Oil’s continued plunge is vying with China for the early financial headlines in 2016.
Yet many U.S. investors are missing the most important aspect of oil’s collapse: the dramatic effect oil’s falling prices are having on Saudi Arabia.
In November 2015, I speculated that the Saudis may have to devalue their currency, the riyal, versus the U.S. dollar for the first time since 1986.
Today my prediction looks prescient, as this supposed long-shot, black swan event is now becoming a distinct possibility.
Saudi Arabia’s Gigantic Budget Problem
The low price of oil – caused in part by the Saudis’ market share war – has blown a hole in the country’s budget.
Saudi Arabia announced at the end of 2015 that it ran a record budget deficit of $98 billion. That’s 15% of the country’s gross domestic product. To stem the bleeding, the Saudi government slashed its 2016 budget by 14%, and increased domestic fuel prices by two-thirds, even though it’s still only around $0.20 per gallon.
Meanwhile, the Saudis have also taken other measures to right the ship.
A few months ago, their sovereign wealth fund began repatriating funds from overseas money managers. This served to drain liquidity from global financial markets and hurt stocks. The Kingdom also sold sovereign bonds for the first time since 2007, and plans to sell at least $32 billion in sovereign bonds in 2016.
Finally, the Saudi Arabia announced that parts of its crown jewel – Saudi Aramco – will be sold in an IPO. Of all the recent moves made by the Kingdom, this is surely the most telling.
Saudi Aramco dwarfs any other oil company and will fetch a pretty penny. But it would’ve gotten a lot more if the sale had occurred when oil prices were high. That’s why I think the juiciest parts will not be part of this IPO.
Thinking the Unthinkable?
Even selling part of Saudi Aramco is unlikely to get the country out of the hole it has dug itself into with the oil share war. Bank of America (N:BAC) estimates that $30-per-barrel oil will balloon the Saudi budget deficit to nearly $180 billion this year.
Thus, the smart money is betting that the Saudis will break the riyal-dollar peg, which has been set at 3.75 riyal to the dollar since 1986. The 12-month forward contracts on the riyal-dollar rate are trading at a 17-year high.
The Saudis have begun blowing through their massive reserves in trying to defend the peg. Sounds a lot like the Chinese problem, doesn’t it?
Reserves have declined from a peak of $746 billion in August 2014 to $635.2 billion at the end of November 2015.
Even the former head of asset management at the Saudi central bank, Khalid Alsweilem, thinks the peg will be history. He told the U.K.’s Telegraph, “If the reserves keep going down as they are now, they will not be able to keep the peg.”
If the Saudis opt to not devalue the riyal, they’ll have to cut oil production to get the price back up. I believe they’re too far down the path of trying to eliminate their competition to suddenly reverse course, and end up saving the U.S. shale producers from bankruptcy.
Any devaluation would have global implications and upset stock markets again.
Alsweilem said, “The consequences will be dramatic.” After all, the dollar peg has been the anchor of Saudi economic policy and global credibility for the past three decades. A change would surely stir up turmoil within the royal family, and give a boost to those opposed to the regime (such as the Iranians).
Let’s just hope the Saudis can control any devaluation and this doesn’t spiral out of control.
Good investing,
by Tim Maverick