Hi I'm Nicholas Puri.
In our previous video in this series we went through the history of the Petrodollar relationship,
from the events leading to its formation up to the present day.
If you haven't yet watched part 1, I highly recommend you go and watch that before coming
onto this one.
The link to part 1 is in the description box.
In this video, which is based on an article we published on seekingalpha.com we will build
upon this understanding and take a look at the current economic situation in Saudi Arabia,
in order to understand how this may affect their future oil production decisions and
the global implications of this.
This is going to have a particular impact on the price of oil and the US dollar.
This is, understanding Saudi Arabia's economic restructuring - a mirage or a reality?
Saudi Arabia's current economic performance is undermined by a number of adverse factors.
Unfortunately, with such a heavy reliance on oil revenue (representing 90% of government
taxes and 40% of GDP), the potential solutions are somewhat limited.
In 2015, the country ran a deficit for the first time in its history.
According to the Saudi Arabia Monetary Authority (SAMA), this was equal to 22% of GDP.
To date, Saudi Arabia has burned through over $100 billion of their cash reserves, which
now stand at $650 billion.
The projections for the coming years are also negative.
The predominant cause for this unprecedented deficit are the persistently low oil prices
witnessed throughout 2015, which have also continued through 2016 as well.
This decrease in oil price was partially caused by Saudi Arabia itself, due to their refusal
to curtail oil production to counter the recent emergence of shale oil in North America.
Although the recent decision from OPEC looks promising, we are yet to see what economic
impact this will truly have.
One thing is for sure, the longer Saudi Arabia maintains current production, the more likely
it will force other countries with weak cash reserves into a crisis.
The biggest concern from this point-of-view is Russia, which is currently facing difficult
domestic economic conditions and a deterioration of her relations with Ukraine.
Others include Azerbaijan, whose current economic conditions have led to a banking crisis and
protests, and unstable neighbouring countries such as Kazakhstan, Uzbekistan and Turkmenistan.
On the other hand, a reduction in oil production may not actually be an adequate response to
rebalance the accounts, mainly the inability of OPEC countries to maintain their assigned
quota of production.
Additionally, there is an insurmountable surplus capacity that determines an oil glut not manageable
via cutbacks in production.
If a reduction in oil production is unlikely to solve the country's issues, a deficit reduction
needs to be attained in other ways.
Typically, an immediate recommendation would be to undertake austerity measures as a means
of achieving this goal.
However, a closer look at Saudi Arabia reveals a deep reliance on government spending that
it is virtually embedded in public expectations.
As can be observed with the government providing subsidised water and electricity, which an
unbelievable 86% of the public have stated they want to continue.
In addition to the subsidised utilities, the Saudi government also provides free healthcare
and education, paid-for public pensions and does not impose income tax.
The government currently employs almost 90% of all Saudis, often at higher wages than
the private sector.
In fact, employment in the private sector is seen as such an unattractive alternative
that less than 20% of unemployed Saudis would seek it.
To reduce the drawdown on foreign reserves, Saudi Arabia chose to raise a five-year loan
of $10 billion from a consortium of global banks.
This landmark action was the first debt issuance by Saudi Arabia since 1991.
There are rumors they have been considering selling some of their US treasuries, but as
was discussed in the first video in this series, this action has not yet been executed.
Taking a pragmatic approach, the Kingdom of Saudi Arabia engaged McKinsey to conduct an
analysis and propose options for a potential future course of action.
As a result of this, a report was produced in 2015 called "Saudi Arabia Without Oil:
The Investment and Productivity Transformation."
The report indicates a number of solutions, which closely resemble the typical IMF policies,
which were designed to secure Washington consensus: Transform the economy from a government-led
to a market-led one, cut subsidies and transfer payments, and sell government assets to finance
the transition.
Unfortunately, the report could arguably be labelled 'generic', as it fails to consider
the countless cultural, religious and political obstacles, which would need to be removed
in order to implement these strategies.
For example, the report makes the case for a cut in public-sector employment.
However, as mentioned earlier, the culture of Saudi Arabia is very much dependent upon
state employment.
Any changes to this situation could lead to social unrest and protests, which would not
only undermine the political establishment but also potentially the monarchy.
The report also boldly suggests a shift from being an oil-dependent economy to one focused
on other industries, such as tourism.
Not only would this require large amounts of investment, but it would also need cultural
compromises to be made, including relaxing some of their religious norms for tourists.
Despite these limitations, Prince Mohammed Bin Salman (the current ruler of the Kingdom)
approved of the report, and he embedded its findings in his own paper called "Saudi Vision
2030."
Although there is no clear transition roadmap or expected milestones, it does rely on more
private investment to help diversify the economy.
A primary candidate for the role of capital supplier is China, which has already signed
a $2.48 billion nuclear deal with Saudi Arabia and is currently its largest trading partner.
Based on the evolution of the oil pricing mechanism (as explained in the previous video
in this series), the possibility that the Saudi riyal will eventually be de-pegged from
the US dollar is becoming more and more concrete.
This scenario is in line with the view that it will be replaced with a basket of its oil
customers' currencies dominated, for example, by the yuan or gold.
The most astounding measure suggested by both reports is the sale of a small stake of the
state-owned ARAMCO oil company via an IPO.
Total control of Arabia's oil wealth is the root of the royal family's power, influence
and success.
Therefore, a solution involving giving up control of oil potentially poses an existential
dilemma to Saudi Arabia.
A reduction in the royal family's grip on the oil wealth would be perceived as weakness
and could diminish their legitimacy as the absolute rulers of Arabia.
Even floating a small portion of ARAMCO would entail a series of problems.
Firstly, it would complicate the Saudi position within OPEC, due to the need to prioritize
shareholder interests.
This could cause conflicts of interest when these needs run counter to OPEC's agenda,
resulting in a loss of legitimacy for the country.
Secondly, ARAMCO would need to undergo detailed due diligence, which would shed light on various
aspects of the business which are currently well-guarded secrets.
This includes (but are not limited to): the effective state of the oil reserves, operating
financial figures (extraction, production etc.) and real ownership of oil fields.
Overall, the company would have to open its books for public scrutiny and there is always
the risk to find something, which could embarrass the royal family.
Additionally, Saudi Arabia would have to commit to avoid certain decisions that would harm
the company's performance or investors such as not raising taxes which could penalise
investors, not to preferentially employ Saudi nationals due to the higher salary expectations
than foreign workers, and not to use the revenue from oil as a political or economic instrument
of its foreign policy.
Assuming an implied (and very theoretical) valuation as high as $10 trillion, this would
be the largest IPO ever made and it is no surprise it has been attracting the ravenous
attention of the major investment banks.
Even with a meager portion of the overall company being floated, the IPO could generate
fees worth billions for the banks involved.
All major financial stock exchanges are being considered, and as of now, the target date
for the operation is 2018.
The track record for state-controlled oil companies going public does not bode well
for ARAMCO.
The performance and reputation of forbearers such as Rosneft in Russia and Petrobras (NYSE:PBR)
in Brazil have been far from positive.
In addition to poor stock performance, their conduct has also been brought into question
on numerous occasions since multiple cases of corruption and profit-skimming have emerged.
Even considering the financial cash flow the IPO would generate, the deal still leads to
some perplexing questions when the implications and risks it would entail are considered.
Despite the low cost of oil and the depletion rate of the Sovereign State Fund (the main
reserve of cash of the kingdom), the financial situation is not as dire as one may assume
since the country can still count on billions worth of reserves to meet its needs until
the end of the decade, at the very least.
If Saudi Arabia wants to avoid depleting their reserves, a strong case for raising additional
funds by issuing debt could be put forward.
Considering they already turned to the world of private finance earlier this year, it begs
the question why they are discarding this as a further option.
With the current low interest environment, it would appear to be a more efficient measure
than an IPO of ARAMCO, with fewer political and geopolitical implications.
The points above suggest the political leadership of the kingdom is going through a mind shift
and seems to be compelled to push certain agendas.
A question remains unanswered (and one that would provide a key to understanding the most
recent events and decisions): Are these agendas aligned with the overall financial and political
welfare of the country? In other words… who profits?