Saudi Arabia’s Secret Oil Deals

Sean Brodrick By Sean Brodrick,

Oil & Gas

The world knows that Saudi Arabia and the rest of OPEC came to a deal in Algiers about capping production. The deal is deliberately vague and already subject to sniping and increases by member states. It’s supposed to be finalized in November.

That’s the public deal. Now’s here’s what the world doesn’t know: Saudi Arabia has secret deals – yeah, plural – going on in the background.

First, let’s look at the public agreement.

OPEC’s 14 members – who control about one-third of the world’s oil production – agreed to set a collective production target ranging between 32.5 million and 33 million barrels per day. It’s the first production target in more than a year.

Now, since OPEC members pumped 33.24 million bpd in August, that’s a cutback. And a substantial one. Between 240,000 and 740,000 bpd.

The rollback could be accomplished by going to pre-summer levels. Before the summer surge, OPEC produced 32.44 million bpd.

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OPEC, led by Saudi Arabia, hopes that an output freeze combined with continued global oil demand growth will eat away at the oil surplus we’ve had since 2014.

But within OPEC, there are three big sticking points to the freeze idea. They’re called Iran, Libya and Nigeria. All three want to ramp up production.

And there’s a big sticking point outside OPEC called Russia. The big bad bear is producing at record levels.

Finally, there is the wild card of U.S. shale production. U.S. domestic producers have added more than 100 drilling rigs since the end of May.

The Saudis Are Desperate

For Saudi Arabia to come to the table for a deal meant the proud desert kingdom had to collectively eat the words of Deputy Crown Prince (and likely future king) Mohammed bin Salman. Just this past April, he said, “We don’t care about oil prices – $30 or $70, they are all the same to us.”

Saudi Arabia thought the fact that it was the low-cost producer meant it could outlast anybody. But it is paying for an expensive war in Yemen against rebels backed by Iran. Plus, add in generous public subsidies and fat salaries to bureaucrats.

The result: The kingdom’s foreign reserves declined $182 billion from where they were in August 2014. That’s a 24% drop.

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Reserves declined by $53 billion in the first seven months of 2016 alone! Yikes!

To deal with that, the government slashed the salaries of its top officials and scaled back perks for state employees. It cut other subsidies for electricity and water prices as well. Still, it’s hurting. And even by OPEC’s own estimates, the current oil glut will last well into 2017.

Secret Deal

So in September, Saudi Arabia offered OPEC a secret deal. Saudi Arabia, the “central bank of oil,” said it would cut production by 400,000 bpd. That would put it at around 10.3 million bpd.

Under this deal, Iran, which is still recovering from U.S. sanctions, would hold output steady at 3.6 million bpd.

But that deal hit the rocks. Mainly a big rock named Iran.

The Iranians hate the Saudis with the intensity of a burning desert sun. And Iran’s oil minister, Bijan Zanganeh, publicly rejected a limit. Iran has set its sights on producing 4.2 million bpd.

With his secret plan rejected, Saudi Energy Minister Khalid al-Falih came back with another offer: Iran, despite being Saudi Arabia’s biggest rival, would essentially be exempt from production limits. The rest of the cuts would be absorbed by Saudi Arabia and other big OPEC producers.

This shows just how desperate Saudi Arabia really is. Iran is holding the cards, so Saudi Arabia folded.

And that’s the deal that is currently being worked through. Who exactly will cut? What about Nigeria and Libya, which also want to raise production? This is all supposed to be worked out by November.

Sure it is. I’ll bet you C-notes to camel feed this “deal” doesn’t work out as planned. After all, Russia and OPEC previously agreed to a production freeze in February, and we can all see how well that worked out.

I guess the proof will be in the petro-pudding when the next OPEC meeting rolls around on November 30 in Vienna.

What You Can Do

I wrote about OPEC’s oil conundrum on September 17. We see how that was resolved.

In that issue, I recommended the SPDR S&P Oil & Gas Exploration & Production ETF (NYSE: XOP). Since then, the fund is up about 6%.

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Not a bad move for a short period of time. And that’s about seven times the performance of the S&P 500. I think the fund is still a great buy.

To be sure, investments zig and zag. You shouldn’t be thinking about the short-term here. Like the Saudis, you should have your eye on the future.

I think select oil stocks could do very well longer term. And the U.S. dollar may be in for a day of reckoning.

Good investing,

Sean