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Mon 12 Oct 2015 02:06 PM

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Saudi Arabia is playing 'oil poker' with the world but will the gamble pay off?

If other major oil players such as Russia and North America maintain or increase their oil production, prices can stay low longer than Saudi Arabia anticipated, which will decrease the kingdom’s reserves further and faster

Saudi Arabia is playing 'oil poker' with the world but will the gamble pay off?

In 2014, the world’s greatest oil producers started an ‘oil poker’ game, refereed by the major oil importers, for one of the largest payouts on the planet. All gamblers play to win the lion’s share of the market and the reward that goes along with it. ‘Oil poker’ is an event that brings together the biggest oil producers in the world.

In the chip-leading position Saudi Arabia, which possesses 18 percent of the world’s proven petroleum reserves, sits with its allies including UAE, Kuwait and Qatar. In the second chip position, Russia, one of the largest non-OPEC oil producers, sits with Iran and Iraq. Finally, in the third chip position, the OPEC and other oil producers are trying to secure their positions and stay in the game.

In the last quarter of 2014, amidst an oil oversupply, Saudi Arabia thought that the growth in oil production outside OPEC brought inefficiencies, which dropped oil prices, in the global market. Saudi officials bet that abandoning the country’s role as the guarantor of existing oil prices will allow free market forces to set low prices in the short term, but reduce investments in the long term, which, eventually, will increase prices.

The Saudi economy depends heavily on the oil and gas sector, which accounts for about 50 percent of GDP. Oil revenues account for roughly 90 percent of the government’s total revenue and its exports account for about 85 percent of the total export earnings. Nevertheless, Saudi officials had confidence in the country’s financial capabilities to withstand oil prices as low as $80 per barrel for a year or two.

Obviously, Saudi Arabia were short in hand. The average price of Brent fell below $80 per barrel in November 2014, to $62.34 per barrel in December 2014, to below $50 per barrel in February 2015. Prices rebounded to $60 per barrel, for a few months, before continuing to fall till date. To mitigate the revenue shortfall, Saudi Arabia ramped up output from 9.6 million barrels a day in the fourth quarter of 2014 to 10.5 million barrels a day in the second quarter of 2015, but the budget deficit was bigger than the revenue from increased production.

In December 2014, the Saudi government approved spending $229bn in 2015, resulting in $39bn deficit (5 percent of GDP). In mid-2015, the IMF estimated the budget deficit will be, approximately, 20 percent of Saudi Arabia’s GDP and that GDP growth will fall from 3.6 percent in 2014, to 3.3 percent in 2015, to 2.7 percent in 2016.

In ‘oil poker’, the number of chips is limited to the global demand for oil, which is volatile. At the time Saudi Arabia played its hand, the demand for oil was stagnant in major export markets and the growth in demand was narrow and limited to Asia, particularly China. All gamblers were incentivised to undercut each other by reducing their selling prices or absorbing shipping costs and/or delivery risks and creating new revenue streams. The UAE ended fuel subsidies and Saudi Arabia floated a $4bn domestic bond.

Can Saudi Arabia maintain the composure they displayed at the beginning of the round? I doubt it can for long. It doesn’t have spare production capacity and can’t increase it substantially, in a reasonable timeframe, to make up the revenue shortfall. Low oil prices and government’s expenditure in national and domestic security needs, reduced the government’s capabilities to fund new investments. If Russia, Iraq, Iran and North America maintain or increase their oil productions, prices can stay low longer than Saudi Arabia anticipated, which will decrease its reserves further and faster.

Can Saudi Arabia increase the oil price, durably? It’s reluctant to admit it, but I doubt it can. The daily output of Saudi Arabia and its allies is roughly equal to the daily output of countries with which it is in conflict directly or indirectly. Hence, they have an incentive to take advantage of Saudi’s unilateral concession. Nevertheless, matching the Saudi decrease barrel for barrel could increase oil prices and revenue for all.

This is a classic application for The Game Theory.

Ahmed Sharawy is the Senior Risk Management Specialist.

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Mohamed Ozoun 4 years ago

Good article and intresting application of the game thery from .. let's watch what gonna happen