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ModernDiplomacy.eu: The Great Saudi Bet

Posted by: Berhane Habtemariam

Date: Friday, 29 December 2017

The Great Saudi Bet

Osama Rizvi

By Osama Rizvi

 

The Saudi decision to not to cut production back in 2014 was a ham-fisted strategy. It went askew. Besides the market share, the Kingdom of Saudi Arabia (hereinafter, KSA) put their title of ‘swing producer” in jeopardy as well(see my article here). On the other hand Shale producers in US taking advantage of the technological developmentswere successful in eating up KSA’s market share. Not only this, the Vienna accord in November 2016, according to which most of the OPEC and NOPEC producers cut their production by 1.8 mbpd, and the resultant increase in price, led US to increase its own production to an all-time high of 9.66 mbpd.

Now, as if to make amends, and relying on the principle of “it is never too late” (rightly so) the Crown Prince, known in the West as Mr. Everything, Muhammad Bin Salman (MbS) has embarked on an ambitious plan: to wean the Kingdom off oil. How? Through the Initial Public Offering (IPO) of what is estimated to be a $2 trillion company, Aramco. But there road ahead is bumpy. The stakes are extremely high. If the scion fails there can be serious repercussions for the Kingdom. The issues are galore.

A  pertinent question: What if KSA ends up selling its ‘crown jewels’, but fails to diversify its economy yet again? There is a new way of thinking, which Muhammad Bin Salman has peddled. He says oil should be taken as an investment, “nothing more, and nothing less.”However, MbS try to elude the Catch-22 situation the Kingdom is embroiled in. This makes oil more than an investment.

Price tri-lemma—Once the IPO is completed. Saudi Arabia according to plan will move towards diversification. Which means oil, at least in the kingdom, will lose its value, demand. This in turn signals negative consequences for the investors!

Also, Saudi’s want high oil prices for two reasons—to breakeven their budget and for a lucrative IPO. But US shale is a hiatus. The vicious circle seems unresolvable, rebarbative. The rising prices, as a result of production cuts,will help Shale production to increase subsequently increasing the supply glut. This in turn will put downward pressure on oil prices, affecting the IPO.Demand, that too, very strong and sustainable, is the only way to rescue KSA unless the grinding and battering of this price corollary leaves them exhausted. There is another threatthat the linchpin of the Vienna deal, Russia, now wants an exit. Why? Because oil executives in Russia, that met a month ago, do not like the idea of further extension as this results in a growing US market share. Russia cannot tolerate this and has already some tricks up their sleeves.Their tax structure along with the growing exports of wheat and other commodities makes Russians to better deal with low oil prices than other countries. They reportedly have lower energy extraction costs as well. The OPEC and NOPEC countries that agreed for an extension on 30th November 2017 will meet again in June 2018. According to observers, this ‘review meeting’ can be an ‘exit strategy’ especially for the Russians, as they have been looking for a wicket gate. Russian economy has proven to be resilient even in the face of a double-whammy (lower oil prices, Western sanctions).

The case for United States in the equation is evidently. They want higher oil prices. However, not so higher that it becomes feasible for Saudi’s or others (Russians) to go on a pumping frenzy in turn glutting the markets and eating up the share of US shale which they have built, with so much effort, in recent years. IEA in their latest World Energy Outlook 2017 claims that U.S. will take over KSA as the swing producer. Their future prospects are rosy. They have to be cautious.

The long term quandaries—If the Saudi’s want to realize their dream then this act of passing the buck (of oil and swing producer) is significant, necessary even. But if the plan fails they can be left in lurch. Everything depends on the IPO and then the execution of the plan. Observers are concerned with the IPO and its effect on the region and Kingdom itself.

The concern for exposure to legal risks is relevant. It can also affect the sovereignty of the state by wresting the power from the state to adjust taxes.  The ownership of the reserves is another question. According to experts, the type of agreement between KSA and the operator will be a concession agreement. This means that the holder of the concession will have the full right to exploit and monetize the underground reserves “in return for payment of taxes and royalties to the government”. In simple words, through the IPO, Aramco will offer investors an ownership in the concession.

The valuation of the company is itself not confirmed. Estimates about $2 trillion might be exaggerated. According to one calculation, if the old system of a royalty (20%) and taxes (85%),is maintained the total valuation will be far less than the touted $2trillion.Even if the oil price is kept at $70 and production at 10mbpd, with above taxes and royalty, the total valuation will still make only $251 billion. Recent measures which had cut the tax rate to 50% will only stretch it to $419 billion. According to Wood Mackenzie, Aramco’s valuation is about $400 billion.

How can one forget social discontent? As the government tries to wend towards a more diversified and modernize economy the masses, which were in wont of benevolent government largesse, might have to face hardships. The long holidays, low taxes, and generous government programs have to be curtailed. Will the society accept the economic overhauling?

It is instructive to note here that financial diversification and economic diversification are two different things. Economic diversification relates to changes in the economic base e.g., creation of jobs, whereas financial diversification caters to diversifying the sources of income that doesn’t necessarily translate into job creation.Most of the investment is expected to be in the foreign market as the current economic depth of the Kingdom is not enough to absorb the investment. The recent deal between Softbank and PIF is indicative that most of the investments will be towards the tech sector outside the kingdom having a limited impact on the economic infrastructure at home.

As the Kingdom welcomes 2018 this will be the most pressing issue. The above mentioned problems are not the only ones. One thing should be vivid by now. The path is riddled with problems. The IPO is directly linked with the future of Saudi economy. The ante is high. MbS’ ambition confronts the conventional mindset and the reality of international political economy. This is an ambitious plan but worth taking risk for.

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