Good business strategies generally create good investments over the longer term. And so Aramco needs to ensure it has the best possible strategies, if it wants to maximise the outcome from its planned $2tn flotation. Unfortunately, the current oil price strategy seems more likely to damage its valuation, by being based on 3 questionable assumptions:
- Oil demand will always grow at levels seen in the past – if transport demand slows, plastics will take over
- Saudi will always be able to control the oil market – Russian/US production growth is irrelevant
- The rise of sustainability concerns, and alternative energy sources such as solar and wind, can be ignored
These are dangerous assumptions to make today, with the BabyBoomer-led SuperCycle fast receding into history.
After all, even in the SuperCycle, OPEC’s attempt in the early 1980s to hold the oil price at around today’s levels (in $2018) was a complete failure. So the odds on the policy working today are not very high, as Crown Prince Mohammed bin Salman (MbS) himself acknowledged 2 years ago, when launching his ambitious ‘Vision 2030:
“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”
As I noted here at the time, MbS’s bold plan for restructuring the economy included a welcome dose of reality:
“The government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal:
“The process of listing will completely change the character of the company and demand a new openness from its senior management“.
MbS is still making good progress with his domestic policy reforms. Women, for example, are finally due to be allowed to drive in June and modern entertainment facilities such as cinemas are now being allowed again after a 35 year ban. But unfortunately, over the past 2 years, Saudi oil policy has gone backwards.
SUSTAINABILITY/RENEWABLES ARE ALREADY REDUCING OIL MARKET DEMAND
Restructuring the Saudi economy away from oil-dependence was always going to be a tough challenge. And the pace of the required change is increasing, as the world’s consumers focus on sustainability and pollution.
It is, of course, easy to miss this trend if your advisers only listen to bonus-hungry investment bankers, or OPEC leaders. But when brand-owners such as Coca-Cola talk, you can’t afford to ignore what they are saying – and doing.
Coke uses 120bn bottles a year and as its CEO noted when introducing their new policy:
“If left unchecked, plastic waste will slowly choke our oceans and waterways. We’re using up our earth as if there’s another one on the shelf just waiting to be opened . . . companies have to do their part by making sure their packaging is actually recyclable.”
Similarly, MbS’s advisers seem to be completely ignoring the likely implications of China’s ‘War on Pollution’ for oil demand – and China is its largest customer for oil/plastics exports.
Already the European Union has set out plans to ensure “All plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.
And in China, the city of Shenzhen has converted all of its 16359 buses to run on electric power, and is now converting its 17000 taxis.
Whilst the city of Jinan is planning a network of “intelligent highways” as the video in this Bloomberg report shows, which will use solar panels to charge the batteries of autonomous vehicles as they drive along.
ALIENATING CONSUMERS IS THE WRONG POLICY TO PURSUE
As the chart at the top confirms, oil’s period of energy dominance was already coming to an end, even before the issues of sustainability and pollution really began to emerge as constraints on demand.
This is why MbS was right to aim to move the Saudi economy away from its dependence on oil within 20 years.
By going back on this strategy, Saudi is storing up major problems for the planned Aramco flotation:
- Of course it is easy to force through price rises in the short-term via production cuts
- But in the medium term, they upset consumers and so hasten the decline in oil demand and Saudi’s market share
- It is much easier to fund the development of new technologies such as solar and wind when oil prices are high
- It is also much easier for rival oil producers, such as US frackers, to fund the growth of new low-cost production
Aramco is making major strides towards becoming a more open company. But when it comes to the flotation, investors are going to look carefully at the real outlook for oil demand in the critical transport sector. And they are rightly going to be nervous over the medium/longer-term prospects.
They are also going to be very sceptical about the idea that plastics can replace lost demand in the transport sector. Already 11 major brands, including Coke, Unilever, Wal-Mart and Pepsi – responsible for 6 million tonnes of plastic packaging – are committed to using “100% reusable, recyclable or compostable packaging by 2025“.
We can be sure that these numbers will grow dramatically over the next few years. Recycled plastic, not virgin product, is set to be the growth product of the future.
ITS NOT TOO LATE FOR A RETURN TO MBS’s ORIGINAL POLICY
Saudi already has a major challenge ahead in transforming its economy away from oil. In the short-term:
- Higher oil prices may allow the Kingdom to continue with generous handouts to the population
- But they will reduce Aramco’s value to investors over the medium and longer-term
- The planned $100bn windfall from the proposed $2tn valuation will become more difficult to achieve
3 years ago, Saudi’s then Oil Minister was very clear about the need to adopt a market share-based pricing policy:
“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”
As philosopher George Santayana wisely noted, “Those who cannot remember the past are condemned to repeat it.”
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Saudi Arabia’s U-turn to revive oil output quotas is not working and fails to address the changing future of oil demand, as I describe in my latest post for the Financial Times, published on the BeyondBrics blog
Saudi Arabia’s move into recession comes at an unfortunate time for its new Crown Prince, Mohammed bin Salman (known to all as MbS).
Unemployment is continuing to rise, threatening the social contract. In foreign affairs, the war in Yemen and the dispute with Qatar appear to be in stalemate. And then there is the vexed issue of King Salman’s ill health, and the question of who succeeds him.
This was probably not the situation that the then Deputy Crown Prince envisaged 18 months ago when he launched his ambitious “Vision 2030” programme and set out his hopes for a Saudi Arabia that was no longer dependent on oil revenues. “Within 20 years, we will be an economy that doesn’t depend mainly on oil . . . We don’t care about oil prices — $30 or $70, they are all the same to us. This battle is not my battle.”
The problems began a few months later after he abruptly reversed course and overturned former oil minister Ali al-Naimi’s market share policy by signing up to repeat the failed Opec quota policy of the early 1980s.
His hope was that by including Russia, the new deal would “rebalance” oil markets and establish a $50 a barrel floor under prices. In turn, this would boost the prospects for his proposed flotation of a 5 per cent stake in Saudi Aramco, with its world record target valuation of $2tn.
But, as the chart above shows, the volte face also handed a second life to US shale producers, particularly in the Permian basin, which has the potential to become the world’s largest oilfield. Its development had been effectively curtailed by Mr Naimi’s policy.
The number of high-performing horizontal drilling rigs had peaked at 353 in December 2014. By May 2016, the figure had collapsed to just 116. But since then, the rig count has trebled and is close to a new peak, at 336, according to the Baker Hughes Rig Count.
Even worse from the Saudi perspective is that oil production per Permian rig has continued to rise from December 2014’s level of 219 barrels a day. Volume has nearly trebled to 572 b/d, while the number of DUC (drilled but uncompleted) wells has almost doubled from 1,204 to 2,330.
Equally disturbing, as the second chart from Anjli Raval’s recent FT analysis confirms, is that Saudi Arabia has been forced to take the main burden of the promised cutbacks. Its 519,000 b/d cut almost exactly matches Opec’s total 517,000 b/d cutback.
Of course, other Opec members will continue to cheer on Saudi Arabia because they gain the benefit of higher prices from its output curbs.
But we would question whether the quota strategy is really the right policy for the Kingdom itself. A year ago, after all, Opec had forecast that its new quotas would “rebalance the oil market” in the first half of this year. When this proved over-optimistic, it expected rebalancing to have been achieved by March 2018. Now, it is suggesting that rebalancing may take until the end of 2018, and could even require further output cuts.
Producers used to shrug off this development, arguing that demand growth in China, India and other emerging markets would secure oil’s future. But they can no longer ignore rising concerns over pollution from gasoline and diesel-powered cars.
India has already announced that all new cars will be powered by electricity by 2030, while China is studying a similar move. China has a dual incentive for such a policy because it would not only support President Xi Jinping’s anti-pollution strategy, but also create an opportunity for its automakers to take a global lead in electric vehicle production.
It therefore seems timely for Prince Mohammed to revert to his earlier approach to the oil price. The rebalancing strategy has clearly not produced the expected results and, even worse, US shale producers are now enthusiastically ramping up production at Saudi Arabia’s expense.
The kingdom’s exports of crude oil to the US fell to just 795,000 b/d in July, while US oil and product exports last week hit a new record level of more than 7.6m b/d, further reducing Saudi Arabia’s market share in key global markets.
The growing likelihood that oil demand will peak within the next decade highlights how Saudi Arabia is effectively now in a battle to monetise its reserves before demand starts to slip away.
Geopolitics also suggests that a pivot away from Russia to China might be opportune. The Opec deal clearly made sense for Russia in the short term, given its continuing dependence on oil revenues. But Russia is never likely to become a true strategic partner for the kingdom, given its competitive position as a major oil and gas producer, and its longstanding regional alliances with Iran and Syria. China, however, offers the potential for a much more strategic relationship, which would allow Saudi Arabia as the world’s largest oil producer to boost its sales to the world’s second-largest oil market.
China also offers a potential solution to the vexed question of the Saudi Aramco flotation, following the recent offer by an unnamed (but no doubt state-linked) Chinese buyer to purchase the whole 5 per cent stake. This would allow Prince Mohammed to avoid embarrassment by claiming victory in the sale while avoiding the difficulties of a public float.
The Chinese option would also help the kingdom access the One Belt, One Road (OBOR) market for its future non-oil production. This option could be very valuable, given that OBOR may well become the largest free-trade area in the world, as we discussed here in June.
In addition, and perhaps most importantly from Prince Mohammed’s viewpoint, the China pivot might well tip the balance within Saudi Arabia’s Allegiance Council, and smooth his path to the throne as King Salman’s successor.
Paul Hodges and David Hughes publish The pH Report.
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Its been a long time since oil market supply/demand was based on physical barrels rather than financial flows:
First there was the subprime period, when the Fed artificially boosted demand and caused Brent to hit $147/bbl
Then there was QE, where central banks gave free cash to commodity hedge funds and led Brent to hit $127/bbl
In 2015, as the chart highlights for WTI, the funds tried again to push prices higher, but could only hit $63/bbl
Then, this year, the funds lined up to support the OPEC/Russia quota deal which took prices to $55/bbl
As the Wall Street Journal reported:
“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.”
These developments destroyed the market’s key role of price discovery:
Price discovery is the process by which buyer and seller agree a price at which one will sell and the other will buy
But subprime/QE encouraged this basic truth to be forgotten, as commodities became a new asset class
Investment banks saw the opportunity to sell new and highly profitable services to sleepy pension funds
They ignored the obvious truth that oil, or copper or any other commodity are worthless on their own
There was never any logic for commodities to become a separate new asset class. A share in a company has some value even if the management are useless and their products don’t work properly. Similarly bonds pay interest at regular intervals. But oil does nothing except sit in a tank, unless someone turns it into a product.
The impact of all this paper trading was enormous. Last year, for example, it averaged a record 1.1 million contracts/ day just in WTI futures on the CME. Total paper trading in WTI/Brent was more than 10x actual physical production. Inevitably, this massive buying power kept prices high, even though the last time that supplies were really at risk was in 2008, when there was a threat of war with Iran.
Finally, however, the commodity funds are now leaving. Even Andy Hall, the trader known as “God” for his ability to control the futures market, is winding up his flagship hedge fund as he:
“Complained that it was nearly impossible to trade oil based on fundamental trends in supply and demand, which are now too uncertain.”
Hall seemed unaware that his statement exactly described the role of price discovery. Markets are not there to provide guaranteed profits for commodity funds. Their role via price discovery is to help buyers and sellers balance physical supply and demand, and make the right decisions on capital spend. By artificially pushing prices higher, the funds have effectively led to $bns of unnecessary new capital investment taking place.
NOW MARKETS WILL HAVE TO PICK UP THE PIECES
The problem today is that markets – which means suppliers and consumers – will now have to pick up the pieces as the funds depart. And it seems likely to be a difficult period, given the length of time in which financial players have ruled, and the distortions they have created.
Major changes are already underway in the physical market, with worries over air quality and climate change leading France, the UK, India and now China to announce plans to ban sales of fossil-fuelled cars. Transport is the biggest single source of demand for oil, and so it is clear we are now close to reaching “peak gasoline/diesel demand“.
OPEC obviously stands to be a major loser. Over the past year, the young and inexperienced Saudi Crown Prince Mohammed bin Salman chose to link up with the funds. His aim was keep prices artificially high via an output quota deal between OPEC and Russia. But history confirms that such pacts have never worked. This time is no different as the second chart from the International Energy Agency shows, with OPEC compliance already down to 75%.
Consumers will also pay, as they have to pick up the bill for the investments made when people imagined oil prices would always be $100/bbl. And consumers, along with OPEC populations, will also end up suffering if the shock of lower oil prices creates further geopolitical turmoil in the Middle East.
As always, “events” will also play their part. As anyone involved with oil markets knows, there seems to be an unwritten rule that says:
If the market is short of product, producing plants will suddenly have force majeures and stop supplying
If the market has surplus product, demand will suddenly reduce for some equally unexpected reason
The rule certainly seems to be working today, as the catastrophe of Hurricanes Harvey, Irma and Jose creates devastation across the Caribbean and the southern USA.
Not only is this reducing short-term demand for oil, but it will also turbo-charge the move towards renewables. Mllions of Americans are now going to want to see fossil fuel use reduced, as worries about the impact of climate change grow.
“Those who cannot remember the past are condemned to repeat it“. George Santayana
9 months ago, it must have seemed such a good idea. Ed Morse of Citi and other oil market analysts were calling the hedge funds with a sure-fire winning strategy, as the Wall Street Journal reported in May:
“Dozens of hedge-fund managers and oil traders attended a series of closed-door meetings in recent months with OPEC leaders—the first of their kind, according to Ed Morse, Citigroup Inc.’s global head of commodities research, who helped organize some of the events.
“Group officials made the case for how supply cuts from the Organization of the Petroleum Exporting Countries would reduce the global glut…. Mr. Morse of Citigroup said he arranged introductions between OPEC Secretary-General Mohammad Barkindo and the more than 100 hedge-fund managers and other oil buyers who have met with Mr. Barkindo in Washington, D.C., New York and London since October…
“After asking what OPEC planned to do to boost prices, fund managers came away impressed, Mr. Morse said, adding that some still text with the OPEC leader.”
Today, however, hype is disappearing and the reality of today’s over-supplied oil market is becoming ever more obvious. As the International Energy Agency warned in its latest report:
“In April, total OECD stocks increased by more than the seasonal norm. For the year-to-date, they have actually grown by 360 kb/d…”Whatever it takes” might be the (OPEC) mantra, but the current form of “whatever” is not having as quick an impact as expected.”
As a result, the funds are counting their losses and starting to withdraw from the market they have mis-read so badly:
Pierre Andurand of Andurand Capital reportedly made a series of bullish bets after meeting a Saudi OPEC official in November, but saw his fund down 16% by May 5
Once nicknamed “God” for his supposed ability to forecast the oil market, Andy Hall’s $2bn Astenbeck Capital fund lost 17% through April on bullish oil market bets
In a sign of the times, Hall has told his investors that he expects “high levels of inventories” to persist into next year. Consensus forecasts in April/May that prices would rally $10/bbl to $60/bbl have long been forgotten.
OIL MARKET FUNDAMENTALS ARE STARTING TO MATTER AGAIN
This therefore has the potential to be a big moment in the oil markets and, by extension, in the global economy.
It may well be that supply/demand fundamentals are finally starting to matter again. If so, this will be the final Act of a drama that began around a year ago, when the young and inexperienced Mohammed bin Salman became deputy Crown Prince and then Crown Prince in Saudi Arabia:
He abandoned veteran Oil Minister Naimi’s market-share strategy and aimed for a $50/bbl floor price for oil
This gave US shale producers a “second chance” to drill with guaranteed profits, and they took it with both hands
Since then, the number of US drilling rigs has more than doubled from 316 in May 2016 to 763 last week
Even more importantly, the introduction of deep-water horizontal drilling techniques means rig productivity in key fields such as the vast Permian basin has trebled over the past 3 years from 200bbls/day to 600 bbls/day
The chart above shows what the hedge funds missed in their rush to jump on the OPEC $50/bbl price floor bandwagon.
They only focused on the weekly inventory report produced by the US Energy Information Agency (EIA). They forgot to look at the EIA’s other major report, showing US oil and product exports:
US inventories have indeed remained stable so far this year as the blue shaded area confirms
But US oil and product exports have continued to soar – adding nearly 1mb/day to 2016′s 4.6mb/day average
This means that each week, an extra 6.6mbbls have been moving into export markets to compete with OPEC output
Without these exports, US inventories would have risen by another 13%, as the green shaded area highlights
In addition, the number of drilled but uncompleted wells – ready to produce – has risen by 10% since December
These exports and new wells are even more damaging to the OPEC/Russia pricing strategy than the inventory build:
Half-way across the world, India’s top refiner is planning to follow China and Japan in buying US oil
US refiners are ramping up gasoline/diesel exports, with Valero planning 1mb of storage in Mexico
As Naimi warned 2 years ago, Saudi risked being marginalised if it continued to cut production to support prices:
“Saudi Arabia cut output in the 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell. So we lost on output and on prices at the same time.”
How low oil prices will go as the market now rebalances is anyone’s guess.
But they remain in a very bearish pattern of “lower lows and lower highs”. This suggests it will not be long before they go below last year’s $27/bbl price for Brent and $26/bbl for WTI.
“Within 20 years, we will be an economy that doesn’t depend mainly on oil“.
With that one statement, deputy Crown Prince Mohammed bin Salman (pictured above), changed the outlook for oil and energy markets. The world’s major oil producer, with the lowest cost, was signalling that the kingdom will no longer be supply-driven, focused on maximising oil revenue over the long term. And as the Prince told Bloomberg:
“We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”
Thus the government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal yesterday:
“The process of listing will completely change the character of the company and demand a new openness from its senior management“.
Equally important is that the aim is to use the IPO to create the world’s largest sovereign wealth fund, which will not only include Aramco itself, but also real estate and other newly-privatised companies. This Public Investment Fund will have a value of between $2tn – $3tn, as the chart shows – meaning it could potentially buy the 4 largest public companies in the USA – Apple, Alphabet (Google), Microsoft and Berkshire Hathaway.
And the aim of this Fund will be to:
“Invest half its holdings overseas, excluding the Aramco stake, in assets that will produce a steady stream of dividends unmoored from fossil fuels”.
Why is this happening? Part of the answer, at least, is due to the financial crisis that engulfed Saudi this time last year. As the Prince’s financial adviser, Mohammed Al-Sheik, has explained, the post-2009 period of $100/bbl oil prices meant Saudi spending went:
“Beserk…with between 80 to 100 billion dollars of inefficient spending every year, about a quarter of the entire Saudi budget….At last April’s spending levels, Saudi would have gone completely broke by early 2017″.
It is clear from the Vision and the Prince’s interviews that this crisis was the catalyst for major change because:
“An oil price of 30-40-50 dollars spurs reforms (and enables Saudi) …to focus on the non-oil economy”
And now this change is underway. Saudi has already begun to boost its market share, selling on a spot basis (outside contract) to a Chinese refiner. And as the Prince has explained, Aramco in the process of being:
“Transformed from an oil and gas company to an energy/industrial company…We’re targeting many projects. Most important is building the first solar energy plant in Saudi Arabia. Aramco is now the biggest company in the world and it has the capability of controlling the shape of energy in the future and we want to venture into that from today.
Also, we want to develop the petrochemicals market that depends on oil and the services provided by some of the oil derivatives as well as some of the industries that we might create given the size of Aramco. For example, we could create a huge construction company under Aramco that will also be offered to the public and that services projects other than Aramco’s projects in Saudi. So all these projects that we announce will be how we transform Aramco from an oil and gas company to an industrial and an energy company.”
In their own way, therefore, these new policy statements are likely to be as critical for the global economy as President Xi Jinping’s speech to China’s economic policy conference in November 2013, which effectively abandoned the previous stimulus policy and prepared the way for his New Normal economic direction.
As I wrote then, “we cannot know if he will succeed in moving the economy towards a more sustainable future“. And the same is true, today, for Prince Mohammed’s new policies. But what is clear, is that anyone who still believes that oil prices will “inevitably” return to $100/bbl are fooling themselves, just as were those who argued in 2013 that President Xi would “inevitably” continue with “business as usual” policies.