Reprinted with permission from Stratfor.
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.
