Arabia Analytica* and its partners, Ambassador Michael Gfoeller & David Rundell, were introduced to Henry Hancock of Precision Macro by our Advisory Board member Bill Richards.  Mike and David have over 70 years of combined experience in diplomacy and statecraft in the Middle East, Russia, and Eastern Europe.  The quality of their analysis and information is extraordinary. 

Ambassador Mike Gfoeller:  Mike Gfoeller served from 1984 to 2010 as a US Foreign Service Officer.  His career included service in Riyadh, Saudi Arabia; Manama, Bahrain; Iraq; Moscow, Russia; Yerevan, Armenia; Chisinau, Moldova; Warsaw, Poland; and Brussels, Belgium.  He served for two years (2008-2010) as the Senior Political Advisor to General David Petraeus, then Commander, US Central Command.   From 2004 to 2008, he served as Deputy Chief of Mission and Charge’ d’Affaires at the US Embassy in Riyadh, Saudi Arabia.

David Rundell:  David Rundell served as an American diplomat in the Middle East for thirty years.    Half of that time was spent in Saudi Arabia where his assignments included: Charge d’ Affaires, Deputy Chief of Mission, Political Counselor, Economic Counselor, and Commercial Counselor.  This is a unique record of concen-tration for  American diplomat, not only in Saud Arabia, but in any country.  David lives in Dubai.

Saudi Arabia

Question: How are Saudi Arabia’s political and economic models changing?

The main driver of the change is the fact that their pre-reform economic model was heading for a crack-up due to domestic energy consumption, which was a product of population growth, wastage, and consumption growth.  Saudi domestic energy consumption has risen every year for 30 years except for 2016, much of that on the back of rapid population growth (although that has slowed to 2% now from ~6% throughout most of the past 30yrs).

The Saudis began to worry that they would become a net importer of energy by 2025-2030; their economic model would break down long before that.

The Saudis recognize that their economic model is unsustainable, that the oil windfall that allows the average Saudi to have a standard of living that is totally divorced from his productivity will not be sufficient in the future.  75-80% of Saudis currently work for the government.  That is not sustainable.

The key elements of the reform program include: 1) Raising domestic energy prices; 2) Build-out of oil & gas production using fracking; and 3) Build-out of large-scale energy production from renewable sources.

Funding for the reform program will need to come from 1) the ARAMCO initial public offering, and 2) increased foreign direct investment.

The overriding goal of the reforms is to preserve the exportable oil surplus.  The second (and longer-term) goal is to diversify the economy away from energy production.  The Saudis need to produce new industries, an endeavor they have started – they realize they have missed the boat in the last few waves of industrial change; now they are looking at building out new industries around very high level technologies.

Major investment and the build-out of substantial production capacity in the following non-Energy industries is underway: 1) Mining – Saudi could become quite dominant in phosphate; 2) Fossil Fuel Derivatives – plastics etc.; 3) Tires.  SABIC (Saudi Arabian Basic Industries) has an incredibly diverse product line, bought GE plastics, and is trying to generate new industries out of their existing products.

How long will the change take?

The transformation of the economy is a long-term process that is really only just beginning.  It is not going to be successful very quickly.  If you can produce oil at $3/barrel, it is hard to diversify away from that.

Another part of this is changing the culture, specifically around work.  They are emphasizing that all forms of work are noble, including jobs currently done by immigrant workers.  The goal is to send the immigrant workers home.

How will Saudi Arabia impact the oil price and vice-versa?

Saudi is really not the oil price maker anymore.  The big attempt recently was to collude with Russia to exert control over oil price.  But because of the much lower cost of production of shale oil, that really just means giving up market share.  Shale is profitable at much lower prices than the Saudis ever anticipated.

Other than US shale, other major developments in global oil production that the Saudis cannot influence include: 1) The Russians are striking production agreements with Iraqi Kurdistan (driving higher Iraqi production) at the same time that they are agreeing to production limitations with Saudi Arabia; and 2) Libyan oil production is skyrocketing.

Russians and Saudis need to cooperate until 2018 (because of the Russian presidential elections and the Saudi ARAMCO IPO).  After that, it is questionable to what extent Saudi and Russia will continue to give up market share to US shale, Iraq, Libya etc.

The history of Saudi trying to control oil prices is very bad.  In the 80s, Saudi oil revenues went down 80%; and it took them a long time to get back customers they had lost.  They learned then that sustained efforts to raise the oil price were bad policy.  They are unlikely to do anything like that for very long. 

Saudi is still critically important because they are the only country that has latent production capacity to prevent oil spikes.  If the oil price goes up sharply, the US calls them up to intervene.  And their ability to do this, to prevent prices from spiking, is constant and not going away: They have 2 million barrels of production (per day) that is dormant.  They spent $50Bn building out that unused capacity.  US frackers are starting to have an effect (i.e.  by increasing production when prices rise), but it takes them 6 months to do so whereas the Saudis basically just turn on a tap.

The Saudi elite is well aware of these dynamics.  They know oil is not going to $70 or anywhere close.  They think we “will be lucky to see $50).”

Will the reform program be successful?

The economic transformation (“Vision 2030”) is likely to work because so much of it involves large scale industrial and infrastructure projects with new technologies, which they have a track record of implementing successfully

They have the know-how and organization within the country and within the government to make these economic projects successful in the long-term.  There is plenty of low-hanging fruit: they currently burn crude oil to make electricity (!), and they have enormous frackable gas stores.

The Question is not whether the change happens, it is how quickly it happens.  There is no doubt they will build massive new infrastructure and industries

What explains the rise of Mohammed Bin Salman (MBS)?  

One of the big unspoken things about the rise of MBS is that every weekend Dubai fills up with young Saudis.  Dubai is seen by a lot of young Saudis as the model that Saudi Arabia should aim for, and indeed the government is starting to do just that.  MBS is trying to liberalize Saudi Arabia’s social structure. 

MBS admires the young princes who run the UAE and is very close to them.  He has hired the same consultants who planned much of the UAE’s recent economic development.

One of the great sources of MBS’ strength is his youth and his ability to connect with the young population. 

What role is religion playing in the reform program?  

Saudi society is liberalizing – more liberal interpretations of Islam are becoming mainstream.  ISIS attempted to overthrow the Saudi government and take the country in the direction of the Islamic State.  But ISIS failed.

The Saudis have been trying for the last decade to roll back any support for Jihadi Islam.  Saudi Arabia’s responsibility for the growth of that movement is exaggerated.  The government tolerated militant Islam because there were influential people in the country who supported it.  But attitudes towards religion in the country are fundamentally changing, and support for militant Islam is much diminished.

Much of the elite are adopting far more moderate religious views.  There are hundreds of thousands of Saudis studying and working all over the world.  40% of them are women.   There are 110,00 Saudi citizens in the US.

Just the other day MBS said in an interview that the days of extreme religious conservatism are coming to an end.  It is in the interests of the government and the royal family for Saudi society to liberalize and transition to a more moderate Islam. 

Saudi Arabia only adopted a hardline form of Islam in 1979 in response to the Iranian revolution.

The real problem is not Wahhabism, it is the Muslim Brotherhood (MB).  The MB developed the internationalist aggressive Wahhabi doctrine and infiltrated the education system.  The origin of militant Sunni Islam is really in Egypt, not in Saudi Arabia.  The Saudis have spent years sanitizing their education system, they banned the MB.

How do the Saudis perceive the Trump administration?  

The Saudis love Trump.  When he was elected, a senior figure said “All we care about is his Iran policy.  As long as he takes a hard line on Iran, we don’t care about anything else.”

The Saudis see the possibility of a nuclear Iran as an existential threat.

Why are the Saudis fighting the war in Yemen?  

Yemen is a proxy war between Saudi Arabia and Iran.  The Iranians have subverted Yemen, built a Hezbollah equivalent, and have attempted to take over the state.

The racial and religious tensions between Iran and Saudi transcend everything else.  It is equivalent to the 30yrs war in European history.

The first time Iran has major power-political influence in the Mediterranean region.  Iranian allies / vassal states include: Lebanon, Syria, and Iraq – and then Iranian-supported groups hold substantial power in Yemen, Egypt, and Qatar.

Even though the Iranians are Shiite and Al Qaeda is fundamentalist Sunni, the Iranians did more to help Al Qaeda than the Saudis.

What explains the rift between Saudi Arabia and Qatar?  

The Saudis want a new Emir.  They will continue to exert pressure on Qatar until that happens, unless Qatar accepts the Saudi conditions (which is very unlikely).

The Qatari Emir wants outside influence in the region.  Qatar is the wealthiest country in the world on a per capita basis.  They have $340Bn of forex reserves.  They are supporting terrorist groups to gain influence.

Does MBS have absolute power and, if not, when will he get it?

MBS is already de-facto king.  His father is probably going to abdicate within a year.  The king will do that because he wants to make absolutely sure his son succeeds him, and abdication is the only way to do that.

What is the outlook for the Saudi currency [the Riyal]? Will they retain the USD peg? 

The political elite does not yet support devaluation.  Their future support for it will depend on oil the price and on Saudi Arabia’s borrowing capacity – a borrowing capacity that is not yet under any kind of pressure due to massive forex reserves, government assets, and an excellent credit rating. 

There are swap arrangements between the Federal Reserve and the Saudi central bank – the Saudis can get all the dollars they want.  

The Oil Price

Prices will fall after the first quarter of 2018.  After the IPO of Saudi ARAMCO and the Russian election, the taps will open.  Between now and then, the Iraqi Kurds will double output with the help of Rosneft.  The Libyans are increasing output to 1.6 million barrels per day (from under 900k currently and 250k nine months ago).

Russia & Ukraine

We think a new war may be coming.  It will be helpful to Putin’s reelection campaign (the election is in March).  He needs the help because there is a revived political opposition within Russia.

The strategic goal would be to take Odessa and the major Eastern European cities, and to gain control of the Black Sea coast.  The Russians want total control of the Black Sea as a major oil export route.

Russia has been building up their military infrastructure along border with Ukraine – they have everything in place that they need to mount an invasion.  They have built the insurgent forces up to 30,000 men; in mid-August they will complete an enormously expensive railroad running to the Ukrainian border.

The Russians are laying the ground for a possible blitzkrieg invasion.  Once the railroad has been completed, they will be able to surge large numbers of additional troops into eastern Ukraine.

In this context, the announcement on July 18th of the creation of a new state called “Little Russia” (Malorossiya) on the basis of Donetsk and Lugansk provinces in eastern Ukraine is very significant.  It seems unlikely that the local separatist governments, which derive all of their military support from Russia, would make such a move without coordinating with Moscow.   Russia typically creates a political vehicle of this type whenever it engages in a new military intervention in the former Soviet space that it calls the Near Abroad.

If Russia does act, it will probably do so quickly and decisively, and without a great deal of advance warning.   Moscow will certainly be able to find a Ukrainian “provocation” if it looks hard enough.   Almost any incident along the restive line of contact in eastern Ukraine will suffice.   By creating facts quickly on the ground, as in the Crimean crisis, Moscow will increase the likelihood that whatever sanctions and measures the Western powers may implement will be limited in nature.

Since 2010 Arabia Analytica has served as a political and economic navigator for firms interested in the Middle East, Russia and energy markets.  Arabia Analytica is a team of former diplomats, trade negotiators, bankers, journalists, and academics.  The firm maintains an extensive network of relationships in the Middle East, North Africa, and Russia. 

Arabia Analytica’s clients range from some of the world’s largest energy and industrial corporations to macro hedge funds and private equity firms.



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