Optimistic Saudi Bond Pricing Portends Rocky Future

After oil plummeted from prices of 100 USD to record lows below 30 USD, the Saudi Arabian government is wary of being left with 70 years worth of oil reserves, as this could render the sovereign country dead in the water. Bearing the heavy shackles of oil prices would sink the heavily oil-dependent country into the abyss of insolvency. Saudi Arabia is now looking for new options to soften the blow of the ticking time bomb that is ever-decreasing oil demand. The International Energy Agency (IEA) trimmed global oil demand forecasts for the long term with factors such as slowed GDP growth, China’s transition into a services-based economy, the electrification of the energy industry and improvement of energy efficiency all putting downward pressure on the future of oil.

The country’s path to diversification will require a large aberration in standard practices for the highly traditional nation. Saudi Arabia has kept from fully adopting the economic and financial practices of the western capital markets with the added benefit of shielding itself from the economic woes of the outside world by restricting foreign debt on the international markets. Limiting investment in foreign countries insulates Saudi Arabia from recessions and market downturns that occur abroad. In the days when Saudi Arabia’s economy was robust with domestic demand and stable growth, this was a benefit for the sovereign nation. Now, as slowing oil demand poses a threat to the oligarchical government and its constituents, it is increasingly necessary for the country’s survival to diversify away from oil.

Image courtesy of Edward Musiak © 2013, some rights reserved.

Image courtesy of Edward Musiak © 2013, some rights reserved.

In late October 2016, the Saudi Arabian government issued the biggest ever emerging market bond sale of 17.5 billion USD, nearly double that of most previous emerging market (EM) bond sales. EM bonds tend to offer higher yields, yet the Saudi bond yields were staunchly lower as prices were driven up by demand. Investors were clearly hungry for higher yield in the midst of a period of near-zero interest rates, but the market sentiment behind the lofty price of the issuance might be more unnerving. It seems that the bond sale served one sole purpose—to quench the risk appetite of investors. Many emerging market analysts are saying that the yields on the bonds were incorrectly priced in they simply don’t account for the numerous risks that threaten the Saudi economy.

In large part, this perceived risk can be attributed to the shale revelation that stunned oil markets as the United States doubled its domestic oil production. Fracking is proving to be a major threat to OPEC countries. This sent the US and OPEC member countries into a pricing war—elevating oil supply, driving down oil prices and, eventually, forcing competitors out of the market. The current social instability in the Middle East also puts pressure on the Saudis to cut back on production and raise prices for the good of its economy. It seems between the shale industry’s struggles in continuing to survive by finding more cost effective production methods, as well as the social and economic repercussions striking the Middle East, a clear winner is yet to be identified.

Low oil prices have put a dent in many Middle Eastern economies, and the series of events taking place at the moment could be seen as untimely for the Saudi population. The struggle for jobs among youth in one of the most oil-dependent economies is proving intensely arduous, as over 60 per cent of its population is under the age of 30, suggesting 1.9 million youthful Saudis will enter the workforce in the coming decade. Unemployment for Saudi youth between the ages of 16 and 29 is 29 per cent. Studies point to the education system, implying that it had a hand in bringing about a generation plagued with high unemployment. Saudi college graduates seem to be lacking the skills necessary to meet the demands of the private sector. However, there is little incentive to work for the private sector, as public sector jobs typically offer better salaries, benefits and working hours. As a result, many are employed by the public sector. Nonetheless, pressure on the government for a stable, healthy economy with job opportunities could hardly be more cumbersome.

Beyond Saudi borders, lower oil prices are taking their toll on other countries tied to the market as well. Iraq’s oil minister, Jabar Ali al-Luaibi, griped over the oil production cuts, saying that Iraq should be exempt from these cuts as their war with the Islamic State should allow them a handicap. Were OPEC to allow Iraq to continue production at current levels, this would mean that other OPEC member countries, like Saudi Arabia, would have to bear more of the brunt of the oil production cuts.

Investors buying the Saudi debt issued in late October did not seem too worried over these risks, as the bond issue amounted to the largest and most unprecedented sale for emerging markets. This could be signalling desperation in the markets for higher yield, contributing to the evidence of an overpriced high yield bond market; many market analysts have been worried about such a bubble, especially in the past year. Carl Icahn suspects that beyond the past market correction in January of 2015, the market has yet to fully atone for the ‘keg of dynamite’ that is the junk bond market. There is some speculation that market sentiment is too cavalier in that investors don’t fully understand the risks associated with some of these high yield investments.