King Abdullah of Saudi Arabia passed away on Thursday, 23rd January having contracted pneumonia in the new year.
This initial take looks first at succession, the likely impact on oil, then the Saudi market & currency and finally regional politics. Feel free to contact me with any specific queries.
The process of succession appears to have run smoothly with Prince Salman (79), Abdullah’s half-brother, being announced king and another half-brother and the youngest of his generation (at 69) Prince Muqrin being anointed the new Crown Prince as expected. King Salman has significant financial and power backing as one of 7 sons of Hassa al Sudairi (known as the “Sudairi Seven”) and King Abdulaziz and as such is unlikely to be challenged. Salman is commonly known for his charitable giving and conservative nature, please contact us for other details.
While Salman has the ability to change succession (indeed under Saudi Basic Law and given his family backing he has the power to do anything he wishes), it is likely that Muqrin will remain the next in line. After this, it will skip a generation, with the two main candidates for the throne still the defense minister Mohammad bin Nayef (55), the son of Salman’s full brother departed Crown Prince Nayef and head of the National Guard Mutaib (62), son of Abdullah. As with the announcement of Prince Muqrin as Deputy Crown Prince, we may see an announcement in this regard sooner rather than later to assuage fears of potential rapid succession, although we are in a period where any agreements made under King Abdullah’s reign may be put to the test
With oil prices under $50, the feeling on the ground in Saudi Arabia has been one of concern. After 19 years with of rule by Abdullah (9 as regent and 10 as King), there is significant pressure for the new King to secure the support of the populace through populist measures such as public sector wage increases with 90% of Saudis employed in the public sector (90% of the private sector is foreign) and additional handouts. These may well include expensive measures such as free housing for young married couples and a potential consumer debt jubilee, where the government takes over payments (billions have already been shifted in this manner over the last few years).
The current Saudi budget balances at around $63 (see here: http://www.ecstrat.com/research/balancing-budgets/) and the Kingdom has ample cash assets of around $800bn and the ability to raise huge amounts of debt. It should also be noted that while the budget balances in the $60s, historical spending has been significantly above budget in the last few years, $30bn in excess in 2014. Additional spending may be similar to the Arab Spring, meaning we could see an overspend of $50bn or more this year depending on the measures taken.
Saudi Arabian rhetoric has been firmly guiding the oil price down since the OPEC meeting, with officials pointing out quite sensibly that it is up the market to set prices and not for Saudi to underwrite unconventional oil producers. I discussed why this made the market particularly vulnerable here: http://bit.ly/ecstrat4 and was one of the key reasons I was negative on oil prices (although I did see $70 as a floor as I thought OPEC would cut!).
In reality, rhetoric is about all Saudi has been doing to impact oil prices, with the latest figures for production and exports actually down 300kbpd YoY and price differentials to the US down versus the summer, but still at multi-year highs.
From comments at the WEF in Davos, the rhetoric is already calming with guidance that oil prices should correct over the next year, albeit not too high and moves to focus on the long-term potential for oil prices as unconventional sources come under continued pressure would increase local sentiment and potentially boost the oil price given the current structure.
The current structure of the oil curve is hugely overextended, with almost a 20% spread between 1m and 12m WTI, a scenario that is truly bizarre in a world of negative nominal Eurozone yields. To put this in context, this has only occurred twice in the last few decades, at which time storage was more expensive and interest rates much higher. Oil doubled in the following year both times.
This is also a key reason that inventories at Cushing are spiking and the Brent-WTI spread closed (as WTI is easy to store there), giving a false signal of oversupply when in fact demand figures are likely to be significantly higher (1.5-2mbpd by my estimation) over the last period than the market expects. In addition, 40mb of floating storage have been hired to take advantage of this arbitrage, further reducing the probability of it continuing.
The back end of the curve is where the real story is, having disconnected completely from spot oil prices in terms of correlation as it remains near $80. The super-contango we see now could continue for a period due to some curious structural details, but it is likely that into 2016 we will see a resumption of backwardation, with the spot price above the backend price, which will be higher due to the E of E&P being slashed.
In the medium term, there are several geopolitical events that the oil market may also respond to given the heavy net shorts, from the complex situation in Yemen, where Shia Houthis have ousted Saudi ally Hadi to impending violence in Nigeria, which typically loses 300kbpd of production during elections (due for Valentine’s day), with 1,000 dying in the violence last time around and likely many more this year given the sharp divisions that exist within the country (more here: http://bit.ly/ecstrat7). Libya remains a wreck with reconciliation unlikely absent a significant external force intervening and Iraq is coming under heavy pressure as it looks to run a 20-30% deficit due to lower oil prices.
On the flipside, we are likely ~2 months away from an Iran deal, which would cause the market to price in additional supply coming online rapidly.
Market length is resolutely short, having flipped hard from a record long position last summer and the possibility of a near-term squeeze is high, particularly as crude has consolidated just under $50. In the medium term the likely economic and “fundamental” news may cause the rally to fade, but the long-term outlook remains strong and I retain my view oil will be $130 in a few years absent China blowing up completely
Market & currency
The Tadawul has proved remarkably resilient in the face of lower oil prices – down just 4% over the last 12 months even as oil fell 55%. If you had put that scenario to any market observer a year ago, the likely response would have been that we would be 30-40% lower at least.
This increased resilience may have been aided by a patriotic hand, but the lack of significant downgrades in earnings are also indicative of the fact that the Saudi market may be driven by spending based on oil, but most stocks, petchems aside, aren’t beta to oil as in other markets. Even petchems run with fixed, below market price feedstock prices, meaning they are consistently profitable even at current levels of oil, although the offshore operations of companies such as SABIC do add an element of beta to oil.
The overall impact of the succession is likely to be positive for the Tadawul as wealth transfer to the populace is increased and spending maintained over the next few years no matter what the oil price is. Retail participation in the Saudi stock exchange remains above 90% as it trades billions of dollars each day as it remains one of the main sources of entertainment in the kingdom. It would not be surprising to see some favourable privatizations be introduced ahead of the market opening to foreigners in a few months to fulfil its other main role of wealth redistribution, with retail IPO participation remarkably high.
Credit conditions are likely to be loosed over the coming year to fill some of the gap from lower oil revenues and after banks were disintermediated in the spending boom following the Arab Spring. Capital adequacy ratios remain high with Tier 1 ratios in the teens and asset quality remains high, particularly as the government is likely to continue spending. This should increase overall monetary velocity and potentially stoke inflation, which should increase asset prices. We can also expect a focus on mortgage lending as part of the new policies, particularly to young Saudis. Given this is in effect lending to the government given the high level of public sector employment, this could expand faster than many have figured. It is also likely that the transition to an Islamic economy will be accelerated, building on the NCB experience..
As such, the trade is to buy retail-heavy Islamic banks, which also benefit from higher US interest rates due to their significant zero-cost deposits, leading to rapidly expanding NIMs, retail names, which although expensive match up well to EM peers and will benefit from increased discretionary spending power and real estate stocks, which will benefit from general asset inflation (which should also cause the Saudi market to rerate further despite current oil prices as monetary velocity picks up).
The downside appears limited here as it is difficult to see a scenario where the government wouldn’t step in should retail confidence be lost.
On the Saudi Rial, there has been interesting activity on forwards as a devaluation of the currency would be a quick and easy way to fix any budget issues, much as Russia has done in maintaining the Ruble oil price, hurting importers and consumers. In Saudi the elasticity of demand and ability to withstand inflation is very different to Russia, but it is likely that we would see other Gulf states move first to devalue, with Bahrain and Oman (where succession is not quite so clear cut per my recent note) prime candidates. The first stage is likely to be a move to a Kuwait Dinar-style basket, particularly given increase exports to Asia and the decreasing importance of US crude flows, but any move in this regard from Saudi is unlikely in the next 6 months as they look to stabilize things, but this will grow more likely the longer oil prices stay low.
We may see some debt issuance however to bridge near-term spending spikes, a key measure to developing a yield curve as part of the package of reforms I have suggested Gulf countries should carry out to take advantage of low oil prices here: http://blogs.ft.com/beyond-brics/2015/01/06/guest-post-the-gulf-must-take-advantage-of-low-oil-prices/
The order of the day is stability after a tumultuous few years.
To the north there is the threat of ISIS, but significant strides seem to have been made in patching Iraq-Saudi relations under the rule of new PM Abadi after a somewhat tense relationship with Maliki. Iran looks to be coming out from the cold with Obama actively pushing for a peace deal and increasingly looking like he will accept Assad as an alternative to ISIS, but despite the historical acrimony, the interests of Iran and Saudi Arabia are somewhat more in alignment now than in previous years.
The key exception to this is Yemen, which is a terribly strange situation, but one in where the Shia Houthis (known as “fiver” Shias, closer to Sunnis than the “twelver” Iranians/Iraqis and more a tribe than religious group) who Saudi Arabia has fought for a number of years in north Yemen, have now effectively taken over with President Hadi resigning. Curiously the Houthis are the tribe of former President Saleh and virulently anti al-Qaeda, but it is quite a change on the southern border of Saudi Arabia.
Elsewhere the Arab Spring has turned into an Arab Winter with the challenge of Islamist groups soundly defeated, even if some more virulent forms have popped up but are now largely contained.
It is likely that Saudi may well pursue a less aggressive foreign policy in the near-term as it focuses on internal matters, particularly after certain initiatives did not work out quite as planned.
In conclusion the succession in Saudi Arabia may prove a filip to oil prices in the near-term, even if the medium term outlook looks challenging and should be overall positive for a market used as a barometer for popular feeling. We should expect the focus to be on internal consolidation versus external expansion, but the way that they treat the developing situation in Yemen should provide strong guidance to how foreign policy will be in the future.