There is considerable change underway in Saudi Arabia, from how the country is governed and managed to an even more activist role in the politics of the volatile Middle East, writes Erik Norland, executive director and senior economist at CME Group. Options markets, however, appear to be almost entirely unconcerned about recent developments in the country, the world’s largest exporter of crude oil and a key US ally in the Middle East.
At-the-money implied volatility on West Texas Intermediate (WTI) Crude Oil options has been trading near its lowest point since late 2014 and is well below its long-term average. Are markets too complacent in the face of potential political disruption in Saudi Arabia and its neighbouring countries?
Figure 1: Whistling Past the Graveyard or Rightfully Unconcerned?
Several events have occurred since November 4 that should be of concern to the oil market including the arrests of 11 Saudi princes, four cabinet ministers, dozens of former government officials and 500 others on charges including embezzlement, bribery and extortion. Hundreds of bank accounts have been frozen as part of the investigation. On the same day, Prince Mansour bin Muqrin bin Abdul Aziz, the son of the former crown price and intelligence chief, died in a helicopter crash 70 miles north of the border with Yemen, an event the family described as "an accident." Also on November 4, Saudi forces intercepted a missile allegedly of Iranian origin fired at the Riyadh by Yemeni rebels. Saudi Arabia accused Iran of "an act of war."
These events took place in a broader context of an ambitious reform program, designed to reduce Saudi dependence on oil over the long term, buy time in the short run for a successful initial public offering of state oil behemoth Aramco, and to promote a more assertive foreign policy to contain Iranian ambitions in the region. The new foreign policy also means isolating Qatar, with whom the Saudis cut off diplomatic relations in July, and aggressively fighting Iranian-backed Houthi forces in Yemen.
While oil prices rose a few dollars amid these events, options markets have shown little reaction. There are a number of possible reasons for the market’s nonchalance:
- Market participants apparently view Saudi Arabia and the Middle East as being relatively stable despite the recent events.
- The rebound in US oil production may also be reducing volatility by diversifying the world’s supplies of oil, offsetting potential Middle East supply volatility.
- For oil markets, the recent events are a double-edged sword. On the one hand, if events in Saudi Arabia spiral out of control or if conflict breaks out with Iran, prices could soar. On the other hand, heightened tensions could encourage Iran and its allies, including Iraq, to pump more oil, allowing production cuts by the Organization of Petroleum Exporting Countries (OPEC) to fade and for prices to fall.
- Inventories: although they have begun to decline, they remain at high levels and could temporarily buffer any supply disruptions.
- A low level of realized volatility makes it too expensive to maintain long positions in options.
Still, one must wonder if markets are approaching these recent developments with too high a degree of complacency.
Firstly, while the Saudi Crown Prince appears to be firmly in control of the kingdom at the moment, he has taken on such an ambitious program that he risks encountering a backlash. This is of even greater concern since he is not yet king. Even if he were king, he still might not be immune to forces pushing back against his modernizing agenda. A backlash could have the potential to create turmoil in a country where half the population is below the age of 25, many young people lack employment and crave additional freedoms. Moreover, reducing the power of the Sunni-Wahhabist religious police, whatever its other merits, has the potential to destabilize the heavily Shiite regions which produce nearly all of the country’s oil.
Secondly, how will the recent wave of arrests impact Aramco’s impending initial public offering? Even prior to the recent wave of arrests, potential investors in Aramco were probably wondering about its corporate governance and the rights of minority stakeholders in an organization deeply intertwined with the Saudi state and royal family. The events outlined above might deepen concerns regarding property rights and due process of law, potentially reducing the price that investors are willing to pay for Aramco’s shares.
Finally, the idea that US production might offset any reduction in Middle East supply is looking less certain than it was a few months ago. Over the past year, increased US production has largely offset reduced production from OPEC. Since this summer, however, US production appears to have hit a wall. Rig counts have stopped increasing and production growth has stalled close to its previous record high.
This situation could change if prices continue to rise, incentivizing additional production. Indeed, the International Energy Agency forecasts a surge in US production by 2025 that could solidify the country’s status as the global swing producer. Even so, a surge in prices takes at least a few weeks or months to begin incentivizing the deployment of additional equipment. Once that equipment is in place, its primary impact upon oil production doesn’t occur for another four months meaning that it may take six months or more for the U.S. to begin compensating for any lost supplies.
If things take a wrong turn in Saudi Arabia, it won’t be bad news for everybody. Oil producers outside of the Middle East, including those in the US, Russia, Venezuela and Africa would stand to benefit. The primary losers would be oil consumers, especially in places that produce little in the way of their own oil. A Middle East supply disruption could also benefit holders of energy sectors stocks at the expense of holders of most other equity sectors.