Tue | Sep 26, 2017

Walter Molano | Riyadh’s irrational oil strategy

Published:Friday | February 12, 2016 | 2:00 AM
In this January 24, 2015 photo provided by the Saudi Press Agency, Saudi's newly enthroned King Salman prepares to receive oaths of loyalty in a traditional Islamic investiture ceremony.

Riyadh's irrational oil strategy

In a world predicated by rationality, many events are clouded in irrational behaviour. One of them is the Saudi decision to raise oil production by 25 per cent.

As the world's largest energy producer, Saudi Arabia is the country most affected by the collapse in prices. The stated justification was the desire to improve its market share by weakening high-cost producers. One of their targets was alternative energy technologies, such as fracking and tar sands.

Yet, such an explanation is far from satisfactory because once oil prices recover, these activities will come back to life. Therefore, why would a government do such an irrational thing?

The plunge in oil prices has forced Riyadh to reduce international reserves, slash social benefits, raise gasolene prices and put some of their more valuable assets up for sale. Emotional issues are often the cause of irrational behaviour, and this may also be the case in Saudi Arabia.

Like much of the Middle East, Saudi Arabia is a western construct that emerged from the disintegration of the Ottoman Empire. The vast desert expanse, which was populated by nomadic tribes, was of little interest to anyone until huge oil deposits were discovered in 1938.

Realising that the region was home to one of the largest oil reserves in the world, the United States backed the creation of a fledgling state in return for access to its hydrocarbon fields.

For the next eight decades, King Abdulaziz Ibn Saud and his long network of sons ruled the newly established kingdom. In order to reinforce tribal allegiances, the king sired 45 sons with 22 women from the various clans. While this cemented the monarch's hegemonic rule, it also created a fragmented family structure.

In contrast to European monarchies, where lines of succession are based on the concept of primogeniture, the House of Saud relied on the concept of agnatic seniority. In a primogeniture line of succession, the crown passes vertically to the eldest legitimate heir; while in the agnatic version, the throne passes laterally from brother to brother.

The problem occurs when the last descendant of the line expires and the crown has to pass to the next generation. This has not been an issue in Saudi Arabia so far, given the large number of brothers, but it is about to become one.

King Salman, one of Ibn Saud's last remaining sons, was appointed to the throne last January. The 80-year-old monarch whipped up a flurry of intrigue in April, when he abandoned the precepts of agnatic succession by removing his half-brother from the position of crown prince and named his nephew, Prince Nayef, to the position. He then appointed his 30-year-old son, Mohammed, as deputy crown prince, thus shifting the line of succession to a more primogeniture structure.

A thick veil of secrecy screens Saudi royal affairs, but King Salman's decision must have riled some feathers. There were rumours in Riyadh, a few weeks ago, that the king was thinking of abdicating and passing the throne to his sonthe Deputy Crown Prince. This is where the price of oil comes into play.

A few years ago, WikiLeaks provided some clarity on the stipends that are granted to members of the royal family.US State Department cables reported that more than a million barrels per day are allocated for royal family expenses. Therefore, the economic well-being of the families is directly correlated with the price of oil.

The Saudi royal families are free to spend the funds as they wish. Some have been more prudent than others. Nevertheless, driving oil prices into the ground may be a way to bring the various factions to heel and force an agreement on the issue of succession.

This hypothesis may provide a logical explanation for an otherwise irrational action. But be what it may, oil is clearly a hypersensitive market.

Daily oil production is about 90 million barrels per day. When oil was above US$110 per barrel, it was estimated that there was a shortage of about a million barrels per day. Now, oil analysts estimate that there may be an overproduction of about two million barrels per day. Hence, very small changes in output produce large price swings.

The physical nature of the market may explain this characteristic. Oil storage is expensive and limited. Moreover, the recent reduction in capex will exacerbate the market's sensitivity.

We should keep a close eye on events in Saudi Arabia. Just as is the case in Rome, when the cardinals gather to select the next pope, the only hint that we may see that the succession process is completed is when we see the puff of white smoke rise into the air. In the case of Saudi Arabia, it may be a unilateral decision to cut oil production.

Dr Walter T. Molano is a managing partner and the head of research at BCP Securities LLC.

wmolano@bcpsecurities.com