The Saudis are holding a Royal Flush, and it would be a mistake to proceed as if they were bluffing

There is a lot going on in oil markets these days. The Saudis are threatening anyone who dares to question their abuse of human rights with a curtailment of oil production. Meanwhile, a lack of take-away capacity combined with temporary U.S. refinery turnarounds have resulted in a disastrous pricing scenario for Canadian crude oil — across all grades from heavy to light.

We believe during times like these it’s important to not to get caught-up in the micro and instead focus on the macro. The fact of the matter is that despite all of the press about new innovation and disruption, global fundamentals in the oil sector really haven’t changed that much, with large price responses to marginal changes in supply — both locally and abroad.

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Despite all of the hype, the switch over to alternatives on the demand side such as electric vehicles remains minuscule while growth in demand from emerging countries continues, albeit not as fast a pace as many were calling for during the peak-oil days of the mid-2000s. Interestingly, because of an improvement in vehicle fuel efficiencies, petrochemicals could soon become the largest driver of global oil consumption, according to a recent report by the International Energy Agency.

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Most of the innovation has actually occurred on the supply side, with vastly improved reservoir recovery rates via the transition of horizontal multi-stage fracking into a full manufacturing process. Looking ahead, it gets even more exciting as the industry is just starting to deploy artificial intelligence to down-hole sensor technology.

However, a lot of this supply growth has come solely in the U.S., while other developed countries, including our own, have allowed extremist views to either hijack the application of these new technologies or prevent new production growth from getting to market.

In the case of the Saudi threat, this state of affairs means it is entirely within their power to move oil prices well above US$100 per barrel. Global supply is tight enough that no one country would be able to immediately respond to any disruption that might occur. In other words, the Saudis are holding a Royal Flush, and it would be a mistake to proceed as if they were bluffing.

We also think that the confrontational scenario would actually hurt others a lot more than it would the Saudis as outside of the U.S., the rest of the world does not have a solid enough economic footing to weather the inflationary impact of higher oil prices, which could be the catalyst for a global recession.

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Here in Canada, despite a mass distribution of Alberta’s oil wealth across the entire country there has been considerable push-back against the development of our nation’s resources. Consequently, we have a scenario today where we have become overly sensitive to any temporary demand disruptions out of the U.S., as evidenced by our Western Canadian Select (WCS) crude currently fetching less than US$16 per barrel. Something to think about when looking at that pump price the next time you fill up.

We have essentially let our insurance policy against rapidly rising oil prices expire, leaving us as a nation nearly fully exposed to the damaging inflationary impact should the Saudis choose to go all-in, or if there is some other supply-disrupting event. Perhaps this is why they aggressively called our bluff a few months ago when those in our Federal government chose to criticize them on twitter.

Overall, in a worst-case scenario, we could have a situation where the Canadian dollar delinks from its historical relationship to oil prices, and inflation works it magic throughout our economy. Initially, the impact could be partially mitigated as the rest of the country continues to suck Alberta dry until the province is forced to increase taxes and the deficits get too large that suddenly there is no-one paying into equalization.

Perhaps then, we’ll want to renew that insurance policy but at a substantially higher cost. I’m sure that’s a game of poker most Canadians don’t want to play.

Martin Pelletier, CFA is a Portfolio Manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private client and institutional investment firm specializing in discretionary risk-managed portfolios as well as investment audit and oversight services.