Energy Realpolitik

As the White House hosts Saudi Crown Prince Mohammed bin Salman today, policy makers need to be reminded that any new arms sales across the Middle East could become part of a repeating pernicious cycle that could lay the seeds to the next big oil crisis. That’s an important conclusion of my new economics and policy paper published today with co-author Rice economics professor Mahmoud El-Gamal in the academic journal Economics of Energy and Environmental Policy (EEEP). Bin Salman kicked off the preliminary public relations for his current trip with an important and serious interview aired on the American TV news magazine 60 Minutes, in which he noted “Saudi Arabia doesn’t want to own a nuclear bomb. But without a doubt, if Iran develops a nuclear bomb, we will follow suit as soon as possible.” While Saudi Arabia and the United States share a common view that Iran is a destabilizing force the region, the United States has been resistant to Saudi lobbying that standards for a U.S.-Saudi nuclear deal should not ban enrichment of uranium. Westinghouse and a consortium of U.S. companies are discussing a bid for the multi-billion tender to build civilian nuclear reactors in the kingdom in competition with China. Coincidentally, the U.S. Department of Energy (DOE) tweeted today that the United States needs to “modernize our nuclear weapons arsenal, continue to address the environmental legacy that the Cold War programs, further advance domestic energy production, better protect our energy infrastructure, and accelerate our exascale computing capacity,” noting that nuclear deterrence is a core part of the DOE mission.” In our EEEP article, we argue that geopolitical events that are often considered exogenous to the debt-driven financial boom and bust global economic cycle are part of an endogenous and self-perpetuating meta-cycle, linked by high petrodollar recycling during periods of high oil prices that typically accompany high economic growth periods, like the one seen in the early 2010s. Petrodollar recycling takes many forms, including rising military spending and buildups. El-Gamal offers a theoretical model that explains why an oil exporting country could be “incentivized” to time its military activism during periods of oil price slumps, with the coincident effect of boosting national revenues, thus converting military capital into civilian capital. A significant part of Arab countries’ military equipment (and Russia’s) used in recent conflicts was accumulated during oil boom years following the Iraqi invasion (2003-2007) and during the Arab Spring uprising (2011-2013). Last year escalations in conflict across the Middle East from Yemen to Northern Iraq helped raise the price of oil on the heels of the major down cycle of 2014-2015. The paper using discrete wavelet analysis of oil production at the country level to demonstrate that military conflicts that destroy production installations or disrupt oil transportation networks are the “most significant antecedents of sustained long term disruptions in oil supply.” The paper recommends that “rather than increase arms sales as rentier states seek to externalize their problems, major economies such as the United States, China, Japan and Europe multilaterally and through international agencies should encourage the acceleration of economic reforms such as those proposed by the Saudi Crown Prince. Forty years of military buildups have failed to bring peace and economic prosperity to the Middle East. While it is unlikely that the Middle East oil exporters will intentionally escalate regional proxy wars in a manner that leads to the destruction of oil facilities, the nature of war can be irrational and unpredictable, hence explaining the return of the geopolitical risk premium to the price of oil. The hedge fund community, which trades in oil, has so far appeared relatively unconvinced by announcement of economic reforms in Saudi Arabia. It has also been skeptical of the success of the Iranian nuclear deal. Meanwhile, the oil industries of Syria and Yemen have been decimated by recent geopolitical conflicts. A similar fate befell Iraq and Iran during their eight-year war, our research shows. In light of this self-perpetuating cycle, industrialized governments would benefit from revisiting coordination mechanisms for use of strategic stocks, including discussions with Saudi officials currently visiting for how the United States could respond (in conjunction with Saudi Arabia?) to further deterioration of Venezuela’s oil industry. The United States imported just over 500,000 barrels per day (b/d) of Saudi crude oil last fall, the lowest level since May 1987 and down from 1.5 million b/d a decade ago. The kingdom is now the fourth supplier after Canada, Mexico and Iraq. The drop reflects more than rising U.S. production since Saudi Arabia and Venezuela supply a heavier grade of crude oil used by coker units that economically upgrade poorer quality crudes into light products like naphtha and gasoil. Rising tight oil production is a lighter grade of crude oil less desirable for coker units of the U.S. gulf coast. In years past, the U.S.-Saudi security partnership has included coordination of responses to sudden changes in global oil supply, including strategies that involved targeting Russia when lower oil prices were needed to send a firm message of geopolitical deterrence. The question is with the current Saudi-Russian oil bromance and the United States itself now an oil exporter, is this critical element to the U.S.-Saudi relationship still viable?

This post is co-written by Jareer Elass, an energy analyst who has covered the Gulf and OPEC for 25 years. He is a regular contributor to the Arab Weekly. This week, Saudi Crown Prince Mohammed bin Salman begins his two-and-a-half week-long visit to the United States—including a March 20 White House meeting with U.S. President Donald Trump. Top of the Saudi agenda will be to further cement close political ties between the three-year-old regime of Saudi King Salman Bin Abdulaziz Al-Saud and the Trump administration. That could be harder than it looks if President Trump brings up a request for Saudi Arabian financial support in Syria. Russia has also been publicly out hat in hand to the EU on Syria while behind the scenes trying to shake down Saudi money for Syria as part of its oil collaboration with Riyadh. Saudi Arabia is unlikely to support any peace process on Syria that sustains strong Iranian influence. Beyond the geopolitical, the crown prince is focused on the Saudi economy and wants to bring American business to Saudi Arabia. Regardless of how these complex topics play out, there’s no doubt that the young Saudi leader will have to be in public relations mode. Crown Prince Mohammed has already kicked off his trip with a long interview aired on the American TV news magazine 60 Minutes, in which he controversially indicated Saudi Arabia’s willingness to enter the nuclear arms race alongside chief rival Iran. The subject will be a tricky one: while Saudi Arabia and the United States share a common view that Iran is a destabilizing force in the region, the U.S. has been resistant to Saudi lobbying that standards for a U.S.-Saudi nuclear deal should allow either reprocessing spent fuel or enrichment of uranium. Washington Post columnist David Ignatius’s suggestion that Saudi Arabia try to cozy up to the United States by suspending its oil deal with the Russians to punish Russian leader Vladimir Putin for a recent string of unacceptable actions is also fraught with peril. That's because Putin could similarly be thinking that falling oil prices would hurt Saudi Arabia’s stability more than his own. The kingdom is vulnerable on the oil price front both due to domestic economic pressures and to lofty oil price levels needed to support the Aramco IPO valuation process. Analysts calculate that a sustained oil price around $70 a barrel is needed for the kingdom to hit valuation targets for the IPO consistent with the $2 trillion valuation used in announcing the plan. Raising the stakes, the Saudi crown prince’s visit to the United States follows a similar tour recently led by the Saudi foreign minister that failed to convince potential American investors that the current and future political climate in the kingdom is not a risky one. The tepid response from U.S. institutional investors during the road show makes the New York Stock Exchange (NYSE) increasingly unlikely to be favored as a final choice for the foreign bourse to be selected by the Saudi regime for the Aramco IPO. It has also made the timing of the listing murkier, thereby lengthening the time line for how long Saudi Arabia could need its cooperative oil arrangement with Russia to last. The Saudi case for the durability of its own political stability was shaken by reports in the New York Times last week of the Saudi government using “coercion” to wrangle billions of dollars’ worth of assets from targeted prominent Saudis, including members of the royal family. The report made clear that the campaign of intimidation against individuals who have been singled out for their alleged corruption is continuing, raising questions about the Saudi government’s end game. There have been several constants in what the Saudi government has said over the last two years about its intent to sell a stake in Saudi Aramco. When the IPO was first announced, it was said to involve a sale of up to 5 percent of the state firm, with a listing on the Saudi stock exchange as well as on one or more foreign bourses. According to the crown prince, Saudi Aramco’s valuation could be appraised at more than $2 trillion, with the Saudi government collecting as much as $100 billion from the limited sale. The Saudi regime has grappled with choosing an appropriate foreign listing from the outset amid concerns about the leading exchanges under contention—the NYSE and the London Stock Exchange (LSE)—and the fact that the stated valuation of 5 percent of Saudi Aramco could be hard to achieve. Meanwhile, the International Monetary Fund (IMF) has estimated that an average $70 a barrel is what the kingdom would need to balance its 2018 budget, though it has endorsed the kingdom’s decision to delay achieving a balanced budget until 2023 in an effort to avoid economic damage as Riyadh slows its pace on implementing fiscal reforms. Industry experts have been skeptical of the official projected valuation of the state oil firm, and indeed, by some accounts, the math doesn’t appear to work in Saudi Arabia’s favor, unless oil prices rise significantly and other criteria are met. Moreover, the kingdom’s new $70 a barrel price goal, which seems linked to the Saudi IPO conundrum, has divided members of the Organization of Petroleum Exporting Countries (OPEC), some of whom have been saying too high a rise in oil prices could be deleterious to OPEC’s future. Iran has publicly stated its preference for prices at around $60 a barrel because it believes that $70 could backfire on the group, prompting U.S. shale companies to bump up their output and a long run weakening of demand for oil, resulting in an uncontrolled collapse in future oil prices. The crown prince’s London visit has fueled rising speculation in recent months that the IPO would be delayed beyond 2018. Oil Minister Khalid Al-Falih in a March 8 interview referred to a 2018 deadline for conducting the IPO as an “artificial deadline”, noting that the “anchor market will be the Tadawul exchange” but emphasized that the kingdom has the necessary fiscal and regulatory framework in place for Saudi Aramco to be listed this year. Falih has also suggested that his government saw major issues associated with choosing the NYSE for a foreign listing of Saudi Aramco shares, saying that “…litigation and liability are a big concern in the U.S. Quite frankly, Saudi Aramco is too big and too important for the Kingdom to be subjected to that kind of risk” While Falih pointed to New York City’s decision earlier this year to sue five major oil firms over the “existential threat of climate change” as a concern, the Saudi government is equally worried about the ability of families of 9/11 victims to sue the Saudi government under the “Justice Against Sponsors of Terrorism” Act that was passed by the U.S. Congress in September 2016. During his London trip, the Saudi oil minister praised the LSE, saying that, “The London stock exchange is one of the best in the world, it is well-regulated and we respect it.” But, floating Saudi Aramco shares on the LSE is not without controversy. The U.K.’s chief financial regulatory body came under fire in the spring of 2017 when it recommended easing LSE rules to allow state-owned companies like Saudi Aramco to qualify for premium listing without being subject to the strictest corporate governance rules. The Hong Kong exchange could be a convenient compromise for the Saudi government in its pick for a foreign bourse on which to list Saudi Aramco shares. And then there is also talk of the Saudi government forgoing an IPO entirely and favoring a private sale to strategic investors, or a combination of a listing on the Tadawul and a private sale. This would be beneficial if the Saudi regime believed it was going to fall far short of the $2 trillion valuation and of course, it would free the kingdom from having to be overly transparent about its finances and operations as required by some foreign exchanges. But U.S. officials have argued that a private placement with Chinese firms would not provide many of the structural benefits that come from undertaking a public listing. It would be surprising if the Saudi government failed to float Saudi Aramco shares on the Tadawul, given how the public expects to participate in the IPO and the desire for Riyadh to help build the Saudi exchange into the premier bourse in the region. But, one of the biggest concerns about a Saudi Aramco listing on the Saudi exchange is the lack of liquidity due to the Tadawul’s size. The Saudi exchange is small compared to major foreign bourses—with a market capitalization of around $470 billion and 171 listed companies, a stark contrast to the scale of the NYSE, which has a capitalization of $21 trillion and more than 2,000 listed companies. Tadawul officials have been preparing for the listing and have even recommended the Saudi exchange be the sole bourse for the Saudi Aramco sale. But, there is real concern that the Tadawul will not be able to absorb up to 5 percent of Saudi Aramco shares on offer, and that a large sale could cause much volatility on the domestic exchange, with the potential for investors to shed other company stocks rapidly to raise funds as they buy up Saudi Aramco shares. In fact, according to a recent report from the Energy Intelligence Group, the Saudi regime is reportedly calling on members of the royal family and wealthy Saudi businessmen to commit to injecting new funds into the Tadawul and to purchasing Saudi Aramco shares in a drive to prevent a destabilization of the domestic stock market when the IPO is launched on the local exchange. The Saudi Aramco IPO is the linchpin of the crown prince’s ambitious economic revamping program known as Saudi Vision 2030. Proceeds from the sale are to be directed to the kingdom’s sovereign wealth fund, the Public Investment Fund, which in turn will make investments designed to move the kingdom away from being an oil-driven economy. Though the Saudi regime has made progress on some economic reforms, the Saudi Vision 2030’s agenda to fundamentally transform the kingdom’s economy greatly depends upon the success of the limited sale of Saudi Aramco. That has injected a certain level of inflexibility into the kingdom’s oil policy that makes any talk of Saudi oil cooperation with the United States against Russia a lower probability course of action than it was in the past.