(Bloomberg Opinion) -- On Iran, America has delivered for Saudi Arabia. Yet, unlike last year, Riyadh will take a trust-but-verify approach on how strictly Washington enforces sanctions once waivers expire on May 2. We are looking at a tight oil market this summer and a volatile mix of contradictory forces building as we head toward 2020 — an election year, in case you didn’t know.
Recall that, almost a year ago, President Donald Trump announced he was pulling out of the nuclear deal struck with Tehran in 2015. That fueled a rally in oil prices ahead of November’s midterm elections and, consequently, a string of tweets from the White House calling on the likes of Saudi Arabia to step up and calm nerves with more oil. The implicit bargain here was that the U.S. was turning the screws on Saudi Arabia’s archenemy, so Saudi Arabia needed to do its share of the lifting. Which it did: The country added more than a million barrels a day of extra crude-oil output between May and November.
Then Riyadh ran into a problem: those unreliable and unruly Americans. Trump was rightly concerned about what higher pump prices mean for longer-driving, lower-earning voters in red states (see this). So he effectively reneged on the deal by issuing the sanctions waivers he now plans to ditch. Meanwhile, the oil-price rally led U.S. frackers to do a little reneging of their own, busting through capex budgets to deliver a surge in production — and an all-too-predictable plunge in prices to close out the year.
Hence, we shouldn’t expect Saudi Arabia to take Monday morning’s announcement as a signal to embark on another proactive supply surge. In theory, the kingdom can add roughly another 500,000 barrels a day without breaching its (reset) target agreed with OPEC and its partners in December. That would equate to perhaps half of the Iranian exports now seemingly at risk of coming off the market. But after 2018’s head-fake, it seems more likely Saudi Arabia will wait and see what happens with actual flows, inventories and pricing before making a significant move. Energy Minister Khalid Al-Falih’s statement on Monday that Saudi Arabia is “closely monitoring” the situation and will coordinate with others to ensure “the global oil market does not go out of balance” speaks to such an approach.
Such caution would come at a critical juncture. The risk of a sudden drop in Libyan oil production — 1.1 million barrels a day in March versus about 600,000 a year before — has increased amid renewed violence. Venezuela’s oil output has plunged further this year, and the country also faces a potential tightening of U.S. sanctions within a week. And we are roughly a month away from the start of the traditional seasonal upswing in U.S. gasoline demand. Meanwhile, later this year, new regulations on marine fuel could lead to further disruption and upward pressure on oil prices. Brent crude jumped another 3 percent on Monday morning, and is up 37 percent so far this year.
Saudi Arabia has little incentive to arrest that for now. As analysts at IHS Markit pointed out in a report earlier this month, efforts to support prices since early 2017 have mitigated deficits and arrested the decline in the country’s foreign-exchange reserves, but not replenished them. Fighting wars and easing the inevitable frictions generated by Crown Prince Mohammed Bin Salman’s efforts to reform the economy are expensive, and the damage done to foreign investment inflows by the Khashoggi affair haven’t helped. As the prince’s Ritz-Carlton fundraising round, along with Saudi Arabian Oil Co.’s giant bond offering and deal to buy the state’s stake in Saudi Basic Industries Corp., show, money may not be exactly tight but every extra dollar is welcome.
Yet it’s a fine line Saudi Arabia is walking, and one that will get finer still as the year progresses. There is, of course, demand to consider, and gasoline consumption isn’t looking strong as it is.
And then there’s the president. Trump expressed faith in his ally via the usual method Monday morning, tweeting “Saudi Arabia and others in OPEC will more than make up the Oil Flow difference” resulting from “Full Sanctions.” After 2018’s switcheroo, though, his faith will be tested; when it comes to this topic, he doth tweet too much. Yet if gasoline prices spike this summer — and they’re already close to $3 a gallon on average — Trump’s anxiety about the 2020 campaign will only increase, as will the potential for him to intervene in the market.
The other Americans Saudi Arabia must regard with a wary eye are mostly in Texas. A geopolitical premium on oil represents a windfall for frackers. The big question is whether they would respond to higher prices in 2019 the way they did in 2018. There are good reasons to think they will be more cautious this time around. Investors, including activists, have made it clear they aren’t impressed with oil rallies being diverted into more wells rather than their own pockets. This should temper the E&P sector’s natural instincts.
That said, these are natural instincts we’re talking about. Monday morning’s oil rally lifted many E&P stocks, particularly those at the riskier end of the spectrum, such as Denbury Resources Inc., California Resources Corp. and Chesapeake Energy Corp. Meanwhile, the yearly Nymex oil swap for 2020 has risen to $61 and change — almost exactly where the 2019 swap was this time last year. If those longer-dated prices keep rising, frackers will take advantage to lock them in and set higher output targets in 2020.
No Saudi Arabian cavalry will be riding ahead of time to prevent higher oil prices, and Monday’s news carries rewards in terms of income and geopolitics. As the year wears on, though, Saudi Arabia’s essential dilemma will reassert itself. It is an oil-dependent economy in a bad neighborhood that must maximize its revenue while placating a mercurial ally — which now happens to be the biggest source of rival marginal oil supply.
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Liam Denning is a Bloomberg Opinion columnist covering energy, mining and commodities. He previously was editor of the Wall Street Journal's Heard on the Street column and wrote for the Financial Times' Lex column. He was also an investment banker.
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