord signals is the changed attitude of Saudi Arabia.  I think this must mean that Riyadh is in worse financial shape than is commonly believed.

Certainly, the country is radially dependent on oil   …and has become accustomed to the revenue from  $100+ per barrel prices.  So it is now running a large government budget deficit.  My guess is that it is also having a much harder time than expected in borrowing to bridge the gap between revenue and spending, and that efforts to develop other facets of the economy are not moving forward smoothly.  Saudi Arabia has just announced a salary cut for government workers, which can’t imply greater political stability.

If there is a valid reason for oil to have risen on the OPEC announcement–and I don’t think there is–it would be worries of political developments in Saudia Arabia that disrupt oil production there.

Personally, not owning any oil stocks at present, I’m thinking that the seasonal low point for demand, that is, January/February, would be a better entry time than right now.

the proposed Aramco IPO: why?

Aramco and an IPO

Over the past few days, as a new, younger generation prepares to take over leadership of Saudi Arabia, the kingdom has been announcing plans to overhaul the structure of its radically oil-dependent economy.

The most concrete of these is a proposed IPO for the Saudi national oil company, Aramco (the Arabian American Oil Company before it was nationalized in the 1970s).  The idea would be to sell roughly a 5% interest in Aramco to the investing public, with a dual listing in Saudi Arabia and somewhere else.  The leading “somewhere else” contender is the US.

It’s not clear yet exactly what the future shareholders would have an ownership interest in.  Aramco contains all sorts of oil-related operations, from exploration and production to refining to petrochemical production.  The Saudis intend to restructure Aramco into a holding company with subsidiaries–structured presumably by type of business–before offering equity.  To me, it sounds as if the offering will be of stock in a subsidiary, not the holding company.

Why?

money

The obvious answer is that the kingdom wants to raise money to fund its budget deficit.  It figures the proposed IPO will raise $100 billion – $150 billion, a figure that already has investment bankers around the world salivating.  This, by the way, implies a total value for Aramco of $2 trillion – $3 trillion.

deeper motivation

But there’s almost invariably a deeper motivation when a country takes action like this.  It wants to focus and streamline operations of the to-be-IPOed company, either because current service is terrible and/or to generate more funds from operations to fill government coffers.  The IPO offers potential wealth and prestige to the management of the government-owned company if they run it well.  That substitutes for pre-IPO motivation, which may simply be to do the least work possible, and make the fewest waves, without getting fired.

better than they look

In my experience, such IPOs, however dreary the prospectus may sound, often do quite well for at least the first couple of years.  Two reasons:

–their scope for change becomes much wider when public scrutiny protects the manager from interference by politically-connected sluggards who like the status quo, and

–managers tend to, in a sense, stop working once they find out an IPO is in the offing.  Why make improvements today that will only make post-IPO earnings comparisons harder?  Better to save them for the time when the stock is publicly traded and holders of stock, stock options and management incentive plans will cash in on them.

in sum

The IPO itself is evidence that the Saudis are serious about a reorientation of their economic priorities.  Human nature argues that 2016 will be like wading through molasses for Aramco but that it will break very quickly from the gate after the IPO.