The House of Saud - February 26, 2011

The London Brief

The House of Saud

February 26th, 2011

The Ikhwan were the main military force for Ibn Saud when he "unified" the Arabian peninsula in the 1920s. They were composed from Bedouin tribes, who adhered to the teachings of Muhammad ibn Abd al-Wahhab. This group believed that Islam's decline was the result of religious innovation and the abandonment of pure Islamic teachings. They believed that Muslims should emulate the three early generations of Islam and purge foreign influence from religion. In particular, they rejected "kalam" or debate, a key tenet of Greek philosophy. They were merciless. Every male opponent captured in battle was put to death by cutting their throat.

Ibn Saud was a different character. He rose to power on the back of charisma and opportunism. He kept his men well supplied with arms and plunder. In more a marriage of convenience, he allied with the Ikhwan with the support of the Wahhabi clergy.

During his war with the Al-Rashid clan, an ally of the Ottomans, the British government established relations with Ibn Saud. By the early 1920s, they supplied him with munitions to complete his subjugation of the Al-Rashids and capture the Najd area, central Saudi Arabia, which culminated in 1922. In 1925, Ibn Saud and the Ikhwan captured Mecca from Sheikh Hussein ending 700 years of Hashemite rule and taking over the Hejaz region, the western coast of Saudi Arabia. Two years later, the British signed the Treaty of Jeddah which recognized Ibn Saud as the ruler of the Hejaz and Najd.

The Ikhwan would have nothing to do with Ibn Saud's ventures with the British. In the 1920s, they raided Transjordan and Kuwait to try to unify the Arabian peninsula under a Wahhabist banner. In both incidents the Ikhwan took heavy casualties, courtesy of the British Royal Air Force. The Ikhwan accused Ibn Saud of "going soft" and that the Saudis were "as much use as camel bags without handles". The result was the battle of Sbillah in 1930 between Ibn Saud and the Ikhwan. Ibn Saud won. The survivors were jailed, the leaders executed and the Ikhwan reorganized.

Eighty years later, the Ikhwan's descendents remain opposed to the House of Saud. In their view the royal family has gone from "soft" to outright corrupt and immoral. One direct descendent, Juhayman al-Otaibi, gained prominence when he led the Grand Mosque Seizure in Mecca in 1979. There are many other Saudis that believe in this puritan vision of Islam. In order to pacify these elements, the House of Saud have given substantial discretion to the ulema to set laws on social behaviour and administer jurisprudence using Shariah law. But it is a weak alliance particularly as King Abdullah has taken steps to mute the ulema's influence and become more liberal.

The Opponents

The House of Saud faces four main opponents to their rule: (1) the Islamists and descendents of the Ikhwan; (2) liberal pro-democracy advocates; (3) the Shi'ite minority; and (4) long-standing tribal and regional opponents. In addition, there is internal strife from the Sudairi faction within the family.

The Islamist threat is well known. They have created havoc over the years including a car bomb that killed five U.S. citizens in 1995 and the Riyadh car bombings that killed 35 people in 2003. In 2004 there were 38 incidents involving militants. There were 22 incidents in 2005. After several raids in 2006 by the National Guard, the Islamists have been more quiet, but they are still there waiting for their opportunity.

Liberal, pro-democracy advocates also oppose the regime. Over the weekend, 119 intellectuals and businessmen signed a position writing, "The current situation ... is full of reasons for concern. We are seeing ... a receding of Saudi Arabia's prominent regional role for which our nation was known and the .... prevalence of corruption and nepotism, the exacerbation of factionalism and a widening in the gap between state and society." They detail a list of economic and social problems and say "the people's consent is the sole guarantee for the unity and stability" of the country. The disaffected aspire for a representative system of government; the same rallying cry as Egypt and Tunisia.

The Shi'ite minority has also been restive. In 1988, four blew up fuel storage tanks at the Saudi Petrochemical Company. They comprise 15% of the population. The Wahhabists commonly refer to them as "heretics", "traitors", and "non-Muslims". Fatwas have been passed by the Saudi ulema calling them apostates. One member of the Higher Council of Ulema sanctioned the killing of Shi'ites. Wahhabi religious literature repeated the jihad call as late as 2002. There is no Shi'ite elite for the Saudi family to dialogue with, no cabinet ministers, no representation in the security forces or army, no mayors, no police chiefs and no principals of schools. The government restricts the use of certain names when Shi'ites are born to mask their identity. Saudi textbooks teach that Shi'ism is worse than Christianity and Judaism. Teachers call them heretics in front of school children.

The tribes in the former Hejaz and the descendants of the Al-Rashid clan are also sources of instability. The Saudi royal family and its estimated 7,000 members occupy almost every significant post in the Saudi government. The thirteen regional governor posts and key ministries are reserved for the family. The other tribes are given no representation and seethe with resentment.

Finally, there is internecine family risk. The Saudi Arabia National Guard (SANG) has 75,000 soldiers. This is King Abdullah's private army, which he keeps separate from the 75,000 strong Saudi Army, which is controlled by a member of the Sudairi clan. King Abdullah's ascension was criticized by the Sudairis and a power struggle in the younger generation is inevitable.

The stage is then set for instability in a country that produces 13% of the world's oil and has 20% of the world's oil reserves.

The Immediate Effects

Last week Brent oil peaked at $120 and WTI at $103. This shock will slow down developed economies. However, if Saudi production can get oil prices back down into the 80s, earnings should only be negatively impacted for a few weeks.

It's quite possible that Libya makes it without a civil war. The opposition forces are not laying claim to resources and most villages talk about "one Libya". Abdurrahman Shalgham, the Libyan UN ambassador and a life-long friend to Gaddafi said, "Ninety percent of our missions all over the world are not with Gaddafi. We are working for Libya". Gaddafi made it illegal for Libyans to hold arms, so most of the country do not have weapons unlike Iraq or Afghanistan. Meanwhile Gaddafi's "voluptuous blonde" Ukrainian nurse is leaving him along with many former supporters, indicating that Gaddafi's days are numbered.

In Saudi Arabia, the king has wagered a $37 billion bribe to keep the peace This includes spending for health and education, unemployment benefits, job creation and loans to small businesses. Even before the unrest, he spread wealth to the Shi'ite minority employing large segments of that community within Saudi Aramco.

In Algeria, the President put out a press release saying that any policeman who beat protesters would be severely punished. He lifted a state of emergency, which had banned peaceful protests. He pledged to address issues in housing, employment and administration services. People still remember the turmoil of the last civil war and don't want to go through that again. The protests have not focused on a change of regime, but rather an improvement in economic conditions. With 35 million people, it's unclear whether Algeria's government can spread the wealth around that much, but they have flexibility.

Equity Market Outlook

In the near-term, Algeria and Saudi Arabia are the ones to watch. If one of them goes, this would be a major shock and the oil market has no capacity. Saudi Arabia is shaky. If pro democracy advocates or Shi'ites take to its streets in protest, the Islamists and the opposing tribal heads will join them. There are 25 million people in Saudi Arabia. A combined mercenary National Guard and Saudi Army of 150,000 will not be able to protect the House of Saud. One of the LB's ex-CIA sources says the royal family has moved the bulk of its financial assets to financial institutions in the United States. A disruption in Saudi oil production would be worse than Lehman Brothers.

If Algeria and Saudi Arabia remain stable, but Libya dissolves, oil supplies will still be quite vulnerable to shocks and we should see oil settle in the mid to high 90s level WTI. This is a level that could inhibit earnings growth, but it would not cause a crash or a negative growth scenario. Oil could settle in the low 90s if Saudi and Algeria fears dissipate. If Libyan production is out, this is an interesting accumulation point as downside risks are low and there is potentially high upside on a new shock.

If Gaddafi is deposed and Libyans put aside tribal differences to forge a new government, then oil prices should go back to the mid 80s as there should be extra capacity. By year end or early 2012, the demand for oil should rise and eliminate that capacity and my longer term bullish outlook for oil remains.

If prices hover around high levels for a month or two, we are likely to see an earnings crimp for the first quarter. However, it also means that it is unlikely that governments raise interest rates given the lower economic growth. This is risk asset bullish. So I would pick spots in equities carefully with a view to being invested by the end of the first quarter. Note though that stability in Algeria and Saudi Arabia remain key to that theme and as the analysis above shows, there is instability risk in both countries particularly Saudi Arabia. This means that it's important to buy gap risk protection to hedge against blow-ups in the land of OPEC.

China

Another event that was a bit under-reported this week is that China passed milder than expected measures with regards to minimal capital requirements at its banks. The original measures from the CBRC had spooked the market, but the final requirement came in at 5%, 6% and 8% representing core Tier 1, Tier 1 and total capital. Basel III requires 4.5%, 6% and 8%. Originally CBRC had proposed 6%, 8% and 10%. I think the risks to a hard landing in the short term are low as China continues to go easy on tightening measures.

The End Note

In the midst of the oil shock, two traders in Australia got a bit scrappy at UBS. The altercation concerned a "line of stock" trade. It started out with a gentle shove and quickly turned into a World Wide Wrestling Federation match. UBS management was not too pleased, particularly when it hit all the Australian television stations. One has lost his job and the other his manager role. Maybe they should have emulated Gandhi and just sat down.

On another note, the London Brief web-site is close to arrival. I'll describe the site in more detail in the weeks ahead.

Omar Sayed

London, February 26, 2011