Cut Oil Supply or Drop Riyal Peg? Saudis Face ‘Critical’ Choice

How Shale Oil Is Disrupting OPEC
  • Saudi riyal forward contracts jump to highest in 13 Years
  • Crude slump undermining kingdom's ability to sustain spending

The longer oil languishes, the more pressure builds on Saudi Arabia to abandon its currency peg.

QuickTake Currency Pegs

Contracts used to speculate on the riyal’s exchange rate in the next 12 months jumped to a 13-year high on Monday. That reflects growing bets for the currency to weaken for the first time in almost three decades, even after Saudi Arabia said it’s ready to cooperate with other oil producers to stabilize prices.

The decoupling of oil prices and Saudi production has fueled speculation of a riyal devaluation
The decoupling of oil prices and Saudi production has fueled speculation of a riyal devaluation

Saudi Arabia is pumping record amounts of oil this year, leading OPEC’s effort to defend market share even as Brent crude trades near the lowest level in six years. The slide in oil revenue has forced the kingdom to tap savings and sell debt to preserve the riyal-dollar peg that’s been in place since 1986. For Bank of America Corp., that may mean the country faces a “critical” choice next year: either cut production to help boost prices or adjust the riyal’s rate to stem the decline in foreign reserves.

“A depeg of the Saudi riyal is our number one black-swan event for the global oil market in 2016, a highly unlikely but highly impactful risk," Bank of America strategists led by Francisco Blanch in New York wrote in a Nov. 19 report. “It is a lot easier politically to implement a modest supply cut at first than allow for a full-blown currency devaluation."

One-year forward points for the riyal climbed 120 points to 575 as of 3:53 p.m. in Riyadh, the highest level since December 2002. That reflects expectations for the currency to weaken about 1.5 percent to 3.8088 per dollar over the life of the contracts.

Weaker global growth and inflation as well as the strength of the dollar will remain “huge" headwinds for dollar-based commodity prices, Bank of America said. Brent crude, the benchmark for more than half the world’s oil, advanced 1 percent to $45.09 per barrel, trimming losses over the past 12 months to 43 percent.

Robust Reserves

Still, Saudi Arabia’s reserves are hardly depleted. Though net foreign assets fell to a near three-year low in September as the government drew down financial reserves accumulated over the past decade, they’re among the highest in the region at $646.9 billion.

Central Bank Governor Fahad Al-Mubarak said in September the nation will maintain the currency’s peg to the dollar as long as the economy is dependent on oil. That attachment has survived lower oil prices in the 1990s and revaluation pressure resulting from surging prices in the late 2000s, Shaun Osborne, the Toronto-based chief foreign-exchange strategist for Scotiabank, wrote last week.

The government has "plenty" of options to avoid a currency devaluation that could accelerate inflation and impact political stability, Jason Tuvey, London-based Middle East economist at the research house Capital Economics, said in an e-mailed report Monday. If authorities don’t cut oil output, they are more likely to cope with low prices by cutting capital spending, already underway, or energy subsidies before weakening the riyal as "a very last resort," he said.

Yuan Pressure

Watch Next: Saudi Arabia Burns Cash As Oil Falls

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Pressure may also build on the Chinese yuan as reserves at central banks across the world decline against a backdrop of looming U.S. interest-rate increases, Bank of America said. A slump in the yuan may ultimately force Saudi Arabia’s hand because of the “very high sensitivity" of commodities to the currency, the bank said.

Saudi Arabia, the biggest member of the Organization of the Petroleum Exporting Countries, produced more than 10 million barrels of oil a day in each of the past eight months and pumped a record 10.57 million barrels a day in July, according to data compiled by Bloomberg.

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