Understanding the Oil and Saudi Dilemma

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The Black Gold

Oil is undoubtedly the most important natural resource of the industrialized world, due to its vast functions for most technological, and manufacturing processes for many different sectors. Thus, its price plays a major role for most economies. Saudi Arabia, being blessed with such vast oil rich lands, accounted for 18.5% of total crude oil exports worldwide in 2014. It has been the most dominant player in the oil production market since the 1960’s; back then it co-created the organization of petroleum exporting countries (OPEC), a monopolistic cartel that united the five top oil producing countries –Iran, Iraq, Saudi Arabia, Kuwait, and Venezuela. OPEC exploited its power to control the market and gain supernormal profits by limiting overall supply. By 1973, OPEC has become a 12 country band accounting for two-thirds of the world’s oil production; and by 2010, 79.6% of the world’s oil reserves was under OPEC member nations. In 2014, oil came crashing down, (as figure above shows), from an overall increase in supply, with weak demand especially from the Asian markets. These  realities wreaked the oil market causing it to fall from a peak of $115 in mid 2014 to a mere $30 in 2016. This has led to financial turmoil for OPEC countries. Not only are less affluent OPEC members such as Venezuela hurt by the lower oil prices, but even rich Gulf States, including Saudi Arabia.

 

An Oil Party

Shale oil, oil found within rock fragments, was discovered in the 20th century and was seen as a gold mine of oil. However, the technologies needed to extract it was not available and was too costly when it was. In 2009, horizontal drilling, a drilling process in which the well is turned horizontally at depth, bundled with hydraulic fracturing, using pressurized water and liquids to break rock fragments to extract oil and gas, have become cost and operationally efficient to be used assuming oil levels remain above $45. This led to an ocean of investment into shale oil fields and created a new key and major player in the oil market.

 

EXCEL
Saudi(Orange-line) increased production, while oil prices(Blue-line) was plummeting.

Saudi fights back

For Saudi Arabia, oil accounted for roughly 80% of its exports and thus, the so called “Black Gold” source of revenue for the country, has turned from being its greatest feat to its greatest threat. Moreover, Saudi Arabia’s strategy towards declining oil prices have been surprising. Referring to the graph above, unlike most of the other countries, Saudi Arabia, extracts oil at a price of $8 in comparison to the world average of $40.This cost-advantage has allowed Saudi to boost production levels to further drive prices down to drive out competitors while maintaining minimal profits, however not enough to maintain a balanced budget. We can observe a simple decision tree in the chart below to better understand the decision behind the strategy.

Decision Tree Saudi
The best decision was  Saudi to not cut its production to yield                                              [Increase Price and Gain Market Share]

Is the Oil party over?

The amount of Shale Oil Rigs have decreased by 70% since 2014 but production of existing rigs have increased and thus overall, production capacity has not fallen significantly. However, R&D into oil fields have ceased to exist with many firms selling exploration lands at huge discounts. Moreover, Blackrock, the world’s largest asset management firm, has announced that if prices remain low in 2016, over 400 companies will declare bankruptcy and all other firms will have to take loans and lay off a large chunk of their workforce.  If oil companies default on their loans, banks get affected,  causing a domino effect throughout the economies of the world.

Competitors and the world have been enduring much more than Saudi and OPEC have expected. This has caused oil economies (OPEC) to use their foreign assets (figure below for Saudi’s NFA) to fund their budget deficits which for Saudi was at 15% in 2015. Other examples of large downfalls is the Russian Rubble depreciating by 70% since 2014 and Venezuela’s inflation reaching 140% in 2015.

SAUDI net foriegn assets

 

Time to diversify?

Oil-rich countries are battling to reform their countries, lowering oil dependency. Saudi Arabia is implementing policies under the new King to diversify the economy, and promote growth of the private sector. The Finance Minister Ibrahim Al Assaf stated on national television during an interview, that the ministry is willing to guarantee bank loans on small and mid-sized businesses, also known as SME’s. In response to a fearful market where banks might be hesitant to lend. By easing credit, young Saudi entrepreneurs will be able to start new businesses and grow current businesses at a faster rate than it normally would.

Furthermore, another initiative that Saudi is considering to implement is to privatize some of the government-owned entities, such as electric companies, airlines, and others. The most controversial privatization proposition, that created a thrill in markets, is the possibility that Saudi might initiate an IPO for Aramco, considered to be the most valuable company in the world, it aims to generate an excessive amount capital.

Saudi Arabia’s oil reign will definitely be marked in history as one of the major and most successful players in the oil market. However, times have changed as technological advances in clean, and renewable energy  develops, along with breakthrough in innovative oil extraction methods. Saudi Arabia must break the dependency on oil, and diversify its economy. To make it less susceptible to volatile oil prices, so it can preserve safety and stability for generations to come. 

Federal Open Market Committee Sept 2015: Report & Opinion

Due to the vast weakening of the domestic and global economic environment by the aftermath of the financial crisis, that lead to the great recession. The Fed kept interest rates at 0% for nearly a decade to cushion the hit, and increase liquidity, to ease credit markets (FRED, 2015). But low-interest rates for too long presented a dilemma for the Fed, it has not generated any upward pressure on inflation, and previous efforts from the QE bond buying program did not stimulate inflation (WSJ, 2015). The Federal Open Market Committee (FOMC) met on September 16 & 17 of 2015, and decided not to increase the interest rates, maintaining a [0,0.25] percent target range for the federal funds rate (FRB1, 2015). There are many interconnected factors that contributed to their decision. Among them was the current weakening of global demand, especially in China. The current and potential appreciation as a result of an interest rate hike would increase the demand for the US dollar, would negatively affect net exports even more and slow the growth of the economy. Another key factor is the low inflation rate, that has been below its 2% preferred measure for several years (The Economist, 2015). However, the committee claims that the recent drop in energy prices has put downward pressure on inflation, and are thus waiting for the prices to rise, and stabilize (FRB, 2015).  During the press conference held by Chairwoman Janet Yellen, the lag of the labor market’s adjustments relative to wage growth and actual unemployment rate was addressed and it was concluded that she would like see further improvements in the labor market that should generate some inflation, before raising interest rates (C-SPAN, 2015).  Since wage growth has been shy of expectations in comparison to previous post recovery periods (The Economist, 2015).  The current low rates have fueled auto sales and the commercial real estate while also contributing to the steady decline in the unemployment rate peaked 10% in 2009 to 5.1% in August 2015 (Hilsenrath, J, 2015). From a political stance, the U.S government depends on deficit spending, once interest rates increase, interest payments are going to be larger, and harder for the government to maintain a balanced budget. Hypothetically, as the presidential campaigns ends in 2016, a new president’s fulfillment of promises to their constituents to address the nation’s affairs could further increase the deficit. With higher interest rate the crowding effect from government spending will crowd out investments (Mankiw, 2012).

Prior to the FOMC, many economists and financial professionals have expressed their predictions and expectations towards the outcome of the Feds’ decision in major news sources. CNBC asserts that an interest rate increase will upset the bull market, bond yields will climb (Cox J., 2015), meaning that investors would consider investing in money market products which are more secure (Financial Times, 2015). The Economist claims that the faster the economy allows for higher rates, the better it is for the economy through the transition of the business cycle. Conversely, an increase now would pointlessly risk recovery, due to the 3.7% annualized pace in the second quarter of 2015 (The Economist, 2015). Moreover, according to Koch & MacDonald 2014, the banking industry would face interest rates risk, due to the change in net interest income. Furthermore, as bond yields rise, bond prices decline affecting holders of long-term debt securities, since bond prices and yields are negatively related (Croushore, D, 2014). Also increasing payments of free-floating instruments affected by a rate hike, subsequently resulting in major balance sheet changes. Taking the Mundell-Fleming Model into account, a monetary contraction either from the discount rate, the FOMC operations, or changing the reserve requirement would shift LM curve upwards increasing interest rates, thus leading to an increase in net capital inflow, which would lead to dollar appreciation, as a result negatively effecting net export and output, ceteris paribus (Mankiew, 2013).

The Fed is in a peculiar era of monetary theory failure (WSJ, 2015). It has not yet settled its tug-of-war between price stability (2% inflation) and full employment (FRED, 2015). According to the FRB 2015, forecasted projections induce that interest rates increases have a slight chance of occurring in 2015 and a significant chance in 2016 (FRB2, 2015). Whether or not the Fed reaches their target objectives is still in question. On the other hand, continuing with negligible interest rates will still hinder the effects of monetary policy, particularly under the likelihood of a recession.

References

When the Fed raises rates, here’s what happens. Retrieved 17 September 2015, from http://www.cnbc.com/2015/09/15/when-the-fed-raises-rates-heres-what-happens.html (Cox, J. 2015)

Money & Banking 3 + Coursemate Printed Access Card. United States: South-Western College Publishing.  (Croushore, D, 2014)

Federal Reserve Chair Janet Yellen held a news conference following the quarterly Federal Open Market Committee (FOMC) meeting on current economic projections. Retrieved 20 September 2015, from  http://www.c-span.org/video/?328132-1/federal-reserve-chair-janet-yellen-news-conference (C-SPAN, 2015)

Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents Retrieved 18 September 2015 http://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20150917.pdf (FRB2, 2015)

Press Release–Federal Reserve issues FOMC statement–September 17, 2015. Retrieved 18 September 2015, from http://www.federalreserve.gov/newsevents/press/monetary/20150917a.htm (FRB1, 2015)

False start. Retrieved 18 September 2015, from http://www.economist.com/news/leaders/21664137-fed-should-wait-until-inflation-closer-target-raising-rates-false-start (The Economist, 2015)

Fed Delays Interest-Rate Liftoff. Retrieved 18 September 2015, from http://www.wsj.com/articles/fed-leaves-interest-rates-unchanged-1442512974 (Hilsenrath, J, 2015)

Bank Management. United States: Cengage Learning. (Macdonald, S., & Koch, T. W 2014).

Mankiw, G. N. Macroeconomics (8th ed.). United States: Worth Publishers Inc.,U.S. (Mankiw 2012)

Trapped by Zero. Retrieved 18 September 2015, from http://www.wsj.com/articles/trapped-by-zero-1442358927?tesla=y  (WSJ 2015)

Why is the Fed considering raising interest rates now? Retrieved from http://ig.ft.com/sites/when-rates-rise/#what-is-happening. (Financial Times 2015).

Retrieved 18 September 2015,Acquired from FRED https://research.stlouisfed.org/fred2/  (FRED, 2015)

FRED