The Last Temptation of Saudi Arabia

If you’re seeking signs of inflation, look no further than the rapid escalation in Saudi Arabia’s oil-price targets.

Barely a week after Bloomberg News reported Saudi officials pushing to get oil up to $80 a barrel, some are now talking of $100, according to a report from Reuters. It’s just talk, of course. And it’s usually couched in terms of encouraging stability and investment and whatnot. Still, Saudi Arabia seems in no hurry to call off OPEC’s supply cuts, despite the glut in OECD oil inventories having largely drained away.

But inventories are just a proxy for what really matters to petro-states: revenue. On top of this, Riyadh has an ambitious reform program (along with a war) to fund and an IPO of its national oil company, Saudi Arabian Oil Co., or Saudi Aramco, to get done. Triple-digit oil would appear to grease both.

In certain respects, it would. Higher prices mean more upfront revenue, even when selling fewer barrels. For example, in summary financial statements for Aramco I reviewed recently, the company’s revenue doubled between the first half of 2016 and the first half of 2017. Saudi Arabia’s crude oil production declined by 3.5 percent, but average Brent crude oil prices jumped 28 percent, partly because of the supply cuts announced in late 2016.

That, in turn, should bolster Aramco’s valuation. In my latest stab at this, I estimated the company could be worth more than $1.5 trillion if investors demand a 7 percent free cash flow yield and you assume an oil price of $100 a barrel — not the $2 trillion Saudi Arabia says it wants, but closer to that number than $1 trillion.

Raise You A Hundred

Assume an oil price of $100 a barrel, and a 7 percent yield, and Saudi Aramco’s implied valuation rises above $1.5 trillion

Source: Bloomberg News, Bloomberg Gadfly analysis

Note: Assumes crude oil production of 11 million barrels a day; downstream cash flow per barrel of $3; realized crude oil price at 91 percent of Brent.

This is where the problem starts, however. The $100 oil price assumption in that valuation is a long-term one. If you launch an oil-major IPO amid triple-digit prices, then animal spirits may prevail. But a serious valuation would involve taking a view on prices not just today, but years into the future — especially when that oil major sits on a notional six decades’ worth of proved reserves.

Recent history suggests $100 oil has a limited shelf life. To date, Brent has averaged about $100 in just five years 1 :

Those Were The Days

Brent has averaged close to or more than $100 a barrel in just five years: 2008 and the four years prior to the recent crash

Source: Bloomberg

Note: Figure for 2018 is year-to-date as of April 18.

The 2008 spike put the seal on the U.S. recession and accelerated a decline in domestic gasoline consumption that began the year before. Meanwhile, the second bout of triple-digit prices, resulting partly from the turmoil of the Arab Spring, fed the U.S. shale boom that helped spark the subsequent crash.

Think of what it has taken to get to today’s level of roughly $70. Saudi Arabia has had to cozy up to Russia (currently allied with Riyadh’s arch-enemy Iran in Syria); the Iran nuclear deal appears to be on death row; and economic collapse has led to Venezuela “involuntarily” cutting way more supply than it agreed to cut.

Meanwhile, $70 oil has sparked a revival in non-OPEC supply, especially U.S. shale production. Triple-digit oil would supercharge the latter, especially, raising the longer-term cost for petro-states in terms of market share (see this).

The other side of the equation is demand. This is strong today, helped by economic growth and the low energy prices of recent years.

Now consider what $100 oil might mean for this. U.S. gasoline demand finally regained its 2007 peak only in late 2016 2 — helped in large part by the price crash.

Having bottomed out at less than $1.90 a gallon in February 2016, the national average pump price is now around $2.86. Of that, 47 cents goes to your friendly state and federal tax collectors, according to the Energy Information Administration. Another 74 cents goes to refiners, shippers and marketers, using average data for the 12 months through February. The residual, $1.65, is the cost of crude oil: an implied $69.50 a barrel, around where oil trades today.

Plug in $100 a barrel and, all else equal, it equates to about $3.60 a gallon at the pump (and probably north of $4.50 in California). That would be almost a dollar higher than today and the highest level since that unsuspecting summer of 2014:

Those Weren’t The Days

A gasoline price of $3.59 a gallon would take us back to the summer of 2014, just before the oil crash

Source: Energy Information Administration

The recovery in U.S. gasoline demand has mostly flattened out since the fall of 2016, which coincides with when pump prices began rising again.

While U.S. economic growth is strong, we are late in the cycle of one of the longest economic expansions on record, at more than 100 months. The unemployment rate is low already, and the Federal Reserve is raising interest rates, albeit cautiously.

Hiking oil and gasoline prices in that environment would provide a short-term windfall but ultimately curb demand (not just in the U.S., either). And unlike a decade ago, internal combustion engines face a credible and expanding competitive threat from electric and hybrid vehicles, whose manufacturers would relish $3-plus gasoline.

Tempting as it is for Saudi Arabia to push for further gains, it risks repeating the mistakes of the past, undermining demand and ceding market share to rivals. It is perhaps the curse of petro-states that, even as they talk the language of stability and long-term planning, immediate appetites are ever the priority.

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