The longer oil languishes, the more pressure builds on Saudi Arabia to abandon its currency peg.

Contracts used to speculate on the riyal’s exchange rate in the next 12 months jumped to a 13-year high on Monday. That reflects growing bets for the currency to weaken for the first time in almost three decades, even after Saudi Arabia said it’s ready to cooperate with other oil producers to stabilize prices.

Saudi Arabia is pumping record amounts of oil this year, leading OPEC’s effort to defend market share even as Brent crude trades near the lowest level in six years. The slide in oil revenue has forced the kingdom to tap savings and sell debt to preserve the riyal’s peg to the dollar that has been in place since 1986. For Bank of America Corp., that may mean the country faces a “critical” choice next year: either cut production to help boost prices or adjust the riyal’s rate to stem the decline in foreign reserves.

“A depeg of the Saudi riyal is our number one black-swan event for the global oil market in 2016, a highly unlikely but highly impactful risk," Bank of America strategists led by Francisco Blanch in New York wrote in a Nov. 19 report. “It is a lot easier politically to implement a modest supply cut at first than allow for a full-blown currency devaluation."

David Fuller's view

We do not always know what governments are going to do, let alone one ruled by a new king, as we see in Saudi Arabia.  However, devaluation by Saudi Arabia next year would be seen widely as either bizarre or a sign of weakness.  Either may be true in some respects but the country remains the richest oil producer by far, even though it currently has a burn rate of approximately 20 percent of its reserves.  This is clearly unsustainable so the Saudis obviously need to find another solution.   

One option would be to slash spending much more significantly, perhaps combined with tax increases.  These would be risky policies, especially for an autocratic regime in which new king Salman recently created some goodwill with salary increases.

A better strategy for realists, which I have mentioned previously, would be to declare ‘victory’ and cut oil production by 20 to 25 percent, preferably after reuniting OPEC, if possible.  Significant production cuts would rout current short positions and lift Brent and WTI crude oil sharply. 

Agreed production cuts by a number of suppliers, including OPEC, would probably lift crude oil to a new price range of between $60 to $80.  Even if the Saudi’s had to take the lead on their own, having done so with their increased production commencing in mid-2014, oil would most likely trade above $60.  Thereafter, it might be easier to persuade some other large producers to cut supplies to achieve higher prices. 

Ego, unrealistic expectations for oil prices and rivalries stand in the way of supply cuts.  The same can be said for all other industrial commodities.