Tom Stevenson
 

When, a couple of years ago, Saudi Arabia was twisting the arms of Russia and 22 other oil producing countries to stem the flow of crude, the oil price was already off its low of less than $30 a barrel. But at around $50 in late 2016, it still represented a big problem for the oil-rich kingdom. With an expensive economic transformation underway, a war in Yemen to fund and an upstart Shale industry in North America eating into its market share, it badly needed to take back control.

The production curbs which kicked in at the beginning of 2017 have been an unqualified success as far as Saudi Arabia is concerned. The oil glut, which had seen the price of oil fall by nearly three quarters peak-to-trough between 2014 and 2016, has been all but eliminated in just over a year. The surplus over the long-term average stocks of oil and refined products in the developed world has fallen from 340 million barrels to just 10 million. In the US, there is actually a deficit for the first time since 2014.

Now, as officials from Saudi and Russia consider what to do next, the talk is of the oil price rising above $80 a barrel. There is even speculation that the Middle Eastern oil giant (if not its Russian ally) would be happy to see oil rise to $100. This would represent a significant shock even for a global economy that is currently firing on all cylinders. The extra revenues that would be generated by an oil price hike on this scale will be extremely tempting in Riyadh. Perhaps too tempting.

It’s not hard to see why Saudi Arabia is manoeuvring the oil price higher. Sometime next year, the state-owned oil company Aramco will come to market. The Saudis are looking for a $2trn valuation which most industry watchers think is way too optimistic. A flirtation with $100 a barrel oil, however brief, would be extremely timely ahead of the IPO. The flotation of Aramco is the centre-piece of Crown Prince Mohammed bin Salman’s ambitions to modernise the Saudi economy.

That programme will be costly, as will the ongoing war in southern neighbour Yemen. Already, the kingdom’s massive foreign cash reserves have dwindled from a peak of $737 billion in 2014 to $488 billion today. Some oil experts think that break-even for Saudi Arabia is somewhere close to $85 a barrel.

The rapid reduction in the world’s excess oil reflects an unusual combination of events over the past 15 months. First, the compliance with the proposed production cuts has been remarkably disciplined. Typically, OPEC has talked a good game on output curbs but then seen revenue-hungry member states peel away from the agreement to exceed their allotment. This time the targeted 2pc reduction in supply has been met almost precisely. The 1.9 million barrels a day that the group is leaving in the ground represents 1.98pc of 2016 production.

Next, the implosion of Venezuela’s economy has seen that country’s output fall to multi-decade lows, adding to lost production from Angola’s ageing fields and temporary maintenance-related shutdowns in Algeria. Looking forward, the re-imposition of sanctions on Iran might keep another 500,000 barrels a day off world markets. Iran pumped about 4pc of the world’s oil production in March.

Rising price expectations are not just about supply. Demand growth in the first three months of 2018 is forecast to reach more than 2.5 million barrels a day, according to Goldman Sachs. That represents the strongest year-on-year growth since 2010. In the US, demand for petrol has not been so high since 2007, the American Petroleum Institute said. With the traditional summer driving season about to get underway, the market is likely to remain tight.

In these circumstances, you might expect the oil producers to feel more relaxed about cashing in on higher prices by opening the spigots a little. Far from it. Saudi energy minister Khalid al-Falih told CNBC last week: ‘we have to be patient. We shouldn’t jump the gun, we shouldn’t be complacent and listen to some of the noise such as ‘mission accomplished’. I think we still have work ahead of us.’

That was a clear indication that at June’s meeting of the production cartel the current curbs will not only be extended to the end of this year but well into 2019 as well. What might this mean and why might Saudi Arabia come to regret its short-termist approach to managing the oil price?

The first risk is that a return to $100 oil is the trigger for the next economic downturn. The US is deep into one of the longest-ever economic upturns, more than 100 months old now. Unemployment is close to historic lows. Wage growth is creeping back and the Fed is on a tightening path. Gasoline demand finally reached its 2007 peak in 2016. Put $100 oil into that cocktail, however, and the end of the cycle hoves into view.

Last week, the implied probability of three further US interest rate hikes in 2018 rose above 80pc. The chance of four more this year, not on anyone’s radars until very recently, is now a non-negligible 30pc. Oil-fuelled inflation could sound the death knell for lower for longer monetary policy.

The second risk is that the Saudis enjoy a short-term windfall but in the long run shoot themselves in the foot. A higher oil price will trigger an even stronger response from North American Shale producers who are profitable above $60 a barrel and would be massively so anywhere near $100. The longer-term danger is that a return to expensive oil hastens the inevitable transition to electric vehicles. A spike in the oil price will bring peak oil that little bit closer. Be careful what you wish for.
 

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 (“Fidelity Australia”).  Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Investments in overseas markets can be affected by currency exchange and this may affect the value of your investment. Investments in small and emerging markets can be more volatile than investments in developed markets.

This document is intended for use by advisers and wholesale investors. Retail investors should not rely on any information in this document without first seeking advice from their financial adviser. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider these matters before acting on the information.  You should also consider the relevant Product Disclosure Statements (“PDS”) for any Fidelity Australia product mentioned in this document before making any decision about whether to acquire the product. The PDS can be obtained by contacting Fidelity Australia on 1800 119 270 or by downloading it from our website at www.fidelity.com.au. This document may include general commentary on market activity, sector trends or other broad-based economic or political conditions that should not be taken as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be taken as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. This document is intended as general information only. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia. The issuer of Fidelity’s managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009. Reference to ($) are in Australian dollars unless stated otherwise. 

© 2018 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity International and the Fidelity International logo and F symbol are trademarks of FIL Limited.

Get Fidelity insights

Fidelity Insights is a free, monthly e-newsletter that brings you valuable and distilled investment insights, opinion and education.

Subscribe 

Latest insights from portfolio managers around the world
News and views on Australian markets & companies
Education and behavioural finance insights

Subscribe 

 

Related insights

Tools for your clients: Active vs passive
James Bateman

Tools for your clients: Active vs passive

There’s been a great deal of debate whether active or passive management is the right choice for investors but is this the right question to be asking?

How much is too much? (2 of 4)
Jeremy Podger

How much is too much? (2 of 4)

It’s not necessarily easy to assess whether the technology sector is overvalued. Can current market leaders continue to justify their value?

Behavioural finance: When what you see is all there is
Fidelity International

Behavioural finance: When what you see is all there is

Forming conclusions based on limited data helps us to process things quickly in a complex world however these shortcuts can lead us astray… 

Along the continuum
Bill McQuaker Portfolio Manager, Eugene Philalithis Portfolio Manager and Vanessa Glennie Investment Writer

Along the continuum

Conditions change throughout an investment cycle, so how and when should investors combine the various shades of active and passive to maximise returns?

View more insights