Lower for Longer: Saudi Arabia Adjusts to the New Oil Era

Saudi Arabia, with the largest economy in the Arab world, is deeply dependent on oil exports (approximately 75–80 percent of total revenues). Largely due to high oil prices during most of the last decade, Riyadh was able to establish itself as one of the strongest and fastest-growing economies in the Middle East. According to a recent report by McKinsey Global Institute, the Saudi economy in 2003 was the twenty-seventh largest in the world; by 2014, it had risen to number 19. This economic expansion also eliminated national debt, accumulated huge reserve assets, raised average household income by about 75 percent, and created more than 1.7 million jobs.1 This astonishing economic performance was driven, almost exclusively, by public spending. The government and the public sector served as the engine of the rapid economic growth. Though for years this fiscal policy and economic structure were seen as unsustainable, high oil prices provided few incentives to initiate serious economic reform. The sharp drop in oil prices since mid-2014, however, means that the day of reckoning has arrived. Fiscal surplus has turned into deficit, and the need for structural reform has become urgent. The huge stock of assets the state has accumulated makes the kingdom relatively better able than most other producers to alleviate the impact of the price drop. These assets are, unfortunately, rapidly eroding. Within this context, the government launched its Vision 2030 in late April and a National Transformational Plan (NTP) in early June. The main goal of these initiatives is to reduce the kingdom's heavy dependency on oil revenues and create a diversified and balanced economic structure. The next section examines the dynamics of the global oil market in both the short and long terms. I argue that this cycle of low oil prices is different from previous ones. For one thing, low oil prices are projected to last for a long time. A return to a $100-dollar-per-barrel price range is not likely any time soon. The analysis proceeds to discuss the Saudi government's efforts to cope with persistent low prices and overcome the evolving economic challenges. Different options have been tried or are under consideration: borrowing from local and international markets, drawing down foreign reserves, introducing various forms of taxes, and rationalizing government expenditures by scaling back capital projects and cutting subsidies.2 Volatility has been an underlying characteristic of oil prices in the last several decades, due to several factors. As in the case of other commodities, the price of oil reflects the equilibrium between supply and demand. Equally important, given that oil is considered a strategic commodity, geopolitics has always had a significant impact on production, demand, trade and pricing. Finally, oil companies are among the richest in the world and have always allocated substantial resources to improving and developing exploration and production technology. The soaring oil prices that followed the 1973 Arab-Israeli war were driven by political developments in the Middle East. Arab exporters, led by Saudi Arabia, cut production and imposed an embargo on the United States and a few other countries for their support to Israel. A second oil shock in 1979–80 was triggered by the Iranian revolution and the Iran-Iraq War. Concerned about the stability of the Middle East and the interruption of supplies, major oil companies have invested heavily over the last four decades in developing other sources, such as the North Sea and the Gulf of Mexico. They have also invested in a new technique: hydraulic fracturing (fracking) combined with horizontal drilling. The use of horizontal drilling and hydraulic fracturing in the United States has greatly expanded the ability of producers to profitably recover natural gas and oil from complex geological plays. Generally, under the combination of these technologies, water, sand and chemicals are injected into a horizontal borehole of the well at very high pressure to crack the shale rock and release the gas. This has allowed wider access to oil and gas in shale and tight formations where the density of the rock has blocked the migration of hydrocarbons to conventional oil and gas reservoirs. Although experimentation dates back to the twentieth century (the first well was fracked in the United States in 1947)3, efforts were intensified in the mid-1970s with a partnership of private companies, the Department of Energy and research institutions. This partnership facilitated the commercial production of gas and oil from shale rock. One of the earliest successful applications was led by the Mitchell Energy and Development Corporation in Barnett Shale and North Central Texas. Since the mid-2000s, this combination of hydraulic fracturing and horizontal drilling has been widely recognized in the United States and around the world as a “game changer.”4 This technological innovation has fundamentally altered the U.S. energy outlook; production has substantially increased, and dependency on imported oil has been drastically reduced. In addition to the impressive rise in production, this technological innovation has key characteristics that fundamentally differ from “conventional” oil extraction. The exploration and development of tight oil requires a much lower investment of time and money. Accordingly tight-oil production is more responsive to price changes. In other words, persistent low oil prices are likely to slow investment and production, but once prices start recovering, investment and production will accelerate. In the next few years, most of the non-OPEC supply will likely come from U.S. shale, Brazilian deep water and Canadian oil sands. Similarly, projections within OPEC point to additional supplies. With the signing of the nuclear deal between Iran and global powers, some sanctions have been lifted and Iran has re-entered the global market. Iranian authorities have insisted on raising production to the pre-sanctions level, categorically rejecting demands to freeze output. Oil Minister Bijan Zanganeh has recently argued that an “oil freeze would equal fresh oil sanctions.”5 Since the implementation of the nuclear agreement in early 2016, the volume of Iran's oil production and export has steadily increased. In May, Mohsen Ghamsari, director of international affairs at the National Iranian Oil Company, stated that in the first half of 2016, the Islamic Republic had been able to increase its production to more than 3.8 million barrels per day (b/d) and raise its market share by 900,000 b/d.6 Similarly, Iraq is redeveloping its oil reserves after years of sanctions and war. Its crude-oil production grew by almost 1.5 million b/d over the past five years, from 2.6 million b/d in 2011 to almost 4.1 million b/d in 2015.7 These extra barrels from both OPEC and non-OPEC members mean that the global oil market has been over-supplied in the last few years. Saudi Arabia has adamantly refused to cut production in order to restore the balance between supply and demand — something it used to do routinely — instead raising production to protect its market share. In the 1980s, the kingdom decided to protect prices. Other oil producers (both OPEC members and nonmembers) did not cooperate and kept raising production. As a result, the demand for Saudi oil declined from 10.2 million b/d in 1980 to 3.6 mb/d in 1985.8 Since the collapse of oil prices in 2014, Riyadh has instead sought a strategy to protect its long-term market-share interests. In the last few years, the kingdom's export volume has witnessed a steady expansion. Exports to the United States have declined, but this has been compensated for by increases to Asia (mainly India and China), Africa and Europe. It appears that Saudi officials are convinced this strategy of maintaining market share will ultimately pay off and benefit the kingdom. Persistent low prices, the argument goes, are likely to retard investment and production in high-cost non-OPEC producers. With its large spare capacity, Saudi Arabia is likely to maintain and even expand its share of the global market in the medium and long terms. The current saturated oil market means that prices are likely to stay low for a number of years, followed by a gradual recovery. The World Bank projects that oil prices will be in the $40 range in 2016 and 20179 and will stay between $60 and $70 in the medium term.10 These low prices are the main driver behind the severe cuts in capital expenditures (capex) in global oil exploration and production, which fell by 24 percent in 2015 and are forecast to fall by anpther 17 percent in 2016.11 In March, ExxonMobil announced plans to cut its capital spending by 25 percent in 2016.12 Low investment means slow supply growth. The Energy Information Administration (EIA) projects that global supply growth will fall from the 2009–15 level of 11 million b/d in 2009–15 to 4.1 million b/d in the period from 2015–2021.13 This combination of slow production growth and robust demand suggests that the global oil market is likely to begin rebalancing in 2017. In its latest Energy Outlook, British Petroleum concludes that the oil market will “gradually rebalance, with the current low level of prices boosting demand and dampening supply.”14 The significant slowdown in U.S. oil production seems to validate the optimistic projection that recovery is imminent and prices will climb. These projections should not be taken at face value. The glut in the oil market over the last two years has prompted consuming countries to accelerate building their crude-oil storage capacity and national strategic reserves. In December 2015, the Chinese government announced that it had doubled its national oil stockpiles.15 Similarly, taking advantage of cheap prices, member states in the Organization for Economic Cooperation and Development (OECD) have accelerated building their commercial crude stocks, and the United States is moving close to full storage capacity. These enormous stocks in Asia, Europe, North America and elsewhere will act as a dampener on the pace of recovery in oil prices when the market starts rebalancing and the gap between supply and demand tightens. Finally, how low oil prices are likely to affect the U.S. shale-gas/tight-oil revolution is an open question. Technology is not static; oil companies will keep enhancing it, making it cheaper and more efficient. It is likely that the projects put on hold due to low prices will be re-evaluated and might see the light of the day at lower costs. As an energy analyst argues, “the short-run responsiveness of shale oil to price changes is far greater than that for conventional oil.”16 As prices fall, investment and drilling operations will decline and production will soon follow. But as prices recover, investment and production can be increased relatively quickly. In short, the global oil market is going through fundamental structural changes driven by technological innovations and geopolitical shifts. The old cycle of lower prices triggering high consumption and low investment, eventually pushing prices up, is not necessarily applicable.17 As the world's largest crude producer and exporter, Saudi Arabia's oil sector has been the driving force behind the kingdom's economic growth and political development for several decades. Petroleum and petroleum products provide the lion's share of public revenues and gross domestic product (GDP). Not surprisingly, the fluctuation of oil prices has always had a significant impact on economic structure and performance. The prolonged period of high oil prices in the early 2000s transformed the Saudi economy into one of the world's largest and the kingdom into one of among the top performers (large fiscal surplus, low external debt and inflation rates, and substantial reserves). The sharp drop in oil prices since 2014 has dealt a heavy blow to the economy, exerting pressure on all indicators. In April 2016, the kingdom took out a $10 billion loan from a consortium of global banks, its first sovereign loan since 1991.18 Cuts in public spending are planned in 2016, for the first time since 2002.19 Reduced government spending will most likely have a negative impact on business activities. This year, oil revenues are projected to fall to their lowest levels since 2003. This will further expand the deficit accumulated in 2015.20 Faced with this gloomy outlook, the authorities have started reviewing existing government projects. The 2016 budget has witnessed only a slight decline in public spending, suggesting that low revenues have not substantially reduced the key role the government plays in the economy. The top sectors receiving public spending are military and security services, followed by education, health and social development.21 Shortly after ascending to the throne, King Salman created the Council of Economic and Development Affairs, chaired by his son Prince Mohammed bin Salman. This development suggests that the Saudi leadership understands that persistent low oil prices have created new dynamics that urgently must be addressed and that major changes are needed. In late April 2016, Prince Mohammed bin Salman introduced Vision 2030, a broad national strategy; and in early June, the NTP was revealed. As to the main goals of these initiatives,22 the prince stated, “We will not allow our country ever to be at the mercy of commodity price volatility or external markets.”23 The plan calls for (among other things) increasing efficiency, diversifying the economy, cutting public spending, reducing subsidies, increasing the role of the private sector, and privatizing major public assets.24 A major part of Vision 2030 involves selling off about 5 percent of the state-owned national oil company, Saudi Aramco, and transforming it into a holding company with subsidiaries listed via an initial public offering (IPO). As the company holds the world's largest proven oil reserves, its listing could become one of the largest IPOs ever.25 Saudi Aramco is widely considered the best-managed company in the kingdom and one of the most efficient national oil companies in the world.26 It enjoys a distinguished status in the kingdom's history and economic policy. In 1933, King Saud Ibn Abd al-Aziz, the founder of modern-day Saudi Arabia, gave Standard Oil Company of California (SOCAL, later Chevron) a 60-year exclusive right to explore for oil in the eastern part of the kingdom. The Californian-Arabian Standard Oil Company (CASOC) was formed to exploit the concession. In 1944, CASOC was renamed the Arabian American Oil Company (Aramco). In 1980, it was amicably agreed that Aramco should become 100 percent Saudi-owned, with ownership backdated to 1976. Nine years later (1989), the last American to preside over Aramco, John J. Kelberer, handed over power to its first Saudi boss, Ali al-Naimi, who later became the kingdom's oil minister.27 Transforming Saudi Aramco into a holding company would involve several challenges, one of them fiscal transparency. The company publishes information about its history, mission, vision, culture, leadership and operations,28 but accurate data on annual revenue, profit and debt is largely missing. More public accountability will be required. Second, Saudi Aramco is, by far, the most valuable national company in charge of managing the most important source of national income. Making such a historical transformation requires building consensus among the country's political and economic elites and policy makers. It is not clear that broad public and support is behind the public listing of Saudi In Prince Mohammed that Saudi authorities plan to the and it one of the sovereign in the “We is a to increase through introducing new assets, the most important of which are Aramco and some huge In the last few decades also as oil have accumulated substantial assets and as major in the and global They are investment for a of The is that share of government revenues from the of a should be put for when these revenues a decline might come about through fluctuation of prices or of resources oil are into two and The are to reduce the impact of volatility in on government and the economy. oil prices are the when prices are the into the are to that not only current but also the of oil by and a of oil oil to both and They the of the long-term investment of assets in involve more and than reserve The of the largest in the Gulf the the and the most of the other large oil exporters, Saudi Arabia has not to an oil The kingdom's of foreign assets is largely by the Saudi Arabian the country's It was in and has since been with several and the national managing the growth of the and commercial and has invested surplus oil revenues in assets income and policy has been and largely to investment in U.S. and In the was by The goal is to provide support to projects of a commercial that are significant for the development of the national economy and be by the private sector of or resources or Since its the has a number of state-owned the Saudi Company, (the Saudi the Saudi and Company, and Saudi In 2016, the invested billion in The of oil in other states to more was in In the Saudi government the of a state investment with an initial of billion Saudi is by the and as a with a on long-term through investment various sectors in Saudi Arabia and In most countries in the Middle for and water a significant share of government spending. with the energy have been a huge on public in Saudi Arabia and other oil producers. A can be as “the between market price and the of the The argument for energy in Saudi Arabia is on several both economic and Low energy prices have been a of the social between the and the and are seen by as a key of They have also been a part of and Low and water prices provide a for Finally, low energy prices keep inflation under the other a number of and energy have recently argued that energy have long their Low prices are all energy and benefit from the of cheap and petroleum They also and reducing incentives to in and energy Saudi Arabia almost all its has recently to reform energy prices. Energy are to have the Saudi government around billion in 2015 percent of The kingdom more than half its by oil and natural gas is in short a significant to the around million b/d of oil and products are to domestic demand. The a rise in demand by 25 percent between 2015 and The 2016 Saudi budget price increases for domestic energy The prices of crude natural oil and all were energy prices in Saudi Arabia are among the in the more reform is needed. For decades, Saudi officials have about the need to the economy from oil reduce the role the government plays in the economy, the private sector and foreign The is that has been The country deeply dependent on and to the fluctuation of oil prices. The current key changes in the oil market and can be seen as an to structural reform. in two major are likely to to a successful economic transformation — investment in capital and For a long has been a between the private and the the for in the private As part of its for a economy, Saudi Arabia launched its first National and Technology in King for and Technology is a of these efforts to support research and In the government launched a under which high of from the The has had only In 2016, Minister announced that the government would a more of in the The goal is not only to provide incentives to private companies to but also to more with the and In short, a serious reform of the would greatly the transformation from an economy heavily dependent on oil revenues to a Finally, domestic structural reform and economic be in from to the in and Iraq and serious economic and political in Saudi Arabia has as the of the Arab In recent years, the strategic between Saudi Arabia and Iran has intensified and become a major force behind the in and the kingdom's military spending has The country has one of the military in the world, both in and per The American in and Iraq the negative between foreign policy and military on the one and economic on the The war between Riyadh and to be transformed into a economic

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