Saudi oil policy risks creating perfect storm for Aramco flotation

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 ensureAll 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.”

The post Saudi oil policy risks creating perfect storm for Aramco flotation appeared first on Chemicals & The Economy.

Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear

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.

The post Saudi Arabia’s ‘Vision 2030’ is looking a lot less clear appeared first on Chemicals & The Economy.

Speculators’ tail wags oil market dog as paper trading dominates

WTI futures Jan17aTrading oil markets used to be hard work.

You had to talk to all the major players all the time (not just message them), and learn to judge whether they were telling the truth or inventing a version of it.  You had to watch for breaking economic and political news.  And you needed your own supply/demand balances.  Plus you had to guess how the fabled  ”Belgian or New York dentist” – who traded oil futures to break the tedium of drilling teeth – might be feeling each day.

Today’s trading world is completely different:

   More than half of all trading is done by machines at ultra-high speed.  These are the “legal highwaymen” described in Michael Lewis’ great book Flash Boys. And they don’t care about the real world of oil markets or the economy, as these factors are irrelevant to their business models
   Then you have the hedge funds, and even some pension funds, with quarterly targets for profit.  They can’t afford to spend time developing a detailed analysis, and waiting for the market to catch up.  They have to play the momentum game of finding a story, and jumping on it as quickly as possible
   In addition, of course, there are still producers and consumers, who actually need to buy or sell oil.  They used to set the market prices in the past, but are just an also-ran today as their volume is so small relative to the others.  But in the “real world” outside of financial trading, they are the only people who matter

New data from the CME highlights the change.  It shows paper trading in just WTI futures averaging a record 11 million contracts each day in 2016 (each of 1000 barrels).  Actual physical production, by comparison, is around only 92 million barrels per day.  The speculative tail is indeed wagging the dog.

The chart above shows the current net position of the speculators, which is at a record 371k contracts.  It highlights just how much they love the OPEC production cut story – it is easy to understand, and is easy money for everyone, particularly the momentum traders, as the story seems never-ending.

OPEC Feb17The only problem – for players in the real world – is that the “story” isn’t true.  Today’s headlines may say that OPEC has 82% compliance, but this was only because of Saudi Arabia – which cut 564kb versus the promised 486kb, according to the Reuters data above.  Outside the GCC countries, not much happened.  Venezuela – which led lobbying for an output cut – delivered only 18% of its promise, and Russia only cut 117kb versus its promised 300kb.

“Who cares?”, you might say, if you are one of the highwaymen or a momentum trader.  Talk is cheap, and you can tell the media it is early days, and countries take time to adjust.  They love an easy story, just as you do, and believe their viewers want a quick trading tip – not a boring discussion about rising US inventories for oil (up another 6mb last week) and gasoline inventories (now actually above the upper limit of the normal seasonal range).

You certainly don’t want to dive into the detail of rising US shale production (already back at April’s level), and rising numbers of drilling rigs (back to November 2015 levels). And you certainly won’t discuss the 5300 drilled but uncompleted oil/gas wells, where producers only have to turn the tap to start earning revenue.

Well, not just yet, anyway.  Maybe in a week or two, it might be time to learn a new script.  After all, “what goes up, comes down”.  The dream scenario for the paper traders would be if today’s major rally was followed by a major collapse.  After all, the refinery maintenance season will soon be starting, causing physical demand to drop.

Of course, all this volatility has a price.  The market is a zero-sum game where overall, the consumer and the producer pay the cost of the speculator’s outsize profits.  And in the geo-political world, there is one major loser – Saudi Arabia.

The Saudis know that President Trump doesn’t support the ‘Oil for Defence‘ agreement made 70 years ago, which protected them in 1990/1991 when Iraq invaded Kuwait. So they have to stay close to the other OPEC members, and make the major share of the cuts.  But what will happen in Saudi, if and when prices fall back – say to the $30/bbl level seen a year ago?

Naimi finally allowed to retire, Saudi oil policy stays the same

Naimi, Falih May16

80-year olds are allowed to retire, even if they have to wait a year for final permission to be given.  But it seems a simple headline saying “Saudi Oil Minister retires after 69 year career” is not “exciting” enough in today’s media world?  So perhaps we can’t be too surprised to find some of the world’s media using headlines such as:

  • “Saudi Arabia just fired its oil minister”
  • “Saudi Arabia Dismisses Its Powerful Oil Minister Ali al-Naimi”

But it is still disappointing that a desire for “clicks” should over-ride the facts, particularly on such a critical issue.

It has, after all, been common knowledge that the 80-year old Naimi wanted to retire a year ago, after the death of Saudi King Abdullah.  He was only persuaded to stay on to provide continuity.  Now, just before Ramadan begins on 7 June, is an ideal moment for the long-planned handover to Saudi Aramco chairman Khalid al-Falih to take place.

One benefit of his year-long lead-in to retirement was that Naimi was able to give a “retirement interview” to Daniel Yergin at the IHS/CERA conference in February.  This was a tour de force of everything that Naimi had seen and learnt during his 69-year career in the oil industry, which began when he joined Saudi Aramco as an office boy in 1947.

The question-and-answer session with Yergin was highly revealing of Naimi’s and Saudi thinking on the outlook for oil prices, particularly when he dismissed suggestions that OPEC production might be cut to rebalance the market.

Arguing that this decision was made in November 2014, he described the freeze concept as being modest in scope, even it it was possible to make it happen, due to the “lack of trust” between the major producers:

A freeze is the beginning of a process and that means if we can get all the biggest producers not to add additional barrels, then this high inventory we have now will probably decline in due time, its going to take time.  It is not like cutting production, that is not  going to happen, because not many countries are going to deliver even if they say they will cut production, they will not deliver.  So there is no sense in wasting our time seeking production cuts, they will not happen.”

Today it is clear that even the freeze concept has been abandoned.  So in terms of oil market developments,now is a sensible moment for Naimi to move into his well-deserved retirement.  But lets be clear. He wasn’t fired or dismissed.

Equally important is that the change of personnel doesn’t mean any change is likely in Saudi oil policy.  This has always been a slow-moving process, controlled at the highest level of the government.  And as Naimi explained to Yergin, the key decisions were made as long ago as November 2014.

The fact that even a freeze has proved impossible to agree, reconfirms the rationale for the decision.

WEEKLY MARKET ROUND-UP
My weekly round-up of Benchmark prices since the Great Unwinding began is below, with ICIS pricing comments:
Brent crude oil, down 57%
Naphtha Europe, down 53%. “Arbitrage window to Asia shut”
Benzene Europe, down 53%. “Market is still facing the structural challenges of limited liquidity”
PTA China, down 40%. “Weaker upstream feedstock prices and diminished buying sentiments dampened discussion levels.”
HDPE US export, down 27%. “Talk of falling values in a few Latin American countries.”
¥:$, down 5%
S&P 500 stock market index, up 5%

Saudi plans to transform Aramco to energy /industrial company

Salman Apr16Within 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.”

Aramco IPO Apr16Thus 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.

scenario-study-iec-horiz

OPEC faces New Normal dilemma as oil demand slows

OPEC Oct14aYesterday’s post described how OPEC oil producers are seeing their export sales to the US start to disappear.  But this, of course, is only one side of the story.  As the chart from the Wall Street Journal shows, Saudi needs a $93/bbl oil price to balance its budget.  Most of OPEC needs a higher price.  Only Kuwait, UAE and Qatar need less.

Most analysts choose to focus on this question.  But important though it is, it is not the key concern.  We are in the New Normal – where demand growth may no longer exist, and suppliers have to fight for market share.  As the International Energy Agency has warned recently, “the recent slowdown in demand growth is nothing short of remarkable.”

A moment’s thought, after all, reveals that there is no point in having a high price if it becomes purely nominal.  OPEC countries will have no income if they cannot sell their oil barrels.

The coal market provides a vivid example of the problem.  50 years ago, it was common to assume the world was running out of coal.  Today, however, coal is being left in the ground, as it is no longer needed.

ASIAN OIL DEMAND IS NO LONGER ON A GROWTH PATH
Developments outside the US provide a vivid wake-up call.  Already Asia has become unable to accept cargoes of Russia’s highly valuable Sokol oil.  The economic slowdown, and increasing African competition, means the market is over-supplied.  So it has been forced to travel to California to find a home.

Even worse, from the producer viewpoint, is that Asian governments are being forced to cut back on fuel subsidies.

China has been doing this for some time, and now indexes domestic prices to world levels.  India began cutting them last year, and the new Modi government is now increasing them to world levels.  Indonesia will have to follow and increase them by 23%, as the end of the commodities boom makes it impossible to fund subsidies.

Already the subsidy cuts have slowed India’s growth in diesel sales to zero, from up to 11%/year growth in the past.  Clearly the pattern is now being repeated across Asia.

And one immediate result is that Indian refiners are demanding better terms from Saudi and Iraq.  Bloomberg reports payment terms are likely to be extended to 60 days – essentially a price cut by another name.

Global oil consumption growth had already slowed to 1.2%/year before these changes, as the blog discussed back in July.  Western oil consumption has been falling for some years, with even US consumption falling 0.6%/year since 2008.  And this trend is likely to continue:

  • US Dept of Transport data highlights that “as we age, we drive fewer miles
  • Similarly, the world is now entering its “peak car” moment, where sales will start to decline
  • High prices have also spurred moves to gas, and to increased fuel efficiency

Thus oil producers are now effectively in a battle for market share.  This is not only between themselves, but also against other forms of energy such as gas and renewables.  Those who lose, like coal producers in the past, will have to shutdown.

Saudi Arabia knows this.  And its reliance on the US for its defence needs means it has to be amongst the winners.

Tomorrow the blog will look at the key question of what these changes in supply and demand balances will likely mean for prices.