As oil prices drop, Saudi Arabia is refusing to cut its output to defend prices, writes Sarah Rundell.


When the Organisation of Petroleum Exporting Countries (OPEC), gathered at their Vienna headquarters last November against the menacing backdrop of plummeting oil prices and a global glut, an agreement to cut production seemed the most likely outcome. Despite the world producing around 700,000 barrels a day more oil than it needs, Saudi Arabia – the world’s largest crude exporter – led OPEC’s decision to maintain production, holding the group’s output target at 30 million barrels per day. Oil had just experienced its second steepest decline in history with credit rating agency Moody’s Investor Service now predicting an average price of US$55 a barrel for 2015. Yet Saudi is steadfast on a hands-off policy.

The strategy is designed to maintain market share with key Asian customers in Japan, South Korea, Singapore and China. “Saudi Arabia’s primary concern is to not lose market share. In the 1980s they slashed production in response to North Sea supplies, the oil price fell, they lost out and they are determined not to repeat the mistake,” says Elizabeth Stephens, a strategic risk advisor at Veritas International. “The Saudis want to hold onto the Asian market at all costs, even if it means falling revenues because of the lower oil price,” agrees John Sfakianakis, regional directorat Ashmore Group.

By maintaining production levels Saudi will force curtailments on high-cost, non-OPEC producers that now account for 60% of the world’s oil production and include the increasingly dominant US fracking industry.

With Saudi production costs of between US$5 to US$6 a barrel, the Kingdom has some of the cheapest charges in the business and can withstand oil prices falling to as little as US$20 a barrel. “Saudi Arabia has pledged not to take out supply even if the price drops to US$40, US$30 or even US$20 per barrel,” says Sabine Sechels, commodity strategist at Bank of America Merrill Lynch (BofAML) in a research note.

Conversely, some experts argue Saudi’s own budgetary needs also lie behind the decision to keep pumping. The Kingdom recently released a 2015 budget showing a US$38.6bn deficit, its largest ever, on the back of a significant decrease in oil-generated revenue. “The second reason behind the decision not to cut production is the domestic budgetary arithmetic and its decreased flexibility. All things being equal, at these levels, every 250,000 bpd cut in oil output increases the fiscal breakeven oil price by US$2.5/bbl. A sticky oil production cut thus lowers the oil export revenue base while higher prices may not fully compensate for the market share loss,” explains Jean-Michel Saliba, Middle East North Africa economist at BofAML.

Saudi is armed with foreign exchange reserves of US$750bn to cushion the impact of low oil prices on government revenue, but falling oil revenue is already crimping GDP, forecast to fall from 3.7% in 2014 to 2.5% this year and 1.8% in 2016, according to Jadwa Investment, the Riyadh-based investment bank.
Outside competition

Crucial to the Saudi-led decision to not cut OPEC production is the point at which the lower oil price will knock out frackers in the US, where production has jumped from about 5 million bpd in 2008 to more than 9 million. If the Saudis are right, a certain amount of US production will not come on stream because drillers in Texas and Dakota can’t afford to fund their production. As more US oilmen announce layoffs, acquisitions and declining drilling activity, the Saudi hope is it will “push oil prices up to a comfortable level of around US$70 to US$80 a barrel”, argues David Butter, an associate fellow in Chatham House’s Middle East and North Africa Programme.

On one hand it looks like the broader strategy is paying off as many of the International Oil Companies, like BP at its North Sea operations, begin to scale back
investment plans. Yet US shale producers are proving remarkably resilient. The number of rigs is only down by 20%, according to Veritas International’s Stephens who says that “production hasn’t dropped off as fast, or on the same scale, as the Saudis had hoped”. Meanwhile, shale extraction costs drop as the technology around it develops, with research firm IHS estimating the cost of a typical shale project has fallen from US$70 per barrel produced to US$57 in the past year.

Saudi’s decision to keep producing was also a bet on oil prices spiking on growing global demand. Regional uncertainty usually sends the oil price northwards, yet this hasn’t happened. Although Islamic State’s insurgent groups have taken over several oil producing regions of Iraq, home to the world’s fifth-largest proven reserves, they haven’t seized key fields or affected global supply. Production in Libya has also rallied. Turmoil in the country had seen oil production drop from 1.4 million bpd to less than 200,000 bpd but production has since rallied to 900,000 bpd.

Elsewhere, economic growth in China, India and Western Europe has failed to come through yet with key refineries cutting back on their crude demand. The Chinese market has also grown much more competitive for Saudi since the US shale boom, with producers in Mexico, Venezuela, which depends on oil for 95% of its export revenue, and West Africa, now pushing into China as demand from their US customers slows. Although Chinese imports of Saudi oil have since picked up, they fell to 900,000 bpd in August 2014 down from 1.3 million bpd in January 2013.

Critics counter that Saudi depends more on stalwart, longstanding customers in markets such as Japan and South Korea where demand is unchanged. New demand for Saudi oil could also come from Italy and Spain, as these European markets diversify from Russia. “This could mark a big shift in geography and trade,” says Rebecca Harding, CEO of Delta Economics.


Diversification options

Saudi’s oil woes underscore the urgent need to encourage diversification in the oil-dependent economy, which derives 90% of export earnings and 80% of government revenues from crude exports. The country’s fast-growing population of 28 million, half of whom are under 25, is also characterised by high unemployment. So far, most progress has been made in the refining and petrochemical sector. Saudi is pushing up the value chain, aiming to become the second-biggest exporter after the US of refined oil and petroleum products by 2017. Most of Saudi’s refining industry is based overseas in joint ventures with other oil companies, but now two state-of-the-art refineries known as SATORP in Jubail, and the Yasref refinery in Yanbu, will add 800,000 barrels per day to the country’s refining capacity. Another plant in Jazan will come online in two years’ time, pushing refining capacity to over 3 million barrels a day.

It’s unclear whether declining oil revenues will stall Saudi’s ability to maintain large-scale diversification and infrastructure spending. Much of Saudi’s oil export receipts have been used to finance imports of goods and services, most evident in the country’s huge transport programmes. BofAML research estimates that around half of the Gulf Cooperation Council (GCC) oil export earnings were spent and recycled through imports between 2003 and 2014.

Arup Roy, head of global transaction banking at the Saudi British Bank (SABB) in Riyadh argues that the fall in oil revenues won’t dent the spend just yet. “Despite the challenges of reduced oil revenue we do not envisage any knee-jerk reaction in terms of the infrastructure spend which is strategic to support sustainable growth momentum,” he says.

Ashmore’s Sfakianakis argues that the Saudis have to keep spending otherwise the diversification programme will grind to a halt. “They don’t have the luxury of not spending because diversification requires constant spending; if they don’t spend they don’t diversify. They will keep investing, sustained by reserves and issuing debt if they have to.”

However, others experts have a more cautious, medium-term approach. BofAML estimates that pressure will grow with the break-even oil price, the level at which the government can balance the budget, at US$94 a barrel. Although the need to keep spending on diversification and infrastructure is urgent, falling oil revenues mean the government expenditure “will lack some firepower”, says Saliba.

Saudi’s massive infrastructure investment has been a rich seam in global trade. Transport is an infrastructure priority with around US$100bn-worth of rail schemes planned or underway, including new metro systems in Riyadh and Jeddah. Industrial and high-speed rail lines are also planned to link Saudi Arabia’s Gulf and Red Sea coasts, separated by the desert. Healthcare is another huge market with billions of dollars earmarked by the government to develop the medical tourism sector. Global companies vying to win lucrative deals include British groups, for whom Saudi is already the biggest trading partner in the region, with the UK exporting £7.5bn goods and services in 2012, according to UK government figures. Recent successes include a £1bn deal for British education companies to set up technical training colleges in the Kingdom. Jaguar Land Rover is planning a £200mn assembly line, taking advantage of the country’s export market and route into the wider Middle East. King Abdullah Economic City, a special economic zone and port on the Red Sea coast 100km north of Jeddah has already attracted companies such as Mars and Pfizer.

Ironically, green energy could be one sector poised for development. Growing local demand means Saudi’s domestic energy consumption will continue to rise, fuelled by intensive air conditioning or desalination plants soaking up more and more oil. The argument goes that in an effort to save that oil for export markets, the Kingdom could adapt to using green energy at home. “Saudi wants to keep oil as an integral part of the international energy mix because of the importance and global relevance this gives them. Domestically Saudi could begin to use other sources or energy,” predicts Stephens.

The next three months are crucial. If oil prices are still languishing come June and the next OPEC meeting, Saudi will have to work much harder to persuade fellow OPEC members to not cut production. “If the price sticks at around US$50 to US$60 a barrel OPEC members will become much more agitated,” predicts Chatham House’s Butter. Nigeria, Iran and Venezuela are already feeling the pinch, battling to keep their budgets on track and suffering much higher production costs than their OPEC partner.

It is too early to see whether Saudi’s standoff will work, forcing non-OPEC producers to cut back and push oil prices up. But the realisation that Saudi isn’t prepared to shoulder the burden of oil cuts on its own anymore means oil prices will stay low for now, and are unlikely to rise at the same rate they rose after the last drop in 2008. The policy has created a large inventory overhang with a lot of oil in storage. Traders will wait until prices go up before they sell, triggering another dampening effect on a market that could also have to factor the US losing its crude oil export ban at some point in the future. Saudi has bet that it can withstand low oil prices for a while, but it’s a strategy that will put its public finances under pressure with implications at home, and abroad.