Saudi Arabia has often counted on having the oil market's equivalent of a nuclear option.
When the kingdom grew tired of Opec members exceeding their quotas in 1986, it opened the spigots and crashed prices to below $10 a barrel, counting on accumulated profits and low production costs to shore the country up against the flood of excess crude. When Saudi wanted to snuff out U.S. shale oil producers last year, it boosted daily output from 9.5 million barrels in December 2014 to 10.6 million barrels by July. Prices fell 30 percent over the course of the year.
Those expecting the same dynamics to be decisive in the current spat with Iran, which sent oil futures in New York rising as much as 3.5 percent today on news that Riyadh had expelled Iranian diplomats, could be in for a shock: Tehran is well placed to fight off the onslaught.
The two countries, already fighting proxy wars in Yemen and Syria, are simultaneously competing for a share of Asia's oil market. For the past five years, Saudi Arabia has held the upper hand, thanks in part to the enhanced sanctions imposed on Iran in 2011 over its nuclear program:
With Tehran likely to meet the conditions needed to lift those sanctions as soon as next week, that's set to change. The government is promising to bring an extra million barrels of daily oil production into the market by mid-year, more than a third of its current output.
Saudi Arabia is unlikely to take that challenge lying down. Its vast reserves and low production costs have traditionally left it best positioned to survive an oil price war -- the "good sweating" that John D. Rockefeller once recommended to knock out Standard Oil's higher-cost rivals. The problem in the current situation is that its rival across the Persian Gulf has already been toiling through four years of sanctions. Combine that with a far more diversified economy, and Iran has much less to lose from low oil prices than it had in the past.
Were both countries' oil production to stop overnight, Saudi Arabia would find itself with a 57 percent budget deficit. Iran's would be just 7.5 percent, not much worse than many Western countries. Diminished exposure to weak oil prices is helping protect Iranian government spending in the current downturn: Government net debt in Riyadh will rise to 44 percent of GDP by 2020, when Tehran will be holding a net asset position, according to the International Monetary Fund. While Iran needs an unlikely crude price of $70.40 a barrel to balance its budget this year, Saudi Arabia needs an extraordinary $95.80, according to the fund:
The kingdom still has some trump cards up its sleeve. Its $642 billion in foreign-exchange reserves are enough to cover three years of imports, according to the IMF, while Iran's would run dry after about 20 months. Low prices will also further discourage investment from international oil companies such as Total and Lukoil which Tehran desperately needs to rebuild its domestic industry. Iran's oil infrastructure is in such a poor state that about half of analysts in a survey by Bloomberg Intelligence last August thought it wouldn't be able to ramp up production until the second half of this year.
Still, those hoping for a repeat of the 1980s experience, where Saudi Arabia's "good sweating" helped oil prices double within 16 months of West Texas crude hitting its low point in March 1986, may be in for a long wait. Both countries are pumping into an Asian market that already appears satiated: The discount for the Oman-Dubai oil benchmark used in Asia compared to Brent contracts rose to the highest level since October 2008 last week, according to data compiled by Bloomberg.
After four years of sanctions, Iran is now likely to take whatever price it can get to bring in more cash. In those circumstances, Saudi Arabia's nuclear deterrent looks more like a promise of mutually assured destruction.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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David Fickling in Sydney at firstname.lastname@example.org
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