SAUDI ARABIA: Gaslands

The billionaire Saudi investor Prince Alwaleed Bin Talal has a talent for making headlines; but only rarely has he put his head over the parapet on politically sensitive strategic issues affecting the kingdom. So when he warned in an open letter to the veteran Saudi oil minister Ali Al-Naimi made public at the end of July, that the kingdom’s oil-dependent economy was looking increasingly vulnerable to rising US energy production, many Saudis were quick to take note.

Alwaleed warned that the boom in shale oil and gas would reduce demand for crude from Opec producers. With consumers limiting their oil imports, Saudi Arabia – the world’s biggest oil exporter – would be forced to produce below its headline production capacity. And this would directly challenge the kingdom’s economy, given its near-complete reliance on oil, accounting for more than 90% of budget revenues.

The prince took issue with Al-Naimi’s apparent relaxed attitude towards the challenge posed by unconventional production, after the minister told an Opec meeting in late May that this wasn’t the first time Opec has had to compete with a surge in output from countries outside the group. Up to now, Saudi officials have sought to play down the threat from surging tight oil – or shale oil – production, which reached 720,000 barrels a day (b/d) in 2012. US imports from Opec members slipped to a 15-year low this year.

Alwaleed is not the first to warn that Saudi Arabia’s traditional dominance of the oil market could be undermined by the emergence of US unconventional production. But his intervention is the first real sign that Saudi policymakers have to take these issues seriously.

While the Syria crisis and outages of Libyan and Iranian oil supply have actually heightened demand for Saudi barrels in the near term, the kingdom faces more existential long-term challenges to its hard-won status as the world’s central bank of oil. True, there is no immediate cause for panic: Saudi oil production remained above 9.5 million b/d for the third consecutive month in July 2013. Geopolitical tensions related to the conflict in Syria and Egypt’s ongoing convulsions have added a risk premium to oil prices that were already supported by the Libyan and Iranian supply disruptions.

Saudi oil revenues are holding up strongly, contributing to net foreign assets of $683 billion at the end of July, up by $32 billion on the start of 2013. However, the kingdom may not find it so easy to carry through the upward trend in oil revenues in the new few years. Saudi-based Jadwa Investment expects government oil export revenues to decline from $339.8 billion in 2012 to $279.4 billion in 2013 and to $263.4 billion in 2014. While the budget is expected to remain comfortably in the black, the balance is expected to halve to 6.3% of GDP this year, or SR177 billion ($47 billion).

Inevitably, say analysts, the downward drift in oil prices will exact an economic price – with the shale oil revolution set to loosen fundamentals in the medium to long term.

CONFIDENCE

Weaker oil output and revenues will clearly have an impact on Saudi Arabia’s hydrocarbons GDP growth and on the government’s revenue and spending. It might also, warns Samba Financial Group, weigh on private-sector confidence. “The ramping up of US production presents a major strategic challenge to Saudi Arabia,” says Samba senior economist James Reeve. “Output gains from North America are such that the market will find it difficult to absorb, in particular as the global demand outlook remains moderate at best.”

The unconventional effect isn’t restricted to tight oil; shale gas has pushed the price of US gas down, which has reinvigorated the US petrochemicals sector – and provided competition for Saudi petrochemicals producers long accustomed to cheap feedstock. “The US price is still way above the heavily subsidized Saudi price, so Saudi producers still hold an advantage. But it means that to stay competitive the Saudis will probably have to maintain that subsidy in place, and this creates inefficiencies,” says Reeve.

Assuming the current scale of unexpected outages eases, Saudi Arabia will have to intervene to reduce its oil production at some point – most likely next year, says Patrick Gibson, an analyst at Wood Mackenzie’s global supply team. “We see the Saudis having to actively withdraw some oil from the market in the next couple of years, due to the emergence of tight oil in the US and growing production from Iraq and other countries.”

Shale oil production has been accelerating in the US, growing from 111,000 barrels per day in 2004 to 720,000 b/d in 2012.

Shale oil is shifting the dynamic of global oil trade. Consultants PWC estimate that it could displace around 35–40% of waterborne crude oil imports to the US. This in turn would create additional effective supply to other locations such as China, competing with Saudi barrels in this key export market.

“The biggest challenge for the Saudis is if tight oil gets going in other parts of the world such as Russia and Argentina,” says Gibson.

But there are valid reasons for Al-Naimi’s confident posture. For one thing, the emerging unconventional oil production bolsters the long-term position of crude as a fuel source in the critical transportation sector. “In some ways, the Saudis welcome the development of shale,” Paul Gamble, a director in the sovereign department at Fitch Ratings, says. “The big picture for them is that it means that there’s less likely to be a fundamental change in vehicle engine technology. The widespread adoption of technologies unrelated to hydrocarbons would have a serious impact on the demand for oil. That is the bottom line for the kingdom.”

SWING PRODUCER

There are reasons why the kingdom should be wary about the developments underway in the Bakken and Eagleford deposits.

Recent years have seen Saudi Arabia resume its role as a de facto swing producer (stepping in to compensate for losses

elsewhere in the Opec system), as it did for much of the 1980s. “They are manipulating their supply unilaterally, not through any Opec mechanisms, to try and balance the market,” says Paul Stevens, a Chatham House fellow. “Over the last six to nine months the oil market has lost an awful lot of supply and yet the price has not risen much, and the reason is that Saudi Arabia has stepped in and deployed its spare capacity.”

Yet the advent of unconventional supply in North America could undermine this and turn the swing producer role against Riyadh’s interests. “If Saudi Arabia is acting as swing producer and less Opec oil is wanted, the pain of reducing output is going to fall on it, which is what happened in the 1981–85 period until it reached a point where it could not cut anymore, which triggered the 1986 price collapse,” says Stevens.

Despite that risk, Saudi policymakers can count on other sources of support. The cost of producing a barrel of Saudi oil remains low compared to that in rival non-Opec suppliers. What’s more, Saudi Arabia has sufficient financial ballast to sit out periods of price weakness, armed with the ammunition accumulated from sustained years of high revenues.

Deposits at the central bank are equivalent to 55% of GDP, according to Fitch. “With high deposits and negligible debt, Saudi Arabia’s net creditor position is the second best of any country we rate. It is in a far better position this time to cope with a price fall,” says Gamble.

On the other hand, the breakeven price for a barrel of crude – the level at which the kingdom needs oil prices to trade to ensure a balanced budget – has risen significantly in recent years. Fitch estimates that it hovers around $76 a barrel. This leaves little wriggle room if prices fall.

“There’s a danger of overstating the financial cushion in Saudi Arabia because although oil prices started to rise from 2002, the Saudis had accumulated a large debt in the 1990s, and a lot of the extra inflow of funds was used to pay that off. It’s only since 2008–2009 that they began to accumulate financial assets to any degree,” says Stevens.

If the oil price goes down and the government maintains the level of public spending, it is going to eat into the cushion.

Were prices to fall to $50 a barrel and stay there for four to five years, then there would be some hard choices facing the authorities. And even if the kingdom can avoid a repeat of the humiliating financial crisis suffered in the late 1990s, when oil prices dropped to $10 a barrel, the advent of new oil supply sources is a sign that the kingdom cannot rest on its oil power in perpetuity.

As Alwaleed’s letter notes, the emergence of US unconventional oil should be a trigger for a more sustained diversification effort, ensuring that the Saudi economy is not beholden to hydrocarbons alone. This is the more arduous challenge facing the government. Policymakers have talked about diversification since the first oil shock of 1973, but progress has been glacial.

Significant obstacles have prevented the non-oil private sector playing a more dynamic role. The local labour market is considered unfit for purpose, a legacy of a poor education system, while private entrepreneurs who lack princely connections can struggle to break through. Given the huge volumes of oil and the cheap production costs, the reality is that Saudi Arabia will remain an oil dependent economy.

“We don’t see much diversification in fiscal revenues. They will rely on oil for the bulk of budget revenues, and it’s hard to see them doing anything to change that significantly for some time,” says Gamble.

Efforts to boost diversification rest on initiatives like the National Industrial Clusters programme, a government-sponsored bid to develop exports oriented in the automotive, minerals and metal processing, solar energy, plastics and packaging and home appliances sectors.

The unconventional oil revolution is a signal to the kingdom that even in good times, there is no room for complacency. The state has the financial resources to give a significant boost to the country’s economic diversification effort. The question is whether it has the resolve. Prince Alwaleed and many others ardently hope that it does.