December 5, 2018

Oil’s Next Bull Market: Saudi Arabia in the Driver’s Seat

Charles Myers Hani Sabra

Chairman Founder
Signum Global Advisors Alef Advisory
charles@signumglobal.com hanisabra@gmail.com

Executive Summary

• Global oil prices are set to rise from current levels given (1) the high likelihood
of a return of a geopolitical risk premium, (2) mean reversion after a $22/barrel
decline in the past month alone, and (3) OPEC/Saudi production cuts, to be
announced this week. Importantly, political, economic and market
considerations will keep Brent crude within a range of $65-75 for the first half
of 2019.
• Saudi Crown Prince Mohammed bin Salman’s political position is less stable
both domestically and abroad than it was just two months ago, notwithstanding
his appearance at the G20. The regime is therefore motivated to move forward
with production cuts, as support for oil prices and the Saudi economy generally
will bolster MBS’s hold on power and future claims on the throne.
• At the same time, regional foreign policy is unlikely to moderate or change
course, raising risks of geopolitical tension with the US, Gulf nations and Iran.
• Spikes in global oil prices remain possible. For example, US-backed military
activity in the Gulf as a diversionary tactic or in response to a terrorist attack on
US assets is within the realm of possible outcomes.

OPEC and Russia: On Track for a Modest Production Cut

At the December 6 meeting in Vienna, the OPEC/Russia group is likely to agree to a

production cut, potentially up to 1 million bpd. The consensus will probably be to rein
in inventory growth rather than an attempt to shock the market back toward its recent
highs. It is also probable that Saudi Arabia will bear a more significant share in what
actually gets implemented, given its weak position as an outlier price hawk.

In terms of price, Brent had fallen beyond most expectations. That price is likely rise
with OPEC/Russian cuts in 2019, but the surge in non-OPEC (largely US) supply in the
most recent revisions of the US EIA data means that cartel influence on crude oil prices
is probably short-lived.

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The debate is now moving back toward what OPEC has tended to say publicly – that
it is focused on managing supply to prevent inventories from getting too high or too
low, rather than targeting a price.

While Saudi Crown Prince Mohammed bin Salman has not commented on the oil
market in recent months, Oil Minister Khalid al-Falih has been openly calling for a cut
since at least October, when Brent was still in the mid-$70s. Though $80 Brent would
of course keep the Saudi budget deficit smaller, OPEC looks unable to sustain a price
anywhere near that figure; indeed, the consensus now is that the cuts are likely
intended to place a floor beneath $60 Brent.

From the Russian perspective, oil industry figures like Igor Sechin, who were always
skeptical about Russia’s participation in production cuts, appear vindicated. (Sechin,
among others, had argued that the new price equilibrium with shale and reduced
deepwater costs was probably closer to $60 per barrel (Brent)). Despite this, President
Putin’s weekend comments indicate that Russia will probably sign on for the cuts, if
only to prevent negative diplomatic optics in the Middle East. This is even more likely
given Falih’s tacit acknowledgement that Russia would not be expected to go back to
its previous production level of 10.7 million bpd, but rather implement a modest cut
from its current level of 11.4 million bpd.

Who will Participate in the Cuts?

Ultimately, countries which have increased production since June 2017 - namely,
Saudi Arabia, Kuwait, the UAE, Iraq, Oman, and Russia - will determine the success of
the current cuts. Iraq will probably also demand a formula which allows it to cut from
current levels, and again fail to fully implement cuts. Kuwait has voiced skepticism
about cuts this week, but probably would not block action. Neither Libya nor Nigeria
is likely to accept the loss of their exemptions, and others like Venezuela will seek to
avoid committing to keep their capacity at the current reduced levels (even though
they are producing at capacity).

Among these participating countries, it should be possible to come up with close to

1 million bpd in pledged cuts, though the issues around Iraq and Russia will probably
keep the communique formulation vague.

A rally on a cut is not likely to be dramatic and may not pass $70 again even briefly.
The non-OPEC supply response implies that a rational course of action would be to
keep the cuts brief and phase them out if fears about a big hit to 2019 demand growth
don’t materialize. For Saudi Arabia, this will prevent a return of truly massive budget
deficits, but also demonstrate that production cuts will not get them near their current
budget balancing level. It also means that Riyadh is accepting something close to a

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return to its previous production cut, while Russia and Iraq keep some of their gains,
not to mention the US. That pattern also is not sustainable.

The Saudi Angle

Mohammed bin Salman: Political Future in Question

Moving beyond the immediate term, domestic Saudi politics are set to play a greater
role in oil dynamics. Crown Prince Mohammed bin Salman will likely succeed his father
and become king of Saudi Arabia - however, the risks to his rise remain significant. As
international outcry over the Khashoggi affair and the war in Yemen grows, MBS must
convince his popular base and the royal family to grant him even more power within
the Kingdom. Given his young age, and the chances that he would remain in power
for decades, the Crown prince’s accession to the throne will mark an inflection point
for Saudi Arabia and could trigger a backlash from members of the political
establishment.

In our view, three primary elements will determine MBS’s political future:

i. King Salman’s abdication or non-abdication

ii. The timing of King Salman’s death

iii. The US presidential election in 2020.

These factors are so crucial because MBS is unlike past putative Saudi leaders. Though
he has cultivated some support within the royal family, he has elicited more hostility
and opposition internally and is more controversial than any previous Crown Prince.
Moreover, he does not have the same kind of tribal and familial backing that others
in his position have previously relied on. Finally, while he does have a public support
base, MBS lacks the kind of gravitas and political capital that past crown princes and
kings have benefitted from.

What MBS does possess, however, is his father’s backing and the personal support of
President Donald Trump. Thus, the decisions those leaders make will ultimately
determine his own political career - and, by extension, the state of the Middle Eastern
oil market.

When it comes to succession, the best-case scenario from an oil markets perspective
would be if King Salman abdicated and turned the throne over to his son. In such an
event, the challenges facing MBS would diminish considerably.

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However, if that does not materialize—and it probably won’t we see a tail risk of
factions within the royal family moving against MBS if he tries to claim the
throne. Given Saudi Arabia’s outsized influence over global markets, regional stability
and geopolitical dynamics, this is an outcome that investors cannot afford to overlook.

If MBS were removed quickly, the impact would be short-lived - so long as a strong
and effective leader(ship) were to take his place. Similarly, if a move against the Crown
prince were to fail, MBS would engage in a harsh crackdown, but the long-term impact
would probably be contained.

The third, and worst scenario, however, would develop if a move against MBS resulted
in uncertainty or some kind of leadership vacuum. Saudi Arabia has never experienced
this, and there is no single institution or individual that would be able to quickly force
a resolution and a return to stability.

Geopolitical Tension on the Rise

Whatever Mohammed bin Salman’s political fate, it is unlikely he will face a sustained
and organized threat to his rule in the near future. Moving forwards, we predict Saudi
Arabia will maintain its hostile position toward Iran, but it is unlikely to adopt a more
directly escalatory position in the short term. Riyadh probably wants to extract itself
from the Yemen war, irrespective of pressure and the spotlight being on Riyadh as a
result of Jamal Khashoggi’s murder and Congressional pressure. This will be tricky,
however, because the gap between what Saudi Arabia would be willing to accept and
project as a winning peace plan is still quite far from where things stand on the ground.

As far as Iran is concerned, maintaining the status quo is good enough. But more
broadly, even if MBS lays low for a while, the Khashoggi murder does not signal a U-
turn in Saudi regional policy. The strong, anti-Iran position that MBS has adopted is
part of the reason the Trump administration backs him. This also helps explain why
the Qatar-Saudi dispute has yet to be resolved.

While the US believes that a united GCC makes weakening Iran easier, and increases
the likelihood of an accord, US allies such as Egypt and the UAE are arguing the
opposite. In their view, forcing Saudi Arabia and Qatar to make amends in the context
of perceived Turkish pressure would weaken MBS and make it harder to confront Iran.
Thus, while the chances of a Qatar-Saudi rapprochement have risen and will continue
to rise, it’s still less than likely that the two sides will reach an accord in the short term.

Finally, regional figures like UAE Crown Prince Mohammed bin Zayed and Egyptian
President Abdelfattah el Sisi, whom MBS visited with last week, will certainly stick by
the Crown Prince. His visits to regional allies before heading to the G20 Summit in
Argentina were designed to demonstrate that while opposition to MBS in Europe and

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the US Congress has strengthened, his regional backers stand with him. Even if
leaders like Sisi and MBZ are privately growing concerned about MBS, they’ve already
invested too much into his rise. Furthermore, given that he is still most likely figure
lead Saudi Arabia for the next several decades, taking any kind of stand or even
distancing themselves from him would be unwise from their perspectives.

Conclusion - A Return of the Geopolitical Risk Premium

As OPEC and Russia head in to their December 6th meeting, we are confident that
the cartel will be able to come close to its 1 million/bpd target and put a floor in oil’s
current selloff.

In the next six months, we see a high likelihood that the incoming Democratic
Congress will adopt a more hawkish stance towards Saudi Arabia - perhaps even
attempting to sanction the Crown Prince over the Khashoggi affair. With Mohammed
bin Salman’s political capital already weakened, the chances of an internal power
struggle in the Kingdom may justify the return of a risk premium to the energy markets.

That premium must also take into account another reality of Gulf politics: escalating
tensions with Iran.

In the seven months since President Trump withdrew from the JCPOA (a.k.a. the Iran
Nuclear Deal), Iran’s direct and indirect military operations across the region have
shown few signs of slowing. Between the Saudi quagmire in Yemen, the survival of
the Assad regime and the growing influence of Iranian proxies in Iraq, Tehran has
managed the mitigate the return of sanctions while effectively silencing dissent at
home.

President Trump has made no secret of his animosity towards the Islamic Republic,
adopting much of the rhetoric of Iran Hawks such as National Security Advisor John
Bolton and Secretary of State Mike Pompeo. As tensions linger over the country’s
nuclear program and regional ambitions, there is a disturbing chance that a small-
scale confrontation - e.g. naval exercises in the Gulf or a cyber attack linked to Tehran
- could escalate into a military crisis.

While this possibility is for now remote, it must still be factored into the geopolitical
premium. In concert with the OPEC cuts and internal tensions in Saudi Arabia, it
informs out bullish outlook on oil and leaves us confident that Brent will settle in the
$65-75 range for the first half of 2019.

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For client inquiries, please reach out to

Jason Press
Global Head of Sales and Client Services, Signum Global Advisors
jason.press@signumglobal.com
+1.917.353.5566

For information on Signum’s new technology practice, please reach out to

Angela Dalton
CEO, Signum Innovation Capital
angela@signumglobal.com
+1 646 535 8507

Paper written with contributions from

Timothy Doner
Policy Analyst, Signum Global Advisors
timothy@signumglobal.com

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December 5 2018, and may change as
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