Saudi Arabia’s oil strategy has changed markedly over the past year. After initially responding to the rise of US shale with a high output/low price strategy, more recently it has sought to cooperate with Opec and Russia to restrict production and put a floor under prices. This has naturally led to a tighter oil market, and one which is much more sensitive to supply or demand shocks.
To appreciate why the Saudis changed strategy, you need to understand the efforts of the ruling monarch, Mohammed Bin Salman (MBS), to reform the country. Rather than relying on the traditional royal power base, MBS has reached out to young Saudis, who typically understand the need for reform and the fact that the current oil wealth will not last forever.
To retain the loyalty of this base, MBS needs to deliver on a reform agenda, and on jobs in particular. That requires diversifying the economy and developing public sectors like education, health and infrastructure.
The government first attempted to promote reform while living with a low-price environment. Several measures were introduced to free up revenue, such as reducing spending and increasing domestic energy prices, as well as raising cash by drawing on foreign reserves and tapping international debt markets. The Saudis even planned to list Saudi Aramco, the country’s national energy company.
While plans around this have since been scaled back, the Saudis still plan to partially list the company to help bring in foreign petrochemical expertise, and develop this sector of the Saudi economy.
However, carrying out the reform agenda and ensuring social peace at the same time did not prove to be an easy task. The Saudis therefore shifted to supporting the price of oil, and played a key part in negotiating the agreement between Opec and Russia, which has succeeded in draining global oil surpluses.
By enabling higher prices, that agreement has helped to fund compensatory benefits to poorer Saudis as cheap energy is withdrawn, as well as enabling strategic investment to help diversify the economy. This has included a 72bn riyal (£14bn) package to stimulate private sector growth, targeting sectors like housing, exports and manufacturing.
The current rally in prices therefore fits Saudi Arabia’s short-term needs, generating higher revenues to fund the shift away from oil dependence. If it encourages further investment in oil capacity globally, it could also help the kingdom in the longer term, as the Saudis do not want prices high enough to choke off the global economy.
The domestic picture and need for revenues means that Saudi Arabia’s new strategy to support prices is likely to extend beyond 2018. The initial aim of Opec and Russia was for oil inventories to fall back into line with their five-year average. With this achieved, the alliance looks to be tacking towards longer-term support for prices.
In the short term, however, it does mean oil is more vulnerable to unintended supply or geopolitical shocks. Gradually rising prices on the back of stronger growth would probably not hurt the global economy – the impact would just be to take the edge off growth. But unintended supply or geopolitical shocks and a sharp rise in prices would clearly be negative for global equities and the economy.