IS THIS OIL MARKET BROKEN? VIEWS FROM RIYADH

C O N F I D E N T I A L SECTION 01 OF 04 RIYADH 000868



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E.O. 12958: DECL: 06/03/2018

TAGS: EPET, ENERG, EFIN, SA

SUBJECT: IS THIS OIL MARKET BROKEN? VIEWS FROM RIYADH



REF: A. RIYADH 751

B. RIYADH 732



Classified By: CHARGE D'AFFAIRES MICHAEL GFOELLER FOR

12958 1.4 B, D, AND E



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Summary

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1. (C) Minister Naimi's offer of an additional 300,000

barrels per day (bpd) in the wake of President Bush's visit

had minimal impact on crude prices; some analysts stated

500,000 bpd-plus would be needed to impact crude prices near

$128/barrel. Market analysts in Riyadh point out widespread

petrol subsidies in China, India, and the Middle East ensure

price feedback mechanisms are broken; they therefore predict

crude demand will continue to rise there. Governments are

abandoning plans to roll back petrol subsidies in the face of

escalating food inflation. Our contacts are concerned

languishing refining margins are driving down refinery

utilization. Recession may be the one brake on crude prices

in the near term, but our contacts are divided on its impact.

Their crude price forecasts range between $90 and

$150/barrel.



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Saudis Resist Continued

Requests for Significantly More Production

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2. (C) The oil industry newsletter "Foreign Reports" summed

up the industry's take-way from the President's recent visit:

"Responding to demand, not demands - The message from Riyadh

this afternoon may be summed up: Saudi Arabia can and will

respond to increased demand from its refining customers by

increasing its production, but it will not respond to

politically-motivated calls for more oil." Minister Naimi

was careful to point to customer requests to justify his

announcement of a increase in production of 300,000 bpd. The

increase should bring Saudi Arabia's June production to 9.45

million bpd. By Monday, OPEC price hawks, Libyan oil

official Shukri Ghanem among them, jumped in to criticize

Minister Naimi's decision "to cave in to requests from the

U.S."



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Is this Market Broken?

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3. (C) Here in Riyadh, our banking sector contacts are

focused more on long-term market disequilibirium. Like

energy economists worldwide, they are scratching their heads,

asking how we can slow this spiral of escalating crude

prices. Brad Bourland, Chief Economist, and Paul Gamble,

Head of Research from Jadwa Investments, one of the

newly-established Saudi investment banking houses, are

concerned the price feedback loop between crude and finished

petroleum products is increasingly tenuous globally.

Bourland points to analysis by Deutschebank's Adam Siminsky,

who posits a growing disconnect between the crude and

finished product markets.



4. (C) Bourland explains while crude has increased by

nearly 6 times in the last four years, gasoline prices in the

U.S. have at most tripled. While consumers complain

vociferously about rising pump prices, nonetheless they are

not absorbing the full brunt of rising input prices. The

refining sector is absorbing the growing pricing

differentials between crude and finished products, leading to

plummeting refining utilization rates in the U.S. For

example, refining utilization rates fell to 84 percent in the

U.S. recently. Bourland noted the U.S. majors would continue

to operate their vertically-integrated refineries - as they

have little choice but to move their crude through the



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system. However, under these price conditions, independent

refiners operate in the red, and many are simply idling their

capacity. The Petroleum Economist confirmed that in March,

many refiners ran at a loss.



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Poor Price Elasticity in China, India, ME:

Food Price Inflation is a New Complication

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5. (C) Bourland noted that given the widespread public

subsidies in China, India, and the rapidly growing markets of

the Middle East, there is no pass-through of these higher

crude prices to the consumer in much of the world's market.

Essentially there is no price signaling, "go slow" sign in

the form of higher prices for consumers as crude rises. As a

result, he expects we will continue to see unrestrained

demand growth, especially in the Middle East and China.



6. (C) Bourland was not optimistic about prospects for

encouraging greater price elasticity in the world energy

markets. Inflation, particularly food inflation, recently

has become a front-burner issue for many nations. Pressed

consumers in many nations have recently found themselves on a

knife's edge regarding food security, and are not likely to

peacefully accept the rolling back of petrol subsidies which

have become effectively institutionalized. Bourland also

cautioned that Saudi Arabia's domestic consumption of crude

continues to grow by about 100,00 bpd annually, ensuring a

tight global market for the foreseeable future.



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U.S. Market Demonstrates Elasticity,

but Price Responses in Europe also Limited

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7. (C) Bourland believes the U.S. market is demonstrating

some price elasticity in the downstream market, and this is

beginning to curb consumption. In the U.S., pump prices are

rising sharply. He noted gasoline in Connecticut, for

example, had hit $4.50/ gallon. Gamble, a British citizen,

noted that in Europe, the pump price is heavily weighted

towards the government's tax take, so the impact of rising

crude prices is felt much more slowly. Consumer response in

Europe is also correspondingly slower. Europe's ability to

respond with transport measures that might have a near-term

impact on per capita fuel consumption is also limited, as

most people already take public transportation or drive fuel

efficient cars.



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IEA Pessimistic on Prospects for

Greater Price Elasticity

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8. (C) Energy Attache queried Dr. Nobuo Tanaka, the

Executive Director of the International Energy Agency, during

a recent presentation at the International Energy Forum in

Riyadh about the prospects for introducing greater price

elasticity in the global market. Specifically, in November

2007, China had announced it would begin rolling back

subsidies. Dr. Tanaka indicated that the harsh winter

weather and the associated transportation problems at the

Chinese New Year had largely halted roll-out of China's

program. He was not optimistic about other large developing

nations following suit with new roll-backs. In light of the

recent tragic earthquake in Sichuan, it is likely China will

be in no position to force a politically unpopular subsidy

roll-back on the population now.



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Jadwa Forecasts $90 Barrel Oil for 2008;

SABB Forecasts $150

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9. (SBU) Looking forward, Jadwa Investments forecasts an

average price of $90/barrel for oil 2008, with a drop to

$70/barrel by the end of 2008. Jadwa forsees a constant

monthly downward trend in demand, due to the U.S. economic

recession and its impact on the global economy. Bourland

noted Jadwa's analyses departed from DeutscheBank's forecast

of an average barrel of $105 for 2008. On the other hand,

Dr. John Sfakiankis, from the Saudi British Bank, an HSBC

subsidiary, remarks that the U.S. is already in recession,

and crude prices nonetheless continue to rise. He predicts

crude prices topping $150/barrel "are not unlikely" by the

end of the summer.



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$15 Billion/Month into Official Reserves

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10. (C) Bourland estimates the Saudi state is earning

roughly $1 billion/day now in oil revenues, of which it

expends roughly half, and adds the other half to its official

reserves. He noted SAMA added $15 billion to its reserves in

March, the seventh month running that reserve additions

totaled more than $10 billion. "The amounts are

overwhelming," Bourland summarized. He also explained that

although the Saudi Arabian Monetary Authority (SAMA),the

central bank, continued to hold U.S. Treasury bills, it was

also diversifying. SAMA's Investment Department "prides

themselves on being diversified," he related.



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Dollars: The Unloved Currency as Saudis

Wait for a Possible Re-Valuation

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11. (C) This enormous influx of petro-dollars is largely

held by SAMA. Bourland explained that Saudi investors,

however, are currently hoarding riyals. They continue to be

afraid of being caught out by a possible re-valuation in the

USD-pegged currency. He noted investors continue to

anticipate an eventual re-valuation, but "the pressure is not

like it was last fall" when the fixed exchange rate came

under heavy speculative attack in November. Instead,

Bourland sees Saudis hoarding riyals because the "U.S.

markets would go on sale" if the Saudi government re-values.

Bourland pointed out it was difficult for Saudi investors to

even find large quantities of U.S. dollars, saying "it's hard

to get $500 million or $1 billion in USD, the banks don't

want to hold that much." Bourland stated he does not see

much Saudi money involved in hedge funds or other speculative

instruments allegedly running up crude prices.



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"The Money is Safer in the Ground"

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12. (C) Bourland noted that the confluence of demands to

manage this enormous cash flow, and the challenges to

managing growth in the oil sector were beginning to worry the

Saudi leadership. He referenced recent comments from an

informed source in the oil sector who explained that Saudi

Aramco was scaling back proposed future expansion plans.

Quoting King Abdullah's recent comments (ref B) that Saudi

Arabia would cap production capacity at 12.5 million bpd and

"leave crude in the ground for its children", Bourland

remarked, "There are more accidents, there are escalating

costs (in the oil sector). I think the King is reaching the

conclusion that the money is safer in the ground than in the

bank. He doesn't want to see it squandered."



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Saudi MinPet:

"Blame it on the Weak Dollar"

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13. (C) The Saudi Ministry of Petroleum has noted to us in



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consultations throughout 2007 and in January 2008 that much

of the run-up of the price of crude could be blamed on the

gradual decline in the USD, as crude contracts are priced in

dollars. We concur to a certain extent, but as crude has

surged beyond $110/barrel, and the dollar seems to have found

a bit of a floor in recent weeks, we find this argument less

compelling. As well, crude priced in euros and yen has also

surged to new record highs in recent weeks. Taking inflation

into account is another issue. The Economist noted in April

that crude would have to hit $134/barrel to equal in

inflation-adjusted terms 1981's record crude prices. Two

weeks ago, the NYMEX market did just that.



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Comment

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14. (C) Our Mission now questions how much the Saudis can

now substantively influence the crude markets over the long

term. Clearly they can drive prices up, but we question

whether they any longer have the power to drive prices down

for a prolonged period. The May announcement of a 300,000

bpd increase in production barely dented price escalation.

It appears unlikely Saudi Aramco could muster the million or

more barrels which appear to be needed to make a dent in the

normally upwards price trajectory. Saudi Aramco's ability to

sustain such a production increase for a year or more raises

serious questions. A series of major project delays and

accidents - industry observers tell us one accident in

November 2007 killed up to 60 people - over the last couple

of years is evidence that Saudi Aramco is having to run

harder to stay in place - to replace the decline in existing

production. Additional production would likely come from

increasingly heavy crude which the world lacks sufficient

capacity to easily refine. The Saudis appear dis-inclined to

discount its heavy crude sufficiently, so the market is

dis-inclined to purchase it. In neighboring Iran, the regime

is now purchasing floating storage for heavy crude which has

no takers. While this Mission is far from embracing doomsday

"Peak Oil" theorists, Saudi Aramco's challenges are

significant.



15. (C) King Abdullah's recent comments on "leaving some

oil in the ground" did not set new oil production policy, but

hewed to the previous Saudi commitments to build a capacity

of 12.5 million bpd. Nonetheless, his remarks may hint at an

emerging conservationist ethic in Saudi Arabia -- extending

beyond energy to encompass how the Kingdom will more broadly

husband its resources for future generations. Bourland

highlights the King's concerns with energy issues, but also

his growing worries with how his successors will manage and

secure the Kingdom's financial patrimony as well.





GFOELLER