Saudi Arabia gets inspiration from Alan Greenspan: Fuel for Thought

Alan Greenspan could be leaving an indelible mark on OPEC.

Saudi Arabia is drawing on the famous central banker’s thinking to frame its new oil alliance with major partners including Russia. Instead of an unstable and hastily brokered marriage of convenience that is fixated solely on boosting prices and market share, OPEC’s latest pact to extend production cuts for another year could have a more lasting outcome: the creation of a new central bank of crude.

The 91-year-old former Federal Reserve chairman believed in the power of markets to cure most of the world’s economic problems and masterminded a decade-long boom in the American economy. His success also created the current era of powerful central bankers running the global financial system. However, his disdain for regulation and failure to spot asset bubbles contributed to the worst financial crisis in living memory. Top Saudi oil officials who now claim to be his disciples would be wise to learn from both Greenspan’s mistakes as much as his triumphs.

Their bad Greenspan moment may have already passed. Years of ignoring the bubble-like rise of US shale production and the dangerous buildup of global inventories triggered the beginning of the oil price crash in 2014.

Crude suddenly dropped from a year-high of $115/b in June 2014 to below $27/b by the beginning of 2016—the lowest level seen since 2003. The scale of the crash that is still rippling through the upstream industry and the petro-dollar economies of producers was compounded by OPEC’s inability to tackle the crisis of its own making head on.

Fixed to an outdated strategy of defending market share instead of price, Saudi Arabia ignored pleas to restrain its supply. By keeping its taps open the kingdom effectively triggered a “price war” against Texas and the threat of Arctic drilling similar to the one it fought in the mid-1980s against rising production from the North Sea.

But last summer the strategy changed. After more than 20 years at the helm of the world’s largest exporter of crude, former Saudi oil minister Ali al-Naimi was replaced by Aramco veteran Khalid al-Falih. His new boss Crown Prince Mohammed bin Salman—now heir to the Saudi throne—also began repairing Riyadh’s fraught relations with Moscow.

Instead of fearing Russia’s growing intrusion in the Middle East and competition from its independent oil producers the kingdom found ways to work with President Vladimir Putin’s Kremlin. Their new alliance is built on oil.

TARGETING STOCK LEVELS

The fruits of that diplomatic effort paid off on November 30 when the Russian led a collection of non-OPEC producers agreed to extend their pact with the 14-member group to remove 1.8 million b/d from global supply for another year. Combined, their alliance now encompasses around over half of global supply. The extension will deprive world markets of around 683 million barrels of crude and help to drain stockpiles in industrialized nations back down to their five-year moving average.

Like a central bank targeting inflation, OPEC is using inventories in the Organization for Economic Development and Co-operation as its preferred benchmark to measure the balance between supply and demand. The price could be pushing crude prices back above $70/b, a level the IMF says Saudi needs to balance its budget and bankers say would boost the valuation of Aramco ahead of its IPO.

As with the appropriateness of central banks focusing on controlling the rising cost of living there is some controversy around OPEC’s obsession with average inventories.

The group says levels have fallen to 140 million barrels above the five-year average, which is lower than the International Energy Agency’s latest projection for October. S&P Global Analytics believes global stocks could be even lower than 50 million barrels.

Goldman Sachs argues that targeting five-year average levels is flawed thinking and prefers a metric of normalizing inventories to physical demand.

Meanwhile, backed by the added power of Russian barrels, Saudi Arabia’s Al-Falih has increasingly looked and sounded like the world’s central banker of oil.

On the night before their formal decision senior Saudi officials worked late into the early hours with their Russian counterparts at the Park Hyatt hotel in Vienna carefully drafting the wording of the declaration which would enshrine their oil alliance for another year and perhaps lay the foundations for a new central bank of crude.

“Al-Falih has become a very effective central bank head since his elevation to Saudi Oil Minister 18 months ago, and his comments on a gradual return of production so as to not shock markets is exactly the type of tapering process that we believe will be necessary,” said investment bank Jefferies in a research note following OPEC’s extension decision.

How the current production cut deal unwinds will become increasingly important if prices continue to recover beyond their $60/b range. At these levels compliance to agreed cuts usually becomes strained and Al-Falih’s new role alongside his Russian counterpart Alexander Novak as co-chairs of the Joint Ministerial Monitoring Committee (JMMC) will be crucial to avoid the equivalent of a taper tantrum. The JMMC is now performing a similar role to the Federal Open Market Committee in the US, which essentially formulates the Fed’s policies and provides stable guidance to the market.

This final comparison is perhaps the most important for OPEC. Greenspan was a master at signaling his intentions but even the second-longest serving chair of the Fed made mistakes.

His use of the phrase “irrational exuberance” once triggered a sell-off on global markets. With oil prices finely posed Al-Falih—like all good central bankers—must choose his words carefully.