Saudi Oil Policy Is Set in Stone
MAY 24, 2016 | 08:00 GMT
By Matthew Bey
Next
week, OPEC will hold its first meeting since talks on freezing
production between the bloc's major producers and their non-OPEC peers
fell apart in April. The June 2 convention will also mark the first time
OPEC members have come together in Vienna since Saudi Oil Minister Ali
al-Naimi stepped down, making way for Khalid al-Falih to take his place.
Both events have raised questions about what direction Riyadh's oil
policies will take in the months ahead, and how they will affect the
kingdom's relationships with its fellow producers.
By
all accounts, Saudi Arabia seems prepared to move forward with its
original plan to protect its share of the global oil market, allowing
concerns about low oil prices to take a backseat. Deviation, at this
point, is not really an option; Riyadh's strategy has firmly committed
the kingdom to riding out fluctuations in the market over the next five
years. Saudi Arabia will have no choice, then, but to redouble its
efforts to dramatically restructure its economy away from excessive
spending and an overreliance on energy revenues. But whether the House
of Saud will be able to get the country's younger generations on board
with what is likely to be a painful economic adjustment remains to be
seen.
A Painful but Logical Strategy
When
oil prices plunged from $115 to $80 per barrel between June and
November 2014, many of the world's oil producers and companies hoped
that OPEC would step in to fix the situation. By collectively reducing
their output, perhaps the organization's members could bring the market
into balance and nudge prices back up. But Saudi Arabia, which has
historically dominated the bloc, had other plans. Al-Naimi chose to
increase production instead, intending to maintain Saudi Arabia's
sizable share of the global oil market. By March 2015, Saudi output had
risen by 660,000 barrels per day and oil prices had fallen even further,
reaching as low as $45 per barrel.
Riyadh's
choice was rational. After all, high oil prices — and the pursuit of
more costly shale and the tight oil plays they encouraged — were one of
the primary reasons new supplies flooded the market in the first place,
putting downward pressure on prices over time. The technological
advances that opened the more challenging basins to exploitation also
reversed the seemingly terminal decline in U.S. oil production. (In
January 2011, U.S. output was 5.5 million bpd; four years later, that
figure had jumped to 9.3 million bpd.) Indeed, within the same quarter
that Saudi Arabia chose not to scale back its production, U.S. output
rose by 400,000 bpd, an astronomical amount considering annual demand
for oil worldwide grew by just over 1 million bpd.
Moreover,
shale projects tend to have different timelines than their more
conventional counterparts. Oil and natural gas production often does not
begin until several years after companies' final investment decisions
are made. In the Gulf of Mexico, for example, it takes an average of
eight years for production to start after an offshore discovery is made.
By comparison, shale resources can be tapped more quickly (even within a
few months) but decline more rapidly once they come online. As a
result, shale projects are more sensitive to short-term fluctuations in
energy prices.
It
thus made sense for Saudi Arabia to risk immediate financial pain by
giving low oil prices time to edge shale producers out of the market,
especially since cutting Saudi output could have easily subsidized such
producers even more. At the time, U.S. shale companies were financially
healthy and enjoyed access to plenty of cheap credit. There was no
guarantee that they would not be able to continue ratcheting up
production unhindered amid higher oil prices, until logistical
bottlenecks or exhausted geological potential got in the way. In fact,
estimates of the U.S. oil industry's maximum potential varied
considerably. Some, including PIRA Energy Group and Rystad Energy,
projected that U.S. shale crude oil and condensate production alone
could increase by another 4.5 million bpd by 2020 if prices stayed above
$100 per barrel.
With
this in mind, Riyadh's best option was simply to wait for the market to
rebalance itself. An adjustment of that kind would not be quick, but
with over $700 billion in reserves, the kingdom could afford to hold its
ground for several years. Raising Saudi production in the meantime
would merely accelerate the corrective process.
That
is not to say the wait-and-see approach would not come at a high cost.
Even at prices of $60-$70 per barrel, some shale plays were still
economically feasible to develop, and below that shale producers proved
extremely resilient. As they continued to become more efficient, shale
oil production kept rising until it peaked at 9.6 million bpd in June
2015. Meanwhile, other oil projects that were locked in before prices
crashed continued to come online, adding to the global energy glut. The
gap between supply and demand worldwide grew until the final quarter of
last year, stopping only when output outstripped consumers' needs by 2.5
million bpd.
Coming to Grips With Reality
No
matter what avenue Riyadh had taken at the end of 2014, it could not
have softened the inevitable blow to its oil revenues. Fewer funds were
simply part of a new reality that Saudi Arabia would have to adjust to,
likely for at least the next five years or so. For a country that had
become accustomed to the lavish spending high oil income enabled, that
would be no easy task.
When
oil prices topped $100 per barrel, Riyadh was able to count on
receiving over 900 billion riyals ($240 billion) a year in revenue. But
now, with prices unlikely to surpass $50 per barrel within the next few
years, the kingdom can expect to collect only about half that sum. Its
annual expenditures far exceed that amount; in 2014, they totaled about
1.1 trillion riyals. If oil prices continue to hover around $40 per
barrel while Saudi Arabia's spending remains about the same, the result
will be a budget deficit of about $150 billion each year. Against this
sizable shortfall, Riyadh's $587 billion cushion in foreign exchange
reserves no longer looks so large.
It
is no surprise, then, that Riyadh's primary focus over the past year
has been curtailing its spending and increasing its revenues from other
sectors, though its Vision 2030 plan also
emphasizes greater transparency and structural reform. The Saudi
government has already reduced its natural gas, gasoline, electricity
and water subsidies — all of which have become significant sources of
tension among the Saudi public, even though the cuts lowered Riyadh's
bills by 975 billion riyals in 2015. This year, Saudi officials hope to
tighten their belts even more to meet a budget of 840 billion riyals.
But
Riyadh has a history of spending beyond its budgeted needs, and
sticking to its 2016 budget will likely prove to be just as difficult.
Redefining the government's social contract with its citizens by
funneling less money toward welfare programs will heighten the risk of
political tension. At the same time, threats to Saudi Arabia's security
do not appear to be shrinking any time soon, nor do the crises in Yemen,
Syria, Iraq or Lebanon seem likely to stabilize in the near term. And
yet the country's 2016 budget allocates only 213 billion riyals toward
military spending, far less than Riyadh doled out in 2014 and 2015.
Still,
the immediate constraints to adopting greater fiscal austerity measures
will not be the most difficult or costly challenges facing the Saudi
government. In the longer term, the structure of the Saudi economy — and
the oil industry at its center — will have to undergo a fundamental
change. This will not be easy or cheap to do, especially since obstacles
to severe cutbacks in military or social spending will make expensive
economic infrastructure and development projects more vulnerable to
delays or cancellations in the short term. In theory, the envisioned $2
trillion Saudi Public Investment Fund and public-private partnerships
are intended to liberalize the domestic economy in a way that protects
these strategic projects from being shuttered, but it is not yet certain
whether they will be effective.
The Kingdom Will Not Budge
Although
Saudi Arabia is unlikely to change course on its policy, it could make a
few subtle corrections in the coming years as it gets its spending
under control. In fact, because the kingdom's actions have already begun
yielding consequences for some of its competitors, Riyadh has dialed
back its aggressive production hikes aimed at pushing more expensive
producers out of the market. Since March 2015, Saudi output has averaged
about 10.28 million bpd. Riyadh needs prices only to stay below about
$50 per barrel for its strategy to work; continuing to raise output and
force prices even lower would only drain its coffers faster and get in
the way of its objectives. As a result, Saudi Arabia has shown itself
far more willing to cooperate with other oil producers when prices are
at $20-$30 per barrel than when they are near $50 per barrel.
And
though Riyadh's strategy is working, it does not want to jeopardize its
success. The global oil market is righting itself, albeit slowly, and
it is possible that the current oversupply could become an undersupply
by the end of 2017. Excess oil supplies have fallen, hovering between 1
million and 1.5 million bpd, and the Energy Information Administration
predicts U.S. production alone will drop by another 500,000 bpd in the
third quarter of 2016. Furthermore, low oil prices have led to the delay
or cancellation of nearly $400 billion in new projects that now may not
come online until after 2020, pointing to the possibility of a
substantial oil shortage emerging within a few years.
Taken
together, these developments make it likely that Saudi Arabia will
avoid any significant upticks in production in the near future. Rather,
it will probably hold its output steady at around 10.5 million bpd for
most of the rest of the year, with the exception of a slight bump during
the summer to meet higher electricity demand. Indeed, Saudi Aramco CEO
Amin al-Nasser has said his country will make only limited increases in
production this year compared with 2015.
But
the same cannot be said for the long term. As global demand for oil
rises and delayed investments create gaps in supply, Saudi Arabia will
find ample opportunity to ramp up its oil production and exports. Nor
will it be the only producer to do so. Riyadh's approach does not differ
much from that of the Gulf Cooperation Council: By 2020, Kuwait hopes
to raise production by 1 million bpd, while the United Arab Emirates
aims to increase its output by nearly that amount. Whether or not they
meet their goals, both countries — as well as Iran and Iraq — will try
to secure a greater share of the oil market throughout the rest of the
decade. Though these countries' strategy diverges from those of their
OPEC peers, many of whom want to freeze or reduce global production,
they have not changed much over time. For Saudi Arabia's part, its
attitude toward OPEC has remained relatively consistent: When a crisis
in demand causes prices to fall, Riyadh will use the bloc to stabilize
the market. But those are not the circumstances of today's environment.
Shale production has led to a substantial shift in supply — not demand —
and unless the global economy falls into recession over the next five
years or so, Riyadh will be unlikely to cooperate with its OPEC rivals
to cut production.
Beyond
2020, the picture is less certain. Given the looming oil shortage,
prices could eventually recover to as much as $70-$80 per barrel, if not
higher. If they do, Saudi Arabia — facing less pressure to fix the
flaws in its economy — will be more likely to slow its diversification
and restructuring efforts.
For
now, though, Saudi Arabia will push ahead with its reforms. And this
time, it may have more success. Historically, the reforms have been
heavily tied to Saudi Arabia's young prince, Mohammed bin Salman, and
his ability to connect with Saudi youths could be the key to the
policies' implementation. The country's younger generations have come to
expect the type of government-subsidized support and employment that
their predecessors experienced, and the promises of greater transparency
and accountability woven throughout Vision 2030 are designed to
communicate to the kingdom's youth that Riyadh is putting a better
future in place for them.
With
an eye toward reassuring its population, the House of Saud is keenly
focused on ensuring that the country's younger citizens are along for
the potentially tumultuous ride ahead. Saudi Arabia needs their buy-in
and wants them to trust that the government's reforms will benefit them,
even if they are uncomfortable in the short term. Should Riyadh gain
Saudi youths' support for the social aspects of the reform as well as
the economic ones, the government is far more likely to continue
implementing them if, or when, oil prices recover.