Byrne Hobart
Aug 5 · 16 min read

I am going to trot out an esoteric formula from advanced quantitative finance.

Ready?

A lot of money

minus

A little bit more than that

equals

Less than zero.

Counterintuitive, I know, but it’s true.

To take a random case study, the Saudi royal family has a number of valuable properties — fine art, vacation homes, military hardware, etc. — and among the most valuable of their properties is the country of Saudi Arabia. Saudi Arabia is mostly composed of sand, but it also includes some oil — 15% of the world’s reserves, at least according to the IEA. This has made the Saudi royal family fantastically wealthy.

On the liability side of their balance sheet is the population of Saudi Arabia. A long time ago, the House of Saud could claim some legitimacy from having conquered the peninsula and united the various tribes. This happened surprisingly recently — we’re used to thinking of kings conquering rival kings as a middle-ages sort of thing, but around the same time FDR was wrapping up his first Presidential campaign, King Abdulaziz bin Abdul Rahman was putting down the last of the Ikhwan rebellions and proclaiming the Kingdom of Saudi Arabia.

Like all countries, the Saudi government gets its legitimacy through procedural continuity with the founders, through the endorsement of the clerisy, and by distributing economic benefits to favored parties.

This is fine if you have money — and the Saudi state has a lot. But the state’s revenues compound at one rate, and the cost of the Saudi welfare state compounds at another; over a long time period, if you compare two growing quantities, the only variable that matters is which compounds faster.

What does a government do when it has more money than it needs? Some of the money it invests — since oil is priced in dollars, and the Saudi riyal is pegged to the USD, Saudi Arabia has to sterilize its incoming dollars by buying dollar-denominated assets. Alternatively, they can sterilize the incoming dollars by buying consumer products from abroad.

Either way, their behavior tells you something about the state of Saudi finances: when they invest aggressively, it’s because they have dollars and need to put them somewhere. When they don’t, it’s because they don’t.

It’s been observed in the past that big, splashy spending tends to presage a decline in one’s economic fortunes. If you’re jealous of someone’s gold-plated bathroom fixtures, you can probably buy them at a bankruptcy auction in a few years.

Statistically, this is true: when companies buy a shiny new headquarters, their stocks tend to underperform. When a country becomes home to the world’s tallest or most expensive building, its market tends to underperform. The Petronas Tower was built at the height of Malaysia’s economic bubble in the late 90s; it was declared the world’s tallest building in April 1996, and the Malaysian market lost roughly two thirds of its value over the next two years. Taipei 101 and the Burj al Khalifa were also associated with not-so-great results.

Here’s a chart of two investment strategies. One is just the MSCI All-World Index. The other starts with the MSCI All-World Index, and shows the results of switching into whichever country has the tallest building in the world at that moment:

(In Dubai’s case, the returns are not bad, but only due to timing: in 2004, the tower was going to be called the Burj Dubai. It only got finished because Khalifa bin Zayed Al Nahyan bailed it out, so Burj al Khalifa it was.)

So, just anecdotally, Saudi Arabia’s $500bn Neom project should make you wonder. Someone who can afford glowing sand, simulated moonrises, robot butlers, and flying cars probably has lots of money. Someone with lots of money who spends it on those things might have a problem.

Anecdotal evidence suggests that the problem has arrived. We don’t have definitive proof, just early indicators, but there are signs that Saudi investment has peaked:

  • Neom is partially funded by outside investors, not Saudi capital (per the WSJ: “The kingdom has used money borrowed from abroad to fund Neom’s first stages, according to people familiar with the matter.”)
  • Saudi Arabia did not appear on the investor list for the second Vision Fund. Some media sources claim that they’re already in — but the WSJ noted that some of the investors listed have not committed capital yet, so the bar is low.
  • A number of tech funding deals involving Saudi Arabia have fallen apart — in at least one case, the company said it turned the Saudis down, but the Saudis were the ones who said no.
  • The Saudi sovereign wealth fund is borrowing money in advance of the sale of one of their holdings to Aramco.
  • Saudi Arabia has restarted discussions to take their state oil company, Saudi Aramco, public, following a successful bond issue earlier this year.

None of this is definitive, but it’s all suggestive. It raises an interesting question: can one of the world’s richest countries run out of money?

If you dig into it, the answer is basically no: Saudi Arabia’s financial reserves are around $500bn — down by a third from their peak, but stable since 2017. However, the evidence also suggests that at some point, their currency reserves will start to drop, and that will lead to some difficult choices. The Saudi welfare state is expensive. The warfare state isn’t cheap, either. A country counting its pennies, even if it has tens of trillions of pennies, behaves differently from one that doesn’t.

Assets: The World’s Most Valuable Company

Saudi Aramco is the world’s single most profitable company. You may have read news coverage claiming that they banked $111bn in annual profits last year. That’s misleading: the number is higher. Saudi Aramco is a wholly-owned subsidiary of the Saudi state, so the kingdom owns the profits Aramco pays, the taxes they pay, and the economic value of their fuel subsidies.[1] The total value is closer to $265bn per year. An impressive number — but the government’s budget this year calls for $295bn in spending, and over the last half-decade they’ve exceeded their annual budget by an average of 10%.

Recent Saudi budgets. Numbers in red extrapolated from recent averages.

Aramco was formed as a joint venture between a few large US oil companies. Over time, Saudi Arabia gradually increased their stake, first by raising taxes and eventually through outright nationalization. Unlike some other prominent examples of nationalization, Aramco appears to be run quite well: it’s enormously profitable, continues to raise production, and has successfully diversified downstream into refining, including refineries in the US, Japan, and elsewhere.[fn]

Outsiders have raised questions about how well the company is doing, however. Most famously, Twilight in the Desert argued that Saudi oil production was likely to imminently peak and then go into irreversible decline, as the massive Ghawar oilfield finally matured and other smaller fields couldn’t come close to matching it. The book came out in June 2005, when Saudi oil production was 9.6m bpd, compared to today’s 10.1m. Over the last decade, Saudi Arabia’s oil production has gradually moved up, at a pace of 1–2% per year.

It’s actually interesting to ask why Simmons was wrong. One explanation is that he was lying and talking his book — the guy was an energy investment banker, and would certainly benefit from the perception of an imminent supply shock. But if you read the book, you’ll come away impressed. This guy did his homework! In fact, he did altogether too much! What Simmons keeps coming back to is that Aramco’s engineers talk a lot about all the technical challenges they face. If you read report after report of all the clever maneuvers Aramco’s petroleum engineers have resorted to, you might suspect that their cleverness will eventually run out.

There are two explanations for all these reports:

  1. Simmons’ view, which is that all the easy oil has been extracted and Aramco’s engineers have to resort to increasingly desperate measures just to keep the oil flowing, or
  2. The alternative view, that the world’s most profitable oil company hires the world’s best engineers, and — since they don’t get stock options — they get paid partially in bragging rights.

So far, the data support argument #2.

But! Saudi Arabia periodically announces large new oil projects, often giving estimated barrels per day. For example, in September 2018 they were bringing on two new oil fields, capable of producing 550k barrels per day, in that quarter. Result: production is down since then. Historically, Saudi Arabia has announced various large oil projects, but total production has fallen short. Either they’re not producing as much as expected or the existing oil fields are depleting fast.

And their stated reserves have been basically flat for years. From 1989 through 2016, proven reserves grew from 260bn barrels to 266bn barrels, during which time Saudi Arabia pumped around 100bn barrels of oil. Since then, their proven reserves have gone up, to just under 300bn. Are they always finding exactly as much oil as they pumped? Here’s what their prospectus says (emphasis added):

The Company has historically replaced the Kingdom’s reserves in a low-cost manner and on an organic basis through revisions of reserve estimates at existing fields and through delineation and exploration to identify new fields.

It’s safe to say that Saudi Arabia’s stated reserve numbers are not accurate. But it’s not safe to say in which direction. Perhaps they’re exaggerating now. Or perhaps they were being conservative before. You can argue in either direction — exaggeration will make it easier to take Aramco public at a healthy valuation; an oil company with six decades of reserves can spend less of its revenue on exploration than a company like Exxon with seventeen years. On the other hand, a lower stated reserve number means less pressure to extract more oil now.

And, of course, there are third parties who can verify their numbers. Saudi Arabia bounced in early 2019 that the oil consulting firm of DeGolyer and MacNaughton had completed the first ever independent reserve calculation, and had hit Saudi Arabia’s numbers. I learned this from the Wikipedia article on Saudi Arabia’s oil reserves, which had this information added to it in a detailed paragraph written by… somebody. Somebody who took pains to refer to the Saudi Energy Minister as His Excellency.

DeGolyer is not some fly-by-night operation, of course. Their founder, Everett DeGolyer, was part of a team of geologists that looked for good sources for oil during World War Two (in Saudi Arabia). In the 1950s, DeGolyer was engaged to help prove that an American oil venture had been understating the value of the oil it exported to avoid paying high royalties to its host government (which was also Saudi Arabia). DeGolyer’s Wikipedia article, incidentally, was recently edited by the same IP address that added the audit to the Saudi Arabian oil industry article.

I don’t think this necessarily implies something nefarious. An oil consulting company that’s worked in the Arabian Peninsula for a long time would be in a position to opine authoritatively on Saudi oil reserves. And obviously, nobody who helped the Saudi government argue (correctly!) for higher royalties in the 1950s is still working there today. What it speaks to, though, is how important it is to Saudi Arabia that their reserves be perceived as high.

Aramco doesn’t just extract crude; they also produce natural gas. Here they’re in an interesting situation: they have a monopoly on selling natural gas in Saudi Arabia, and the Saudi government is increasing its gas power capacity. This represents a captive customer for Aramco, but a corresponding liability for the country — the gas gets sold to provide cheap electricity, which is a big deal in a country where the average temperature in July and August is 110 degrees.

This is actually a pretty smart policy (a recurrent theme here is that, public perception of Neom and Vision Fund notwithstanding, the Saudi government tends to make canny decisions). Gas is expensive to transport, and oil is cheap, so increasing their domestic gas power capacity is a way to reinvest their export dollars in a way that gives them more oil to export in the future. Every new gas turbine essentially puts oil back in Ghawar. And cheap electricity is not just a way to keep the air conditioners humming; it’s also a complement to manufacturing, so it enables long-term diversification away from oil exports.

Liabilities: Domestic and Foreign Policy

The Saudi Aramco prospectus helpfully informs readers that the state’s legal system is based on Sharia Law. It doesn’t go into details, but many of the things we associate with modernity — voting, legal alcohol, legal homosexuality, going on an un-chaperoned date before marriage — are not widely available in Saudi Arabia.

This is the result of a grand bargain between the House of Saud and religious leaders: the Imams say the king is legitimate, the king rules in a way that comports with the Imams’ desires. It’s unclear what the preferred strategy is, here. For all I know, the Saudi monarchy rolls its eyes at all these rules and wishes they’d go away. That would be the usual pattern: elites the world over are more socially liberal than average. Or maybe they’re far more radical — there’s no way to tell.

The Saudi state typically gets described as ruthless at best, and that’s fair. They really don’t mess around. But “ruthless” is just a term for “pragmatic” when you don’t have good options. The Saudi royal family has a lot of wealth and they’re in an unstable part of the world; the baseline expectation is quite low.

Right now, for example, Saudi Arabia is fighting a proxy war with Iran in Yemen. This is, even by the standards of war, a terrible situation. But, at least in an economic sense, it’s a defensive war: if an Iran-backed movement controls Yemen, Iran controls the Strait of Bab-el-Mandeb, through which just under 5m barrels per day of oil get shipped. Iran has already demonstrated a willingness to disrupt oil shipments through the Strait of Hormuz (~21m barrels/day). Presumably, the only thing Saudi Arabia wants less than fighting a war in Yemen is losing it.

And the reason the foreign policy stakes are so high is that their domestic policy is also fraught. Even excluding things like Neom, Saudi Arabia spends vast sums each year on a welfare state for locals. Spending per capita has risen 3.1% per year over the last five years. The population is growing at 2.1% per year. Over a short time period, spending can grow faster than revenue, but over a long timeframe it will catch up.

And Saudi Arabia hasn’t been able to accelerate oil production growth. Growth has been in the 1–2% annualized range over the last decade — healthy, compared to the many countries whose production has peaked, but below what’s implied by their mega-projects. If production grows just 2%, they’ll only be able to sustain spending growth by getting better prices, or by developing other businesses.

Some of their spending might be amenable to cuts — but it will be challenging. For example, fuel subsidies are remarkably sticky; nearby governments have fallen when they’re cut. Even in wealthy countries, motorists object to high gas prices; Americans fight modest fuel taxes even though ours are a fraction of what Western Europe pays.[3]

Saudi Arabia has tried to indirectly cut their social spending, through “Saudification”, the practice of encouraging companies to hire locals. This has been hit-or-miss: Ali Al-Naimi was hired by Aramco as a child, and rose to the position of CEO, and later Saudi Arabia’s oil minister. But as The Economist notes. The process continues. Saudi Arabia recently restricted some hotel jobs to nationals, for example.

This is prudent — especially in a country with a youth unemployment rate that is, by official numbers, 25% — but it’s difficult. Basic Income tends to reduce labor force participation by Great Recession levels, and being out of the labor force for an extended period depletes human capital. Like so many other things in life, unemployment is Lindy. So even a successful Saudification program will face a sort of J-curve of social unrest — initially it means overpaying employees, and making life worse for people who are used to having more free time.

In that sense, Saudification is shifting costs from the state to employers, which the government may have to offset with subsidies. Over a longer period, reducing unemployment will help them, both by reducing the state’s welfare costs and reducing the potential for social unrest. But the adjustment won’t necessarily reduce spending in the short term.

A surprising factor here is US interest rates. In 2006, for example, the government could have invested in 10-year treasuries yielding 5%, topped off their sovereign wealth fund with Aramco money, and expected continuous growth that compounded risk-free at the same rate that their welfare-state grew. But when risk-free USD-denominated assets yield 2%, the stakes are higher: the welfare state becomes equivalent to an underfunded pension`, which needs some combination of higher returns and continuous contributions.

The Saudi State doesn’t face the same game theory as a pension fund manager. For a pension fund manager, it’s politically easier to take risks than to ask for more money (they’ll do both, but only one is easy). But for a country, particularly a country run by a king who expects to hand it down to his descendants, default is an unacceptable risk. Saudi investment follows the theoretical, rather than actual, model of a pension fund: extremely risk-seeking when over-funded, since it’s basically gambling with house money; extremely cautious when underfunded, since it’s gambling with rent money instead.

Results

My read on the Saudi government is that, especially for a petro-state, they’re surprisingly long-term oriented. But they’ve gone through cycles of growth and retrenchment, historically driven by the price of oil. In this case, the cycle is less driven by oil prices and more driven by spending needs, which implies a longer cycle.

From a financial perspective, the way to think about Saudi Arabia is that they sell a high-margin product priced in dollars, and maintain a pegged currency. This requires them to sterilize dollar inflows. They have two ways to do this: paying for good and services in dollars — hospitals, roads, power plants, etc. — or investing in dollar-denominated assets. Those dollar outflows have made them a pillar of the late-stage, pre-IPO funding market. The other pillar, China, is having problems of its own. This leaves public equity investors who have diversified into late-stage privates as the last source of capital for large private companies.

Saudi Arabia’s own stock market has recently gotten inflows from indexers. As a result, the index — heavily weighted towards financials and oil-adjacent companies — trades at a bit over 2x book value. Viewed as a rapidly-growing emerging market, that’s not crazy; viewed as a bet on financial institutions all levered to the same volatile asset, maybe not. It’s a fairly stable market, too; much less volatile than you might expect. There is some artificial mean-reversion here, of which there is a long history.

Oil is a uniquely valuable natural resource because it’s so cheap to transport. A rough rule that won’t lead you too far astray is that a barrel of oil costs about a dollar to ship from one port to another. But this is not a natural law; it’s the result of policy decisions, specifically the US Navy’s decision to keep shipping lanes safe, and to intervene in military conflicts throughout the Middle East.

That was a strategic imperative during the Gulf War in 1990, when we were producing 7.3m barrels per day (declining about 1% per year) and during the second gulf war, when were were producing 5.6m, declining a little over 2% per year, and importing 3.5m barrels per day.

But now, we’re roughly at parity. Thanks to the wonders of fracking US military intervention in the Middle East has gone from investment to something more like charity.

There’s potential for a strategic realignment. Aramco sends about 70% of its oil to Asia. China runs an oil deficit of 9.3m bpd, and they might well agree to keep the Strait of Hormuz safe, for a price. Or they might make such an agreement with Iran, instead. The fact that oil can be a global market, but only at the convenience of global powers, gives those powers a lot of negotiating leverage.

US energy independence may be temporary; there’s a reasonable bear case on the entire fracking industry, and even bulls acknowledge that it’s dependent on continuous investment. But even a temporary shift in the US’s incentives could lead to a permanent realignment, and not one favorable to Saudi Arabia.

Natural resources produce economic rents, and rents lead to rent-seeking behavior. When the Kingdom had the upper hand, they took more of Aramco’s oil money for themselves. China probably just wants the oil.

So, Saudi Arabia finds itself in a difficult situation — politically and financially constrained. It would take a lot to actually weaken the state to the point of crisis, but it will force them to make some tough decisions. They may cut fewer checks to private companies and dial back their Neom ambitious. Maybe in ten years the Riyal peg will switch from USD to RMB. Saudi Arabia seems likely to remain one of the world’s largest oil exporters for the indefinite future, but their status as a dollar entrepôt may be coming to an end.

When cash flows are high and geopolitical stability is a given, it’s not imprudent to spend lavishly. But a combination of ever-higher social spending and volatile cash flows will require a prudent policy adjustment. As I’ve argued before, the fracking revolution has made the US high-yield market the world’s oil swing producer, so upside in oil is muted as long as US investors are willing. Downside is similarly muted by the short lifespan and weak finances of frackers. All this means that the Saudi budget should operate on the assumption that the oil price status quo holds, and a status quo where expenses rise at over 5% per year and oil production rises more slowly than that is a status quo that requires retrenching.

Further Reading

I know less about this topic than I’d like to, so any other suggestions would be helpful.


In the interest of full disclosure, I have a short position in Saudi equities. This could change at any time.

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[1] The prospectus is full of semi-apologetic notes about Aramco letting other parts of the Saudi state run up bills which they have no intention of paying. Aramco’s recent financial statements include payments from the government for subsidized fuel, which should make things more transparent.

[2] Integration makes sense as a way to diversify Aramco. When crude is expensive, refinery margins get compressed, and vice-versa. But it may not make sense as a way to diversify the Saudi economy. Since crude is so cheap to transport, and since refined products actually take up more space, it makes sense to export the unrefined product unless your country has a comparative advantage in both exploration and refining. It’s a deeply unfair economic truth, but: having lots of oil will make you richer if you were already very, very rich; the poorer you were before you found the oil, the more likely it is to just crowd out everything else.

[3] There is a chicken-and-egg problem here: we’re a big, spread-out country, and we built sprawling suburbs back when oil was cheap and we could mostly satisfy demand domestically. We don’t exactly have a comparative advantage at building public transit.The extreme inelasticity of demand for gasoline makes it both a good product to tax from a public policy perspective and a bad one to tax from a political perspective.

Byrne Hobart

Written by

I write about technology (more logos than techne) and economics.

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