House of Saud = House of Cards

By Bill Powers, Editor
Canadian Energy Viewpoint

One of the most important political and economic events of the first decade of the 21st century is the coming regime change in Saudi Arabia. Predicting the fall of governments is very similar to shorting stocks, one gathers all the fundamental facts about the situation, checks and re-checks all facts and figures, and then takes action. While it is impossible to predict the time and date of the fall of the House of Saud, a preponderance of evidence suggests it is inevitable. Let’s examine several of the myths surrounding the current state of affairs in Saudi Arabia and what the country’s downfall will mean for investors in the Canadian energy sector.

One of the greatest myths regarding Saudi Arabia is that it is a wealthy country. While it’s true that Saudi Arabia has the world s largest oil endowment and a royal family that leads the world in conspicuous consumption, the country’s financial health continues to deteriorate. The country’s severe economic problems are a result of an exploding population and a lack of economic growth outside of the oil industry. The country’s population has grown from 10 million citizens in 1980 to over 22 million today. The below quote from the US Energy Information Agency’s website succinctly describes today s economic challenges in Saudi Arabia. (The quote can be found at the following URL: http://www.eia.doe.gov/emeu/cabs/saudi.html)

Slow economic growth is not good news in a country with a rapidly increasing (and young — 50% under age 15) population, many of whom cannot find good jobs outside of the public sector (which is overstaffed and a drain on the country’s budget). Over the past two decades or so, Saudi real economic growth has fallen far behind population growth, resulting in sharply reduced real per capita incomes and higher unemployment (officially estimated at 15%, with the true level likely much higher). Per capita oil export revenues (in inflation adjusted dollars) remain far below high levels reached during the 1970s and early 1980s (around $2,563 per person in 2001, versus $23,820 in 1980, for instance). Saudi Arabia also has a high level of domestic debt (around 100% of GDP) which it hopes to pay down.

Despite many protestations by the royal family that Saudi Arabia has invested its oil money in infrastructure, defense and an economic diversification plan, the country has little to show for all of its spending. Saudi Arabia is burdened with more military equipment than it could possibly use, woefully uncompetitive state supported industries and poor infrastructure. Where did all of the money go? It was frittered away by the thousands of dependents of the royal family and stashed in overseas bank accounts.

With little exploration success since the 1960s and many of its fields showing signs of decline, Saudi Arabia is having an increasingly difficult time keeping production flat. According to energy investment banker Matt Simmons, head of Simmons and Company International, many of the country’s aging fields are showing increased water cuts. Water cuts, water produced along with crude oil that is later separated, are a sure sign that a field is headed into decline. The country’s largest field, Ghawar, now produces over 1 million barrels of water a day along with its nearly 4.5 million barrels of crude. With Ghawar accounting for 60% of the country s 7.5 million barrels per day of crude production, there is little hope Saudi Arabia can keep production flat if Ghawar continues to water out. Since Saudi Arabia cannot invest the billions of dollars needed to maintain current production and develop smaller fields, Ghawar has assured the world high oil prices are here to stay.

Another great myth about Saudi Arabia is that the country has spare production capacity. Many believe that Saudi Arabia’s spare production capacity allows them to turn on the spigots at times of high oil prices. It is extremely unlikely the country has any spare capacity. There exists little incentive to restrict production at times of high prices and low inventories. Unless human nature has changed substantially in recent months, I doubt that the cash-strapped Saudis are producing much below their production capacity.

The situation in Saudi Arabia has caught the world in somewhat of a Catch-22 in terms of oil prices. If oil prices were to fall anywhere near $20US and remain there for a significant period of time, the quality of life for the average Saudi citizen would deteriorate to such a degree that an overthrow of the royal family would be almost certain. History tells us that when a country has a sudden regime change, oil production drops precipitously. A few examples would be Iran in 1979 when oil production dropped from 6 million barrels per day to zero almost overnight, the collapse of the Soviet Union devastated oil production in Russia and more recently the regime change in Iraq halted all oil production in that country.

Some of the best insights into the current state of affairs of a country can be gleaned from those who have gained first hand knowledge of the country through travel. World-renowned investor and author Jim Rogers, who recently completed an outstanding book titled Adventure Capitalist, had the following to say about the country after his visit to Saudi Arabia: (For more information about Jim and his travels please see www.jimrogers.com)

By the 1990 s the Saudis were spending much more money than they had, and the nation’s debt began to skyrocket. Today, despite its considerable assets, the country is one of the more indebted countries in the world. If the price of oil drops, the government will ultimately go bankrupt. It will no longer be able to support all of its princes much less its mullahs. Only if oil prices remain high will Saudi Arabia be able to whether the storm perhaps. Jim Rogers, Adventure Capitalist,” p. 225

The coming fall of Saudi Arabia is going to have a huge impact on investors in the Canadian energy sector. The news that the royal family has been finally thrown out will almost certainly send oil prices skyrocketing. The heights to which oil prices would climb is anybody’s guess. What is more important is that prices will climb to unheard of levels almost overnight. As I mentioned earlier, predicting regime change in a country is like shorting stocks, do your research, take your position and wait for the wheels to come off. While it might seem like an eternity for your thesis to be proven, its fruition is often well worth the wait. I believe we are already seeing signs that the House of Saud is in trouble. With the recent bombing of an American compound and the State Department s temporary closing of the US embassy in Riyadh, it is clear that we are at the beginning of the end of the House of Saud.

Greenspan on Gas

On June 10, 2003, Federal Reserve Chairman Alan Greenspan took the unusual step of speaking to the House Energy and Commerce Committee on the natural gas crisis in the United States. Greenspan, obviously tired from his long days spent devaluing the US dollar, has not had time to update his spreadsheet as evidenced by his below comment:

In summary, the long-term equilibrium price for natural gas in the United States has risen persistently during the past six years from approximately $2 per million Btu to more than $4.50. The perceived tightening of long-term demand-supply balances is beginning to price some industrial demand out of the market. It is not clear whether these losses are temporary, pending a fall in price, or permanent.

It should be quite clear that the recent losses in demand are permanent since there exists almost no chance of the US returning to the days of cheap natural gas. The severe supply/demand imbalances that exist today ensure high prices are here to stay. While I applaud Chairman Greenspan s efforts to bring attention to the seriousness of the natural gas crisis, I also wonder what took him so long. After having failed to recognize the stock market bubble and raise margin requirements, Greenspan thinks he is getting out front on the natural gas issue. He is not. His speech before Congress was merely stating the obvious.

Canada’s (US) Nat. Gas Problems

A sea change is quietly occurring in the North American natural gas market. For the first time in 16 years, Canada is going to experience a significant natural gas production decline in the range of 3-4%. I cannot overstate the impact of Canada s declining production on North America s natural gas market. It is huge. Here is why.

Canada has increased its exports to the United States five fold over the last fifteen years thus masking the real supply/demand imbalance in the US. However this trend is coming to an end. With declining natural gas production in the US and Canada and increasing US exports to Mexico, the gap between demand and supply in the US must be made up through either demand destruction or increased imports of liquefied natural gas (LNG). Both of these supply solutions require high natural gas prices for an extended period of time.

In early June, the Alberta Energy and Utilities Board (AEUB) handed down an order to shutter 900 natural gas wells in northern Alberta on August 1st to protect the bitumen (the raw material used to produce synthetic crude oil) that is surrounding the gas reservoirs. Needless to say, the decision did not sit well with the companies who operate those wells. Current production from the effected area is 90 billion cubic feet per year (250 million cubic feet per day (mmcf/d)) or 2% of Alberta s total gas production. While it is unclear whether the AEUB decision will get overturned in court, it is certain that the shutdown of 900 wells at time of falling production will further strain the North American supply situation.

© 2003 Bill Powers, Editor
Canadian Energy Viewpoint

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