Saudi Oil Prices and ISIS

Global media is focusing on two issues at the moment; the French terrorist attacks and Saudi Arabia’s interventions that have led to a collapse of oil prices. Investors need to spend more time studying global politics to understand that the two events are linked.

The big question facing investors is whether the move by Saudi Arabia to pump out oil is a short or long term move. The answer to this question will have fundamental impacts on the global economy.

Answering this question requires an understanding of the current state of the kingdom of Saudi Arabia.

Saudi Arabia has maintained its kingdom by providing fiscal support for its population and maintaining a strict Islamic culture. The kingdom’s aging monarch King Abdullah is ill, and despite arrangements for succession, the Kingdom is subject to factional power plays with some factions actively interested in disrupting transfer of power. On Saudi Arabia’s borders lies ISIS who is working to achieve an Islamic State in the region. In the last week militants operating from Iraq attacked a Saudi border post killing Brigadier General Awdah al-Balawi who was responsible for Saudi’s northern borders.

Saudi Arabia is facing a budget deficit of around US $39 billion which it will dip into its reserves to fund. Saudi Arabia’s fiscal position is driven by the high proportion of the population that works for the government, which the IMF estimates is around two-thirds of the population. With the emergence of ISIS the Saudi Government cannot afford to reduce spending at this time, as this may in itself lead to civil disruption in the Kingdom.

The question for Saudi is why would they willingly reduce oil prices when the Kingdom needs the revenues for its own budget. The answer is that ISIS represents a greater threat. ISIS was estimated to have been making $3 million a day in August 2014 from captured oil in Syria and Iraq before oil price declines and attacks on ISIS controlled facilities.

The question as to how much of a threat ISIS represents to the Saudi Kingdom is difficult to assess from an outsiders perspective. The killing of Brigadier General Awdah al-Balawi suggests that ISIS may have insider information. What is certain is that with attacks on its senior leaders it is likely that the Saudi royal family is more concerned with ISIS, which would like to replace the Kingdom with a caliphate, than US shale oil producers.

Whether oil prices stay low is likely to be impacted by the success of ISIS. What Saudi cannot afford to do is to give ISIS oil revenues that would enable it to consolidate its power. Low prices are likely to persist so long as ISIS is in control of oil facilities and remains a threat to the Saudi Kingdom. Saudi Arabia has a strong incentive to run its own oil production at full tilt so as to maximise the revenue that it extracts. The US is unlikely to complain as it understands the sensitive situation in the region.

For investors, understanding the future direction of oil prices, will requires an understanding of shifting Middle East sands.

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