Which Way Will Saudi Arabia Swing?

05/01/2015 04:53 am ET | Updated May 01, 2016

Each week seems to bring new twists in Middle Eastern geopolitics, with shockwaves on the energy market and in particular oil prices. Recently, it was the threat of a blockade of the strategic strait of Bab Al Mandab between Yemen and Djibouti with the potential to disrupt global oil supplies, this week it is the reshuffle in the Saudi Royal hierarchy.

Oil prices by their nature are highly volatile and respond to speculative impulse only to readjust to short-medium term norms when prevailing events stabilize. A scenario noticed by the former Saudi oil minister Ahmed Zeki Yamani when he was quoted as stating: "Political dynamics may have a short-term impact on oil markets, but over the long term, prices will reflect supply and demand as the market is demand driven." It was not long ago when King Abdulla passed away that prices increased for a couple of days before they declined again.

The recent reshuffle in Saudi Arabia heralds a major break with established tradition and watershed in the trends of the oil industry. For more than thirty years Saudi Arabia, being the world's largest producer and exporter, has led the Organization of the Petroleum Exporting Countries cartel (OPEC) and usually at the behest of the United States (US) and the other western economies regulated world oil prices by adjusting output to maintain what has until recently been high oil prices -- a scenario which have benefited the development of the high cost oil fields of North America. This year has witnessed an 'overnight' seismic shift in policy as the Saudis rightly refuse to play the role of swing player. This shift in policy is in direct response to a challenge from the U.S. as the number one producer, given the U.S. surge in production in 2014 by over 16 percent, exceeding 10 million barrels a day (mbd).

The fact that both the U.S. and Russia have significantly increased oil production in recent years when OPEC output has been relatively stable at around 30mbd puts the blame for the recent collapse of oil prices squarely at the door of the two largest economies and the shale oil moguls.

This week marks the first time that the oil-rich Saudi royal dynasty are experiencing a radical change as power is being handed over from one generation to another. King Salman bin Abdulaziz has appointed a new heir, rotated some of the top ministerial jobs and for the first time ever appointed a non-royal Adel al Jubair to handle the foreign affairs portfolio. In a move that could affect the oil industry, the well-known Saudi businessman Khalid Al Falih has replaced the oil minister Ali al Naimi as the chairman of the Saudi Arabian Oil Company (Saudi Aramco). Meanwhile, the war in Yemen is contributing to increase their fiscal deficit beyond $38 billion in 2015 and commentators suggest they need an oil price of $80 a barrel for fiscal balance. A price that seems unlikely at the moment in a saturated market but the world is looking to them to be once again the swing producer and help boost prices. However, the Kingdom enjoys a better financial position compared to its fellow OPEC nations, as the government began drawing from its monetary reserves to stave off the effects of low oil prices during wartime. This, however, has reduced Saudi assets from a record $737 billion in mid-2014 to $707 billion as of the first quarter of 2015.

Most oil and gas and political analysts are predicting business as usual failing to see that the world's biggest producer and exporter is no longer as willing to play the role of swing producer. Even before the next OPEC meeting in June some OPEC members are calling for a cut to production to boost prices so as to increase their government revenues whilst Saudi Arabia remains silent on the matter. The experienced swing producer knows only too well that world output is racing ahead of demand and that recent U.S. oil investment in production capacity is still likely to lead to a further increase in its output beyond 2015 into 2016 despite the dramatic fall in its rig count as a sizeable number of wells are due to enter commercial production.

The recent unexpected last quarter slowdown in U.S. and European economic growth seems likely to have postponed any substantial revival in oil demand. Therefore, the swing in production required to restore prices to say $80 is now far beyond the reach of just the largest producer and to do so might significantly damage its own revenue streams and economy. If the U.S.-dominated international oil companies want to see higher prices they will have to look to themselves first to cut production if they want to avoid a price war in a stagnant market. It is worth noting the CEO of Exxon Mobil Rex Tillerson in delivering a recent keynote speech at this year's IHS Energy CERAweek conference, highlighted the dilemma faced by oil producers and the U.S. government when he was quoted as stating "our industry continues to struggle under the weight of policies that are products of 1970s thinking... we need policies that recognize the 'turning point' moment in which we find ourselves."

As for the low cost OPEC countries, they may have to reverse their policies of relying on high prices, sitting doing very little to develop their industries and turn the taps on investing in greater production, thereby fighting for market share by gripping long-term oil contracts in Asia. Already, the most innovative amongst them, such as the UAE, are well down this path with major investments in nuclear, renewable energies and oil and gas production capacity. Will the new Saudi establishment be pragmatic enough in a low oil price market to follow suit by taking their bat home and refusing to play the role of swing producer? Only time will tell but, appointing experienced businessmen and politicians to key positions who are more likely to put Saudi Arabia's interests first rather than acquiesce to U.S. and western energy interests might lead to a hot summer of debate for OPEC and the West, in the mother of all twists.