Oil keeps sliding, leaving Saudis' currency peg in balance

The sun sets over an oil refinery in Saudi Arabia.
Pete Turner | Riser | Getty Images
The sun sets over an oil refinery in Saudi Arabia.

Plunging oil prices, turbulent domestic politics and a troubled domestic economy are all taking a toll on Saudi Arabia. Now add one more item to its list of potential woes: the link of the Saudi currency, the riyal, to the dollar.

For roughly three decades, the world's largest oil producer has pegged its currency to the greenback. Yet with oil prices mired near $40 per barrel and a budget deficit looming, a few Saudi Arabia watchers have speculated that the kingdom could allow the riyal to float, as a way to alleviate some of the pressure on its domestic economy. Already, Saudi Arabia has been selling its reserves to plug a hole in its budget and shore up its flagging currency.

That scenario is part of what Bank of America-Merrill Lynch recently referred to as a "black swan" event, whose implications could have far-reaching effects for the already whipsawed oil market.

Read MoreWhy OPEC's plan to balance oil markets backfired

The combination of a strong U.S. dollar and weak oil prices has been toxic to the Saudi economy. BofA posited that oil's persistent weakness may tempt the Saudis to break its peg, which would flood markets with dollars and send crude even lower, to $25 per barrel. That could be the kiss of death for an economy where oil accounts for 90 percent of its exports and 40 percent of its growth, and spell more trouble for other commodity-linked emerging markets that have found themselves walloped by the commodity bear market.

Such a scenario remains "highly unlikely but highly impactful," BofA said, given the growing pressures on the riyal, which languishes near a multi-year low in the forward market.

Massive selling of its more than $700 billion FX war chest this year has underscored just how badly Saudi Arabia needs to offset the plunge in crude. Dollar reserves are "still high but have been falling at a relatively fast rate," BofA analysts wrote.

As the bank sees it, the key choice for the country is either to "cut [oil] supply or de-peg the riyal." The former option is already on the table, as Saudi authorities recently softened its tone on the issue of cutting supply, and challenged other oil producing countries to do the same.

So what are the chances the Saudis succumb to pressure and break a decades-old fixture break amid a global glut? Apparently, very low.

Paul Gamble, senior director of sovereign credit at Fitch Ratings said that, for several reasons, the peg is safe. "There are ample reserves to support the peg and a very strong commitment to it," Gamble told CNBC.

"Market pressure on the peg occurs at the time of sharp oil price movements, both down and up. And we do not foresee any prospect of a change to the peg."

The country's vast oil wealth obscures a population whose poverty rate is estimated by some economists to be around a quarter of the population. With millions dependent on government spending, Paul Christopher, head global market strategist at Wells Fargo Investment Institute, said that devaluation may even raise more problems than it solves.

"Without the peg, a disorderly devaluation is likely (in the face of very low oil prices), and an ongoing depreciation would be in order, as oil prices come under additional pressure," Christopher said.

"Such a dramatic and sustained depreciation would raise imported [food and medicine] costs sharply, and add to the Kingdom's already serious social strains."

For those reasons, analysts such as Fitch's Gamble expects the country to post record fiscal deficits for the next two years at least, as Saudi authorities dole out large sums of cash on public welfare.

The added spending is one reason why Fitch expects the domestic scene to remain "stable" and is holding its credit ratings steady.