by Ambrose Evans-Pritchard
October 1, 2016

Saudi Arabia has injected $5.3bn of liquidity into the banking system to stave off a financial crunch as the oil slump drags on and capital continues to leak out the country.  This just as the US Congress overrides Obama’s veto allowing 9/11 families to sue the Kingdom.

Three-month interbank offered rates in Riyadh – the stress gauge watched by traders – have reached the highest since the Lehman crisis, ratcheting up 145 basis points over the last year.

The M3 money supply has contracted by 8% in twelve months.  The loan-to-deposit ratio has already blown through the government’s safety ceiling of 90%, touching an all-time high.

“Deposits are falling and liquidity has been tightening for month after month,” says Patrick Dennis from Oxford Economics.

Mr. Dennis said the authorities have tapped the local bond markets for $42bn since mid-2015 to slow the depletion of foreign reserves, but this has led to a squeeze on the financial system.

While there is no immediate crisis, Saudi Arabia faces a difficult balancing act and may struggle to maintain its fixed exchange rate with the US dollar.  The currency peg is deemed the anchor of stability by the Kingdom, but it is also the cause of slow economic asphyxiation.  It contrasts with the ruble flexibility enjoyed by Russia as it rolls with the punches.

Foreign exchange reserves have slipped to $550bn from a peak of $746bn as the regime sells off the family silver to pay the bills.  The International Monetary Fund says the budget deficit reached 15.9% of GDP last year and will be an estimated 13% this year.

The reserve loss automatically tightens monetary policy and can be painful.  Fitch Ratings said there may have to be a state bail-out of construction firms sinking into deeper trouble.  The Bin Laden Group is laying off 77,000 workers.

There are also limits as to how far the reserve depletion can safely go.  Experts say the market psychology risks snapping if they fall much below $400bn, a point well understood in Riyadh.  The government has turned instead to the global capital markets for fresh finance.

Prince Muhammad bin Salman, the de facto ruler, is pushing through radical plans to break dependency on oil and establish a modern industrial base in everything from car plants to, petrochemicals, and weapons production.

It is unclear whether the Kingdom can pull off the massive cuts to the state welfare apparatus needed to clean up the public accounts.  Cradle-to-grave social spending is the social contract that has kept the House of Saud in power.

Fitch says the budget plan includes cuts of $53bn in water and electricity subsidies, and $128bn of cuts in state salaries by 2020.  “The economic impact of such a fiscal tightening would be so severe that the fiscal objectives will probably have to be scaled down,” it said.

The agency said the putative sale of a 5% stake of the state oil giant Aramco for $100bn is fraught with so many problems that it cannot include the sums in its credit rating calculus.

This week’s liquidity boost comes as OPEC oil ministers and their Russian counterparts meet in Algiers, with prospects of a meaningful output freeze receding after weeks of chatter.  Brent crude is still hovering near $47 a barrel, far below levels needed to stop the fiscal hemorrhage for the cartel’s high-spending states.

Deep divisions between Saudi Arabia and Iran – the two regional powers competing for Mid-East dominance – continue to poison OPEC talks.  The Saudis have hinted at a return to its January output level, implying a cut of 500,000 barrels a day (b/d).  But they will not act without a commitment from Iran.

The Iranians insist that they will not freeze production until they reach pre-sanctions levels, but the devil is in the details.  They seem to be moving the goal posts in order to scupper an accord.  Michael Cohen from Barclays says Tehran has shifted to a new definition based on market share rather that the volume of exports, and it is still 300,000 b/d short on this metric.

Francisco Blanch from Bank of America says the two-year oil war is all but over.  OPEC has achieved its key objective by flooding the market, though it has taken much longer than expected and it taken a severe economic toll.

The cartel has raised its global share from 33% to 35% over the last seven quarters, choking output from high-cost fields in the rest of the world.  Natural depletion rates will drive down non-OPEC production by an estimated 1.1m b/d this year.

Mr. Blanch said it no longer makes sense for the Saudis to push for further share in a grueling war of attrition.  They will make more money – and avoid mounting financial stress – over the next fifteen years by capping capacity and letting price float upward.

The risk to this strategy is a surge of supply over coming months from Libya, Nigeria, Iraq, and Kazakhstan, delaying the long-awaited rebalancing until deep into 2017, or even into 2018.  Over 3m b/d has been knocked out of the global market by civil wars or disruptions, near 25-year highs, and this may have disguised the scale of crude glut.

What is clear is that OPEC has failed to knock out the US shale industry.  The US rig count has risen by 107 to 511 since May.  Shale drillers have slashed costs and learned how to survive in a price band from $40 to $50.  They are flourishing in the Permian Basin of West Texas.

There is almost nothing OPEC and Russia can do about this irksome reality.  The upstart frackers have fought them to a standstill.

 

— Ambrose Evans-Pritchard is the International Business Editor of the London Telegraph. This article originally appeared at To The Point News.