Saudi finances and the oil crash

2015 has been a historic year for Saudi Arabia. The royal succession, the war in Yemen, the collapse in oil prices, Obama’s Iran nuclear deal, a crown prince who is a grandson (and not a son) of the kingdom’s founder, Russian and Iranian military intervention in Syria, the coalition against ISIS, the suicide bombings in the Eastern Province and the Iraqi border.

Saudi Arabian finance is also unsettled in these historic times. The 30% fall in the Saudi All Tadawul stock index (TASI) negates the euphoria that greeted the CMA’s decision to open the stock market to foreign investors. The $100 billion budget deficit that the IMF projects at 21% of GDP. The liquidation of $200 billion in offshore assets by the Saudi Arabian Monetary Agency (SAMA) and capital flight. Unlike the UAE, where oil and gas is 30% of GDP (down from 90% in the 1970’s), Saudi Arabia still depends on oil and gas for 80% of government revenues.

Saudi Arabia is the biggest domestic energy consumer in the Middle East and, if current trends continue, could well become and oil importer by 2030. Saudi Arabia is also four times as inefficient a user of energy as Britain and Germany. Saudi Arabia is the world’s largest consumer of oil to generate electricity. Saudi Arabia spends the world’s largest consumer of oil to generate electricity. Saudi Arabia spends the world’s largest amount per capita on defense and finances strategic allies like Egypt, Jordan, Sudan, Pakistan, Morocco and Bahrain.

The budget breakeven barrel for Saudi oil has surged from $40 a barrel in 2008 to $100 a barrel now. Vast subsidies mean gasoline is a mere 60 cents a gallon, one fourth the price in the UAE. The fuel subsidies cost the government $52 billion a year, 8% of GDP. The Saudi riyal peg is under pressure, though I see no real devaluation risk for now since Dr. Fahad Al Mubarak, SAMA Governor, has made a hard commitment to defend the peg. The Saudi Tadawul index trades at 15 times earnings and 1.9 times book value on the precipice of a recession that could well see EPS drop by 10%. If oil prices even stay flat, Saudi Arabia’s fiscal pressure will mean greater Saudi royal bond issuance and higher interest in the local money markets. This almost guarantees a bear market in Saudi equities.

Geopolitics has now amplified the refusal of Riyadh to play the role of OPEC’s “swing producer”, as it did under Sheikh Yamani and even in 2009, when Ali Naimi and Prince Abdul Aziz bin Salman engineered a 4.2 MBD output cut to boost the post-Lehman price of Brent from $40 to $100 a barrel, its level during the first three years of the Arab Spring. So the oil market faces a supply glut, a demand shock (China), a price war (John D. Rockefeller called it “the great sweating” a century ago) and the loss of its swing producer, one with the largest spare capacity and lowest production cost in the world.

The world is running out of storage capacity. When this happens, prices will plunge to balance supply and demand. Russian output is the highest since the fall of the USSR. Mexico, Iraq and offshore West Africa are still pumping big time. Saudi Arabia will not yield to the Kremlin in this game of global chicken now that Putin has chosen the gamble on Assad in Syria. There is only one certain endgame to this savage global price war. A collapse of black gold to $20, its level when George W. Bush rolled history’s dice in Saddam’s Iraq back in March 2003. The Oil Age will not end because the world runs out of oil.

So Justin Pierre Trudeau is the new Premier Ministre of Canada. Stephen Harper’s decade in power as the Tory grand vizier in Ottawa was ultimately doomed by the oil shock, the commodities bust, the 2015 Canadian recession and voter discontent in Ontario, Quebec, Alberta and the Atlantic seaboard states. Even though Justin is the son of a political legend Pierre Trudeau, he has no economic or diplomatic policy making experience. Yet he will rule the first Liberal majority government in Ottawa since Jean Chretien in the late 1990’s. I can envisage higher public spending as Justin (and the electorate) do not share the Conservative Party’s commitment to a balanced budget or a Canadian combat role in the US led military coalition against ISIS in Iraq. This means tensions with Washington beyond the Keystone XL pipeline issue. Justin could even resurrect the ghost of his father’s Third Option in a world where China and Russia both challenge the US. All this reinforces my conviction, outlined in my 12 October KT column, that the Canadian dollar’s strength will not last.

So it did not surprise me that the loonie fell against 15 major currencies in Singapore trading the night Justin Trudeau unseated Harper and entered the world stage. Once the Tories resorted to the xenophobic, anti-niqab campaign, I knew Stephen Harper had run out of ideas and political risk was going to rise in Canada even as oil prices and economic growth rates/mining capex fell. Trudeau’s C$ 60 billion infrastructure pledge (funded rise in deficits) and two shock Bank of Canada rate cuts, fiscal populism and higher US economic momentum means a lower loonie. So does the monetary policy divergence between the Yellen Fed and the Poloz Bank of Canada I expect will widen in 2016.

As a personal friend of former Liberal Prime Minister Jean Chretien and father of (a UAE dirham financed) McGill undergrad, I will not disguise my pleasure at the election result and the softness of the Canadian dollar. Yet the free fall in the Canadian dollar began in spring 2014 under the conservatives, when I recommended a loonie short at 1.06 (or 94 cents) against the US dollar.

Justin Trudeau will only add fiscal stimulus to Governor Poloz’s ultra-dovish monetary policies which have failed to use loonie depreciation to revive the Canadian economy. The yield on the ten year Canadian Government bond is a miniscule 1.46% at a time when Canada’s Federal and provincial debt burden will only rise. In any case, the oil shock and $500 billion reserve falls in China will force sovereign wealth funds to jettison their holdings of Canadian government debt, which has historically been correlated with a rise in Federal budget deficits. A strategic put option on Canadian dollar government debt makes total sense since the yield on the ten year Uncle Canuck note could well rise to 2.0% or higher by late spring. Does Justin Trudeau’s proposed fiscal stimulus threaten Canada’s AAA credit rating? No.

Canada had the stablest banking system in the Western world in 2008 while Wall Street, the City of London and even the Bahnofstrasse/Paradeplatz went ballistic on subprime debt/credit derivatives. The commodity supercycle and China’s spectacular economic growth since 2001 was a financial windfall for Canada. Yet that was then and this is now. Canada is now in near recession, the commodities bust has just begun, epic consumer debt presages a housing crash, energy loans will gut banking profits and the loonie hit 12 year lows in September. Even though Alberta oil sands boast the world’s third largest oil reserves, they are high cost marginal producers who are toast during a global oil glut with no swing producer in either Riyadh or West Texas/North Dakota. Paradoxically, Harper’s “energy superpower” boast now haunts the loonie, since oil and gas is 25% of Canadian exports. Other than the Norwegian kroner, the Canadian dollar is the ultimate Western world petrocurrency now, the political pendulum has shifted back from Alberta to the Liberal bastions of West Montreal.

“Bright lights, big city”. This was the great New York novel de jour when I left the Chicago futures pits for banking Mount Olympus on 1 Chase Manhattan Plaza. I was a young, hip, interest rate, currency, equity and crude oil derivatives specialist doing business with mega banks, sovereign wealth funds and the ultra-rich from Athens to Amsterdam, Geneva to Abu Dhabi, Jeddah to Buenos Aires. I remember I never spent more than three weekends in a row in my lovely East Village apartment. Yet I loved it all – a ringside seat in the financial history of the world in real time.

So I traded sterling on Black Wednesday, September 15 1992, the day George Soros broke the Bank of England and did more damage to the sceptered isle than the Luftwaffe or the NHS. I watched the world and my Kuwaiti clients bleed when Saddam Hussein invaded the emirate on August 2 1990 and changed the course of Arab history.

I watched Drexel Burnham die and the junk bond market freeze after Michael Milken went to Club Fed for insider trading. I made a nice spec profit for myself shorting the Italian lira against the Deutschemark, the Mamma Mia-Achtung arbitrage of history. I heard Citicorp’s death rattle due to Latin American sovereign loans, New York commercial real estate and busted leveraged buyouts – and saw the interbank market freeze and the Greenspan Fed slash rates to act as Mommy (OK, lender of the last resort) to Wall Street. I learnt painful lessons about risk, credit cycles, margin debt, contagion, leverage that have seeped in to my soul. History hurts.

Fast forward to 2015, Year Seven AL (After Lehman). Quantitative easing by the Fed, the Old Lady, the ECB and the Bank of Japan have given the world’s stock market traders the gift of a lifetime as the captains and kings of central banking were desperate to avoid a second Great Depression. Jolly good, chaps, prats and duckies! But all good things must come to an end and so will the Fed easy money wave of 2008-15. There is a time to dial up risk and there is a time to tremble with fear. This is a time to tremble with fear.

The ghosts of the 1991 credit crunch, when Citicorp was rescued from Chapter 11 by a Saudi prince and global equities dropped 40%, have traumatized me for life. I am just a student of credit cycles, global and local. My love for history animates all my macro ideas in banking and finance. Marcus Tullius Cicero said it best in Rome 2000 years ago. “Not to know history is to forever remain a child”.

I have an Irish (Dublinwali) sister and naturally I inflict on her James Joyce, another literary obsession. So Leonard Bloom told me “history is a nightmare from which I struggle to awake”. History does not repeat but rhymes to Mark Twain. Yo Sandy! I saw Citi die and rise from the dead in 1991 – and again in 2008, thanks to Uncle Ben! I survived the debt shock of 1991 that was a requiem for Drexel, Kidder, Manny Hanny and BCCI and those of 2008 that killed Mama Merrill, the Bear, the old Morgan Stanley and the House of Lehman. Santayana was so right. Regulators and investors who ignore the lessons of history are doomed to repeat them in real time, as we saw in 2008.

I am fascinated by medieval, pre modern finance. Marwari money changers in Fathepur Sikri, Mughal Emperor Akbar’s capital in the 1560’s, offered no money down, esoteric mortgages to Afghan warlords given imperial land gifts in Punjab/Bengal. Commodity swaps? Common in Lombardia banks in 1560’s to finance Mexican conquistadores so the Spanish king in the Escorial could crush the rebels in Holland. A few decades later, Amsterdam was the hub of global finance until Rembrandt’s tulipmania and the East India Company in London relegated the Herrengracht to the minor leagues. There was even a shameful but liquid cotton/African slave asset backed loan market in New Orleans, Charleston and London in the 1820’s.

Lenin fast forwarded history. Marx searched for its hidden secret laws. Kant tried to fathom its dialectic. George Soros interpreted history with the prism of reflexivity, Mao and Stalin via their ghastly ideologies of hate. I just try to use history to make money in the market. Nietzsche said it best for me. Gaze not into the abyss, lest the abyss gaze back, as Max Heisenberg and Lord Keynes proved it does. Thank you, Cicero. You made my career possible. Not to know history is to remain forever a child.