Saudi Arabia’s oil policy and fiscal health have come under pressure recently as oil prices slipped from a June 2014 high of $115/barrel to less than $30/barrel in January 2016. Pundits and journalists came up with a melange of explanations for the dip in prices vis-a-vis Saudi Arabian oil policy. The most popular (and inaccurate) was that Saudi Arabia deliberately allowed oil prices to slip in order to harm Russia and Iran, two countries with which the Kingdom has serious political disagreements. Ominous predictions of Saudi Arabia’s economic collapse followed shortly thereafter.
Saudi Arabia’s decision not to cut oil production in reaction to the fall in oil prices is rooted in its own economic interests, far from any geopolitical considerations. And with the announcement of the 2016 budget, Saudi Arabia has emerged more fiscally resilient than international observers expected, despite the sharp decline in oil prices.
Contrary to widely held perceptions, Saudi Arabia did not boost oil production in reaction to the dip in oil prices; it simply chose not to cut production. Saudi Arabia’s competitors are quick to criticise the Kingdom for not cutting production to raise oil prices, but they themselves are unwilling to do the same. After all, most of them are in dire need of the cash from oil revenues.
The key to understanding Saudi Arabia’s oil policy is market share. In a paper titled ‘Addressing False Claims On Saudi Arabia’s Oil Market Motivations and Policy’, the head of the Energy Studies Unit at the King Faisal Center for Research in Riyadh, Noura Al-Saud, succinctly describes Saudi Arabia’s rationale: ‘In today’s situation, ensuring and securing a desirable percentage in market share far outweighs the potential short-term benefits of defending oil prices.’
If Saudi Arabia decided to cut oil production by two million barrels per day, for example, other oil producers such as Russia, Iran, and Venezuela would rush to fill the gap to boost their revenues. This would result in Saudi Arabia permanently losing valuable market share. If Saudi Arabia were to backtrack and reintroduce the withdrawn production to the market, oil prices would slip even further, and the chances of them increasing would be even more unlikely. In short, Saudi Arabia cutting oil production would not result in increased prices in the long term, but would cost the Kingdom invaluable market share that would be very difficult to reclaim.
In February, Saudi Arabia, Russia, Qatar and Venezuela agreed to ‘freeze’ production, a move likely aimed to project stability and predictability to oil markets. However, since the production had been largely constant in the preceding months – when oil prices were dropping – the announcement of the agreement to freeze oil output is relatively inconsequential. If anything, it only confirms that there will be no production cuts. Last month, the Saudi Arabian oil minister, Ali Al-Naimi, reaffirmed that the agreed freeze ‘is not like cutting production. That is not going to happen because not many countries are going to deliver even if they say they will cut production – they will not deliver. So there is no sense in wasting our time seeking production cuts.’
In the 1980s, Saudi Arabia suffered a loss of valuable market share as it unilaterally cut production in efforts to correct an oversupplied market. In 1985, Saudi Arabia’s efforts to reclaim that market share drove the price of oil down to less than $10/barrel. Simply put, Saudi Arabia’s current production policy ensures that it does not make that mistake again.
Another important consideration is that Saudi Arabia has arguably the lowest oil-production cost in the world, with an operational break-even oil price between $5–15 per barrel. Deep water and oil sands, on the other hand, have a production cost that ranges between $60–80 per barrel.
More importantly, there is now a new supplier with ‘spare capacity’: the North American shale-oil producers. As oil prices began their decline in the summer of 2014, the bloated balance sheets and wasteful production of the rag-tag group of unconventional producers led industry observers to believe that North American shale was the marginal barrel of the global oil market – in other words, the first victims of the falling oil price would have to be US shale producers. As oil prices fell, rig counts fell proportionally, but production was rising. Shale production only fell slightly when oil prices were in the $30s, long after many hedging contracts expired, signalling that the much-heralded $61 break-even point (controlled for sunk costs) for North American shale was an overestimate.
Most importantly, shale does not share the main drawback of conventional resources; reservoirs have very long development cycles as discovery-to-production time can span a decade. Shale oil, on the other hand, has a fraction of that development cycle and has shown a remarkable resilience to the oil-price drop. Once thought to be the ‘marginal barrel’ in the market due to its high production costs, shale oil has been successful in cutting costs dramatically by forcing oil-services providers to cut rates, and by focusing on the most productive wells away from fringe activities.
Economists argue that shale oil has become the new ‘spare capacity’ in the market, albeit a spare capacity that is controlled by relatively small entrepreneurs that can rapidly respond to price fluctuations to capture higher profits, as opposed to large governments that seek to stabilize prices. While shale oil resources exist around the world – notably in Argentina and China – the rapid response phenomenon will be hard to replicate outside the US due to legal restrictions in the ownership of mineral resources in other countries.
Hence, in the short term, US shale oil can be considered a stabilizing force in the market – albeit one controlled by entrepreneurs reacting to market signals rather than monolithic governments seeking to stabilize the oil market. This effectively eliminates the need for Saudi Arabia to police the oil market, and allows it to capitalize on its true competitive advantage as the world’s lowest-cost oil producer.
Despite widespread pessimism about Saudi Arabia’s fiscal and economic health during the months leading up to the announcement of its 2016 budget, the Kingdom has shown that it is relatively fiscally robust and resilient in the face of low oil prices.
With foreign reserves amounting to about 100 per cent of GDP and virtually no public debt, Saudi Arabia’s fiscal health is far from worrisome. In fact, Saudi Arabia will continue to have the lowest public debt in the G20, with the 2015 level at 5.8 per cent.
A rough calculation indicates that the number used as an estimated oil price in the 2016 budget is around $35–36 per barrel of Arabian Light ($37–38 Brent). And assuming an export rate of 7.3 million barrels per day while using last year’s figure for non-oil revenues, Saudi Arabia’s fiscal break-even oil price stands at around $49 a barrel if the discretionary 183 billion riyals fund is not used, and around $67 if it is used in full.
It is worth mentioning that the discretionary fund is meant to be used to counter any ‘drops in government revenue’, which essentially means to counter a further dip in oil prices. But even if there were a dip, experts in Saudi Arabia expect a sharp increase in non-oil revenue as a result of the lifting of subsidies, privatization plans, the sale of public lands, and possibly the introduction of sin taxes and VAT on non-essential goods. These factors will further drive the fiscal break-even down, putting Saudi Arabia in a powerful fiscal position in comparison to, for example, Iran, whose 2013 fiscal break-even oil price was approximately $130 a barrel.
Many observers speculated that the ongoing war in Yemen had taken a massive toll on the Saudi budget, yet the 2016 budget document indicates that the increase in military spending in 2015 as a result of the war was only 20 billion riyals ($5.3 billion). This is due to the fact that the operations in Yemen did not require much additional equipment or military purchases, and pre-existing Ministry of Defense resources constituted the bulk of the resources allocated by Saudi Arabia to the Yemen war.
That being said, it is important to emphasize that good fiscal health does not diminish the importance of the many economic challenges that the Kingdom has to address. Saudi Arabia’s fiscal reform, while an important ingredient of a sound economic policy, is not a panacea to all of the Kingdom’s economic ills; on the contrary, several challenges will potentially arise as a result of Saudi Arabia’s new fiscal realities.
While the 2016 budget has shown the Saudi government’s ability to rationalize spending and diversify its sources of public revenue, the more important and long-term objective of diversifying the economy itself remains a challenge to tackle in the coming years if the Kingdom is to reduce its reliance on oil as the main driver of the economy.
Considering its fiscal health and resilience, its power to cut or increase production at short notice, and its vast spare capacity of around 2 million barrels per day, Saudi Arabia can afford to wait out low oil prices in defense of its market share. Saudi Arabia’s power in the oil market is in its ability to weather low prices and raise or lower production at will. No other oil producer can do the same.
Saudi oil policy will likely go in one of two ways. The first is to continue production at current rates, thereby maintaining Saudi Arabia’s market share. The second is to implement a proportionate cut in production by both OPEC and non-OPEC oil producers with ample assurances that no cheating will take place.
Al-Naimi was not optimistic about the latter in a conference in Houston, saying ‘The oil market is much bigger than OPEC. We tried hard to bring everyone together – OPEC and non-OPEC – to seek consensus. There was no appetite for sharing the burden, so we left it to the market as the most efficient way to rebalance supply and demand.’
Al-Naimi reiterated that Saudi Arabia ‘has not declared war on shale or on production from any given country or company,’ but that ‘inefficient, uneconomical producers will have to get out.’
Saudi policy reflects a determination to protect market share. For Saudi production to decrease, overall global supply will have to decrease concurrently and proportionally. Whether that comes about through negotiated collective cuts in production or the collapse of certain oil producers with high operational break-even costs remains to be seen.
This article was first published by RUSI in March 2016.
Mohammed Alyahya is a Saudi Arabian political analyst.