What Saudi-Iranian Tensions Mean For Oil Prices In 2016

January 20, 2016 4:16pm NYSE:USO

crudeoilA prisoner’s dilemma game of sorts between Saudi Arabia and Iran has big implications for oil prices in 2016. Russ and an investment strategist on his team, Terry Simpson, explain.


scottchan / Shutterstock

scottchan / Shutterstock

The recent break in diplomatic relations between Saudi Arabia and Iran adds another complication to the already chaotic environment of Middle East geopolitics. While the sectarian differences between the two nations are capturing the public’s attention, there’s an equally important economic struggle taking place: a prisoner’s dilemma game of sorts that has big implications for oil prices in 2016.

A STORY OF CRUDE OIL AND GEOPOLITICS

Saudi Arabia, more than most other countries, benefited from the decade-long rally in crude oil. According to Bloomberg data, the price per barrel moved from $25 in the early 2000s to just above $140 before stabilizing between $100 and $120 from 2011 to 2014, providing the kingdom with consistent government revenue.

Some of these petrodollars were reserved for future economic hard times. By all accounts, those times have arrived. The decline in oil prices that began in November 2014 has hit Saudi Arabia hard. While the country has very little debt and relatively huge fiscal exchange reserves, the drop in oil represents a huge change in Saudi Arabia’s fiscal position.

Saudi Arabia, which enjoyed a fiscal surplus balance of +30 percent of gross domestic product (GDP) in 2009, had a -21 percent deficit of GDP in 2015, as estimated by the International Monetary Fund (IMF). Saudis need financing for the war in Yemen and a generous system of state handouts (government spending cuts have limits, especially when some 90 percent of the population is employed by the government).

This “more going out than coming in” pattern is supported by the decline of the country’s foreign exchange reserves, still the highest in the region, to $640 billion as of the end of the 2015 third quarter, from a peak of $740 billion in 2014, according to data accessible via Bloomberg.

Funding its ballooning deficit, which can’t be plugged with asset sales and debt issuance alone, and improving its economic situation are partly why Saudi Arabia, the largest producer in the OPEC oil cartel, disagreed to any cut in production at the December OPEC meeting, and more recently has been discounting the price of oil to its customers.

Another reason for Saudi Arabia’s surprising oil supply moves: geopolitics. In my view, Saudi Arabia doesn’t want to cede any market share to its long-time rival, Iran. In other words, the Saudis seemingly would like to impede Iran’s potential new revenue source by maintaining the supply of oil, or even driving it higher.

Iran never enjoyed the oil windfalls of Saudi Arabia, at least partly because it forwent oil profits in lieu of growing a nuclear arsenal. This move resulted in economic sanctions from the U.S., Europe and other global powers. Now, with international economic sanctions against Iran relaxed, Iran is trying to rebuild its wealth by supplying an additional 750,000 to 1 million barrels per day of oil to an already glutted market, as the chart below shows. According to the Institute of International Finance, Iran’s 2015 GDP is estimated at $368 billion, second only to Saudi Arabia’s 2015 GDP estimate of $631 billion. Yet, on a GDP per capita basis, Iran pales in comparison to Saudi Arabia, with a GDP per capita of $5,000 versus Saudi Arabia’s $21,000.

crude_oil

Ultimately, per the IMF, Saudi Arabia needs oil prices to rise to $96 per barrel in 2016 to achieve fiscal breakeven. This is unlikely to happen, as I don’t expect Saudi Arabia to change its tactics on oil production in the near term. Nor has U.S. oil production collapsed, as many had predicted.

Saudi Arabia is playing the long game in the oil market—hoping it can ride out lower oil prices while driving higher-cost producers like Iran out of the market. Though this may be rational in the longer term, the same can’t be said for the near term.

WHICH COUNTRY IS BETTER POSITIONED?

If both countries remain destined to act in their own best interest, like the two prisoners in classic game theory, they’ll both be losers for the time being. The clear implications will be an oil glut that takes longer to work through and more downside for oil prices this year.

At first glance, the Saudis seem better positioned economically to play this game, but the more Iran remains first runner up, the more volatile the situation can become. In the words of John D. Rockefeller, we will have to see who can endure this “good sweating” battle.

Russ Koesterich, CFA, is the Chief Investment Strategist for BlackRock. He is a regular contributor to The Blog.


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