Saudi Arabia slips on cheap oil

What has happened?

The twin shocks of the global Covid-induced recession and the plunging oil price have upended the Saudi government’s “Vision 2030” plans to modernise the country and diversify its economy. In the face of a looming fiscal crunch and a fraying relationship with the US – and with no shortage of alienated and angry cousins waiting for him to fall – the leader Crown Prince Mohammed bin Salman (MbS) now faces “existential” choices, reckons Roger Boyes in The Times.

Does he continue with his ruinous and unwinnable war in Yemen? Should he abandon his plans for a state-of-the-art Red Sea megacity, complete with “flying taxis and a robot underclass”? And how can he continue to fund lavish social spending – and thus keep a lid on social unrest – as oil revenues plunge?

How has he kicked things off?

By recognising the scale of the problem. “We are facing a crisis the world has never seen the likes of in modern history,” says Saudi finance minister Mohammed al-Jadaan, adding that higher taxes and lower social spending would be “necessary and beneficial to maintain comprehensive financial and economic stability”.

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The government has announced $13.3bn of spending cuts aimed at plugging a $2bn-a-week current deficit. Total 2020 cuts are set to total around 15% of the budget – a serious problem for an economy where government spending, fuelled by petrodollars, is the main driver. Last week Riyadh announced the tripling of VAT on goods and services from 5% to 15%. It has also scrapped a $266 monthly subsidy given to all state workers (who account for more than half of all workers) on top of their wages, and announced a root-and-branch review of benefits paid to employees and contractors.

“The measures send a message to the markets that the authorities are prepared to make tough choices to keep the deficit within bounds,” economist James Reeve told Bloomberg. “This is a further blow to the already stricken retail sector.”

Can the Saudis muddle through?

At current oil prices and government spending levels, the Saudi state will run out of money in three to five years, forcing it to take on additional debt, says Karen Young at the American Enterprise Institute. Plenty of analysts expect oil prices to rise as the world slowly recovers from the pandemic shock over the next year or two (though few expect it to hit the highs of the 2003-2014 period). However, the question is whether Saudis will hit a crunch point sooner rather than later.

Saudi Arabia has low operating costs of just $3.20 a barrel (a third of the US level), according to consultancy Rystad Energy. That would “help it in a drawn-out battle for market share”, says The Economist, though the current crisis has “hit about a decade too soon for comfort”: reforms to diversify the economy away from oil are a “work in progress and the country still needs $84 a barrel to finance its budget”. The current price is around $30.

Is the US alliance at risk?

Lots of US analysts think so, yes. The two nations’ strategic partnership dates to 1945, when President Roosevelt and King Abdulaziz Ibn Saud (the current King Salman’s father) thrashed out a deal that promised US military protection in exchange for access to Saudi oil reserves and a strategic US foothold in the Middle East.

This unlikely marriage between a liberal democracy and a theocratic monarchy has survived the Saudi oil embargo of 1973, the 9/11 attacks and the Iraq war. Even today, the US has about 3,000 troops in the country and its Navy’s Fifth Fleet protects the region’s oil exports. But in the past ten years, the relationship has soured.

Most Saudi oil is now sold to China and other Asian importers, while the US energy revolution has slashed America’s reliance on Saudi supplies. By “unsheathing the oil weapon” this spring – deliberately crashing the oil price at a time of global economic collapse – the Saudis have “finally tested the patience of oil-patch Republicans”, who have long been among their staunchest supporters in Congress, says Foreign Policy.

But Trump is still a fan?

Yes, but even Donald Trump has publicly questioned America’s need to protect Saudi Arabia. MbS’s big personal investment in cultivating Trump, and his wider family, may have protected the US relationship in the short-term, but could leave him exposed due to his dwindling number of wider allies in Washington. “The only thing holding the relationship together now is Trump – he has a peculiar affinity for Saudi Arabia,” according to Bruce Riedel, a 30-year CIA veteran now at the Brookings Institution.

But that could easily change with this year’s US election; Democrat Joe Biden has dubbed Saudi Arabia a “pariah” and said he’d cut off military sales. As a result, the US and Saudis are at “a very significant and potentially existential moment in the relationship”, says Riedel. Put bluntly: “We don’t need the Saudis anymore,” and the geopolitics have fundamentally shifted.

So what will happen?

Under intense pressure from Trump, the Saudis agreed last month to end its price war with Russia and cut output. But if the recent oil crisis reflects the growing sense that global oil demand is going to peak sooner rather than later, then for Saudi Arabia – which has 75 years’ worth of oil in the ground – the “most rational approach may be to pump as hard as possible now” and go all out for market share rather than pricing power, says the FT. Yet if prices do stay low, the Saudis face further fiscal and financial pain.

After the last oil price slump in 2015, the kingdom’s reserves fell from $726bn to $500bn. In March this year, they fell by a record $27bn to around $470bn as the Covid recession began. Some analysts think that if they fall below $300bn, the riyal’s peg to the US dollar will be under threat. That peg is vital to protecting the oil revenues, since devaluation would see Saudi income plunge – and the threats to the House of Saud intensify.