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Special Report

All hands to the pump on policy

January 2013

Riyadh must adjust its energy policy in light of a changing domestic and international landscape

On a perfect winter’s day at Saudi Arabia’s giant Shaybah oilfield deep in the Empty Quarter, the red dunes loom over the wells, the weather is cool and the sky is clear and blue. Propelled by high oil prices and near-record output, the kingdom has enjoyed a prosperous decade, even manoeuvering successfully through the global economic crisis and the region’s revolutionary upheaval.

But storm clouds are gathering on the horizon – and policymakers should take heed while these problems are still manageable. Some of these clouds are being blown in from abroad. Others hang over Saudi Arabia itself.

The kingdom enjoyed exceptionally calm and untroubled weather during the first decade of this century. Strong oil demand in China, a poor performance from non-Opec producers, and the elimination of serious Opec competitors – Iraq, Iran, Libya and Venezuela – by war, sanctions and mismanagement meant that it could increase production modestly, while still enjoying record oil prices. Even during the global financial crisis in 2008-9, when prices tumbled abruptly from a record of $147 per barrel to $35, Saudi Arabia was able to muster its Opec colleagues to cut production and protect its revenues.

Opec’s report in November 2012 was the first time it has seriously acknowledged the ominous shadow of the US shale oil boom – oil released from ‘tight’ reservoir rocks by horizontal drilling and hydraulic fracturing. North Dakota alone has already overtaken Opec members Ecuador and Qatar. By some (dubious) measures the US has surpassed Saudi Arabia in total petroleum liquids production – and it should do so convincingly in the next few years. Citibank suggested in March that the US could be self-sufficient in oil by 2020 – driven partly by shale oil, more by efficiency gains and car mileage standards.

The exact level of US oil production, and whether it becomes self-sufficient or remains a modest net importer, is less significant than the big picture - that it promises the first period of sustained non-Opec output growth since 2004. The ‘tight oil’ boom is now spreading to Canada, and perhaps in the next few years to Australia, Argentina and Russia. Kazakhstan and Brazil are set to add significant conventional oil production. Noting these projections, and tepid global demand due to the Eurozone crisis and faltering recoveries elsewhere, Opec forecasts only slight growth in demand for its oil over the next five years.

The tussle over the new Opec secretary-general in December, though irrelevant to production quotas, was symbolic of ‘the enemy within’, as Riyadh may see it. Iran and Iraq put up candidates, as did Saudi Arabia, leading to deadlock. Iraq’s ambitious production growth plans would take it from about 3.2 million barrels per day (b/d) today to nine to ten million b/d by 2017. It is likely to fall short of this, but even six million b/d would imply other Opec members would have to cut back to accommodate it, or risk prices falling. Yet in addition to Iraq, Opec members the UAE, Kuwait and Libya all have plans for significant growth, while with president Hugo Chávez suffering from cancer, Venezuela’s oil industry, after a decade of decline, may also be set for a change of course.

Seeing Shi’a-led Iraq as an Iranian proxy, the Saudis have refused to engage seriously with Baghdad. For their part, the Iraqis have given little apparent thought to their Opec strategy, what quota level they should seek (if any), and how other Opec members, above all the Saudis, might respond.

Because of shale oil and increased output from Iraq and elsewhere, chief executive Khalid al Falih announced in October 2012 that Saudi Aramco did not plan any increase in its current official 12.5 million b/d capacity until at least 2015. “A few years ago, much of the global energy debate was based on the premise of acute resource scarcity and its economic and political ramifications. Rather than supply scarcity, oil supplies remain at comfortable levels,” he noted. Currently, Saudi Aramco’s only major new oil development is the offshore Manifa heavy oil field, whose 0.9 million b/d will mostly be used domestically.

Riyadh has benefited from troubles in Opec peers twice in the last two years. In 2011, it increased production to cover for the losses during Libya’s revolution against King Abdullah’s long-term bête noire Muammar Gaddafi, who sought to assassinate him in 2004. In 2012, it was a leading player in the sanctions campaign against Tehran – replacing more than one million b/d of Iranian exports, and reassuring Asian buyers that it would cover their needs.

Saudi Arabia has deepened its relations with Asian customers. In 2006, King Abdullah was the first Saudi monarch to visit China; Chinese premier Wen Jiabao returned the favour in January 2012 as the Iran sanctions issue was rising to prominence. Saudi Aramco plans to build a refinery in Yanbu as a joint venture with Chinese state company Sinopec, and further refineries in China’s Yunnan province and Indonesia. But it also consolidated its position in the US market by expanding its massive Port Arthur refinery in Texas, a partnership with Shell.

As with their Gulf neighbours, the Saudis are aware that Asia will be increasingly the dominant market for their oil. And, although it is still a remote eventuality, US overstretch and increasing self-sufficiency may cause it to scale down its military presence in the Gulf.

In the nearer term there may, of course, be further geopolitical shocks during 2013 – two of the more obvious eventualities being conflict involving Iran, or an upsurge of unrest in Nigeria. But in the absence of such upheaval, the forecast is for softening prices.

Saudi Arabia can, of course, cut back production to defend prices around the $90-100 per barrel level it is thought to require to balance its budget. Spending was bloated in 2011 by a $130 billion spending package intended to address social issues such as unemployment and housing shortages, and head off discontent amid the uprisings in Tunisia, Egypt, Libya, Yemen, Syria and – closest to home - Bahrain. It is also dedicating growing aid to allies in Jordan, Bahrain, Oman and Yemen.

But sustaining a historically unprecedented price runs the risk of encouraging extra high-cost oil output elsewhere in the world. Now the shale oil genie is out of the barrel, it is unlikely to disappear again. Expensive oil also supports alternative energy, efforts on efficiency, mileage standards, hybrid and electric vehicles.

Scanning the desert horizon, our attention is caught now by the clouds hovering over Saudi Arabia itself. Ever-rising budget demands threaten to collide with stagnant exports and growing domestic oil consumption. Twenty eight million Saudi residents use almost as much oil as 1.2 billion people in India.

A Citibank report in September 2012 projected that, on current trends, Saudi Arabia would be a net importer of oil by 2032. This is a simplistic extrapolation, which is clearly not going to become reality – long before, either the Saudi economy would collapse, or, more likely, drastic action would be taken.

Saudi Aramco has massively stepped up its efforts to develop ‘non-associated’ gas (historically, most of its gas has been a cheap by-product of oil production). But projected gas output will at best keep pace with demand, and new ‘unconventional’ gas will be more costly. Massive new petrochemical complexes, a centrepiece of the country’s drive to diversify its economy and create jobs, are finding it increasingly difficult to secure allocations of gas feedstock.

The kingdom is planning ambitious solar and nuclear power programmes, under the auspices of the King Abdullah Centre for Atomic and Renewable Energy, and has launched a Centre for Energy Efficiency. To its current installed capacity of about 50 gigawatts (GW), it targets adding 41 GW of solar power and 17 GW of nuclear by 2032. With dramatic reductions in the cost of solar photovoltaic systems, they are now more than competitive with oil in the Middle East’s sunny climate.

But the kingdom has not yet taken the most effective step – reforming ridiculously low energy prices, which see oil sold to power stations at less than $4 per barrel, and gas priced at $0.75 per thousand cubic feet (currently around $3.40 in the US and $15 or more in Japan). That demands major reform, not only of its economy, but also of its social model.

The decade to come thus appears much more problematic for Saudi Arabia than that which has passed. It has to manage the rise of Iraq within Opec, and the organisation’s broader challenge of unconventional oil in North America and elsewhere. It must play its geopolitical role, in which oil is its trump card, with the US as partner, Iran as adversary and China a wary onlooker.

The kingdom’s energy and economic position remains immensely strong. But, if it is to dispel the looming clouds of the longer term, it has to make serious progress on reforming its economic model, moving away from reliance on cheap energy and oil revenues to create jobs. Though policymakers are all too aware of the issues, and the massive alternative energy programme could be a key part of the solution, there is otherwise as yet not enough sign of the radical action required.

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