Oil markets in intensive care: an incentive to decarbonate? Perspective from Saudi Arabia

On 12 April 2020, the Organisation of the Petroleum Exporting Countries (OPEC), along with Russia and other non-member oil exporting countries, agreed to a record oil production cut of 9.7 million barrels a day (mb/d) in an attempt to ease a global supply glut and boost crude oil prices. This decision was made against the backdrop of the global Covid-19 pandemic that has caused a steep reduction in the demand for crude oil and led to a drop in oil prices. These curbs will stay in place for May and June, after which they will reduce to 7.7m b/d for the rest of the year, and then 5.8m b/d from January 2021 to April 2022 if compliance with the quotas is enforced. Many experts remain legitimately concerned with the global demand decline as the International Energy Agency (IEA) predicts an overall demand drop of 9m b/d in 2020 (29m b/d reduction for April alone) compared to 2019, erasing almost a decade of growth. However, this short-term surplus of oil shouldn’t overshadow the structural issues of oil markets and the concerns regarding future oil supplies. 

According to the IEA, crude oil production peaked in 2006, and total world oil production peaked in 2018 due to shale oil production in the United States. The current drop in oil prices by 65% threatens an already dubiously profitable and debt-crippled American shale sector which should have doubled its current production by 2025 to meet the growing demand. The Covid-19 pandemic, oil, and climate crises bring to the forefront questions of energy resilience and decarbonation amidst government’s efforts to kick off stimulus packages. Nations could be tempted to go on with business as usual to rebuild their economies, at the cost of ignoring threats of declining oil supplies and environmental hazards, particularly in oil-dependent countries. Prominent examples include Saudi Arabia, leading with 13.3 percent of global oil exports for a total of US$133.6 billion in value, seconded by Russia, with 12.1 percent share of global oil exports valued at $121.4 billion. As energy systems are deeply embedded in society it is essential to analyse the features of the oil industry for each country in order to assess the threats and incentives for them to decarbonate their economies. This paper approaches these issues and potential solutions in the context of Saudi Arabia. 

Saudi Arabia’s Oil Policy

Controlling 16 percent of world’s proven oil reserves, Saudi Arabia’s petroleum sector accounts for 87 percent of its budget revenues, 42 percent of its GDP and 90 percent of its exports earnings. Sitting on 20 percent of the world’s proven oil reserves, Saudi Arabia is the largest exporter of petroleum in the world. The energy rich kingdom plays a major role not only among OPEC countries, but also in the world’s economy. Indeed, it ensures a high flexibility of its production output and maintains a spare capacity of around 2-2.5m b/d in order to stabilize the oil market. As a dominant actor, Saudi Arabia is constantly faced with a trade-off between short-run revenue maximization and maintaining market share and production volumes above a certain level. This trade-off is shaped by the conjunction of oil market conditions and internal country dynamics, with the latter being a growing problem. The following are the key factors influencing Saudi oil policy:

  • High dependency on oil. Oil revenues drive economic growth and consist of the majority of government spending. 
  • Resource depletion or a falling demand in the long/medium term. Even if proven reserves could supposedly last a century, climate change concerns and energy security could seriously weaken the long-term demand/production and pose a threat to oil revenues.
  • A growing domestic demand. A growing population, rising living standards, energy intensive economic growth, and wasteful behaviour have led to an increased demand. 
  • A dominant role in markets. Saudi production shares in Western and Asian imports are  key to securing its outlet. Hence, it constantly has to optimise the size of its spare capacity as oversupply puts downward pressure on prices and affects returns on investment, while low capacity reduces Saudi Arabia’s ability to balance markets when needed.
  • Internal and political instability. Key economic policies are shaped by the Kingdom’s need to maintain its social contract in a politically unstable region.

Saudi Arabia’s biggest challenge: itself

Of all these factors, rising domestic demand is the most alarming one, both for Saudi Arabia’s economy and stability, and its role in global markets. Since the creation of OPEC (1960) and the oil-price boom in the early 1970s, the nation has witnessed  rapid economic development sustained by cheap, domestically produced oil and gas. This has translated to a very high energy consumption per capita, with domestic demand growing twice as fast as the Kingdom’s GDP. Driving this trend is population growth, industrial development, and a subsidy regime that encourages wasteful consumption. The population is set to reach 9.7 billion in 2050 according to the UN, and is particularly energy hungry during the summer heatwaves. Demand for car fuel is also high because of the country’s geographical vastness, an extensive subsidy regime, and the lack of public transport. The industrial strategy itself causes problems by being mainly geared towards vertical integration of the energy chain with refineries and petrochemical plants or towards energy intensive sectors like industry, building, and transport. Saudi Arabia also faces a natural gas shortage and is seeking alternative sources like nuclear power and renewables to avoid wasting oil at power stations instead of selling it on world markets. 

These combined internal pressures are seriously impeding on Saudi Arabia’s export capacity and role as swing producer in global oil markets. This consequently threatens the Kingdom’s main revenue and could force it to increase fiscal and current account deficit by relying on debt to support government spending. One mechanism feeding into these negative feedback loops of wasteful consumption is the low prices maintained by the government, which also deters investment in new energy production. However, a reform of the subsidy regime is politically sensitive, as citizens regard subsidies as an entitlement. Low prices, alongside welfare payments, subsidies, and public sector jobs, are part of the implicit social contract of the authoritarian rentier state to maintain public support.

Climate Change as an amplifier of current Saudi issues 

Growing domestic energy consumption may attest to increased human development. Indeed, authorities have often emphasized the ability of cheap fuel and electricity to alleviate poverty and incentivize the development of non-oil sectors. However, it can be objectively argued that the costs of a cheap energy source to society outweigh the benefits. Maintaining cheap energy forgoes money that could be spent for human development or tackling poverty. More specifically,  the government abandons potential revenues from a profitable tax base as it is wide, inelastic, and proportional to consumption. Additionally,  cheap energy  fosters wasteful practices (i.e. use of AC, US-style driving) and investment decisions that lock in higher than necessary energy demand which benefit the rich. This has various implications, including increasing air pollution and incurring higher transaction costs from traffic congestion. 

Furthermore, like many other Gulf states, Saudi Arabia is highly vulnerable to global warming, which will have tremendous negative social effects. Indeed, climate change  shortens the possible period of transition to a non-oil economy, which may cause job losses in agriculture, fishing, and traditional oil industries, and could cut into welfare spending. Rising sea levels could adversely impact desalination plants (used extensively by the oil industry for refining) and coastlines (where several drilling sites are located). Rising temperatures create the double effect of an increase in domestic water demand and a decline in water quality as the salinity increases (which affects desalination plants). This poses a significant threat to the temperature-sensitive equipment and infrastructure of oil exploitation (potentially leading to more fire incidents like those at the SAMREF refinery in 2017). Finally, the changing climate will also have an effect on working conditions, the country’s production of fresh fruits and vegetables, micronutrient deficiencies, and healthy lifestyle habits. Therefore, the environmental issue sits at the crossroads of conflicting short/medium-term priorities: economic diversification, water supply, food security, environmental protection, and global warming mitigation.

Potential Solutions

The combination of the inflexible energy mix and low domestic resource prices is fundamental to the insecurities that Saudi Arabia is facing and requires major action, notably to reduce domestic demand. The government has  primarily focused on adding more supply rather than reining in demand. However, in the time required to develop new energy sources, oil will likely reach a plateau, and would therefore  be insufficient to balance out the declining exports and the rise in public expenditure to maintain political stability. Like other rentier states and resource-abundant countries, Saudi Arabia is faced with several challenges linked to the ‘resource curse’ theory (including inefficient spending, revenue volatility, enclave effect, low human capital, weak institutions, and social and environmental problems) and has acknowledged the priority of diversification with its Saudi 2030 vision to reshuffle national portfolio assets. Rising domestic consumption is an economic menace for oil-dominated economies as it hinders imports, social welfare, economic diversification, and jobs. Cases in other countries indicate that this issue has been addressed through reduced subsidies (Iran and Indonesia) or increased debt (Venezuela), often accompanied by a process of political liberalization (Indonesia, Mexico, and Malaysia). Even though the Covid-19 crisis has led Saudi Arabia to adopt some austerity measures, stronger demand-management-side policies included in a comprehensive plan to reduce energy intensity are required.

  1. In order to avoid market distortions, subsidies should be removed to allow for the correct market price of energy to send the right economic signal to all actors. This will avoid waste and force policy-makers to fully acknowledge the cost of maintaining low prices for social equity purposes.  
  2. This should be coupled with regulations that allow consumers to reduce their energy bills, thereby decreasing demand. Countries could set national energy intensity targets and implement simple demand-side policies (maintenance requirements, appliances standards, and weatherization of buildings against heat). Government energy price reform support has proved efficient in several cases through rationing schemes, smart cards, targeted subsidies, or standards enforcement (for example in Iran and Egypt). It is essential that governments assist large stakeholders that may suffer from these measures, as well as vulnerable social groups, to avoid unrest.
  3. Private-public financing can help create new markets for services, products, and jobs. This can alleviate the state of some former state-employed labour, incentivise innovation and diversify the economy. Mechanisms like carbon trading systems can further encourage lower oil consumption.  
  4. In order for the energy policy to be coherent and effective, authorities should work on policy and bureaucratic coordination, institutional developments and the role of civil society. It is necessary to engage in dialogue with different interest groups, establish clear communication about reforms, and raise awareness of energy issues through education and public debates.

Conclusion

The main aim for oil-exporting countries such Saudi Arabia is to improve energy efficiency, mainly by acting on the demand-side to push back the eventuality of a decrease in oil exports and government revenues. This added time should provide them with the opportunity to prepare for the long-term objective of decarbonizing their economies. Improved energy efficiency is often the most economic and readily available means of improving energy security and reducing greenhouse gas emissions alongside public sensibilization and education. Current tactics (like investment in nuclear or renewables) provide only marginal relief while more effective energy management,maintenance, and monitoring could provide better results in high-energy use countries (World Bank figure above). Reducing inefficient oil subsidies would also be highly efficient, as low oil prices are only possible because markets fail to take environmental cost into account. This is likely to come to an end due to oil and debt issues rather than environmental ones. Oil production has become increasingly expensive for two reasons: quantities of oil produced have not grown fast enough, and the energy return on energy invested is shrinking ( most of the easily-extracted oil has been consumed, and drillers now have to turn to costlier alternatives like shale). Moreover, the investment required to explore and exploit new oil reserves will be hindered by diminishing profits due to weakened demand.

Ultimately, these trends point to a system whose profit relies on extreme efficiency, and that is now revealing its weaknesses. Therefore, these systems must move away from oil dependence, particularly for environmental reasons; however, an immediate shift to renewable energy seems unlikely. Indeed, the likely decrease in investment because of pressures on public and private budgets, combined with the fact that renewables are less efficient (energy cost of mitigating intermittency, structure and quality of the energy systems) and rely heavily on fossil fuels at the beginning of their life-cycle, make a shift in energy source difficult to implement in a context of economic hardship, especially for developing countries. Nevertheless, the tremendous stimulus packages governments are about to deploy provide a unique opportunity for short-term policies and economic actions to align with long-term environmental objectives. Governments will be able to correct structural issues to prepare the world’s energy infrastructure for a future that will require strong grids and greater flexibility to accommodate increasing shares of variable renewables. The cheapest and fastest way for governments to create enough leeway for these future investments is by becoming less dependent on oil through decarbonation and demand-side action.

Ambre Barria

Ambre Barria is a member of the Energy & Environment Policy Centre’s working group.

The featured image (top) from 2008 of ‘aramco’ is by chrisevans and is licensed under Attribution-NonCommercial-NoDerivs 2.0 Generic (CC BY-NC-ND 2.0).

Bibliography

Al Jazeera, 11 May 2020, Saudi Arabia to impose ‘painful’ austerity measures, triple VAT.

Fattouh, B. and Sen, A. (2015) Saudi Arabia Oil Policy – More than Meets the Eye? The Oxford Institute for Energy Studies. https://doi.org/10.26889/9781784670320.

https://data.worldbank.org/indicator/EG.USE.PCAP.KG.OE

IEA (2019), World Energy Outlook 2019, IEA, Paris https://www.iea.org/reports/world-energy-outlook-2019.

Krane, J. (2015) Stability versus Sustainability: Energy Policy in the Gulf Monarchies. The Energy Journal, Vol. 36, No. 4 October 2015, pp. 1-21. International Association for Energy Economics. http://dx.doi.org/! 0.5547/019.

Lahn, G., Stevens, P. (2011) Burning Oil to Keep Cool: The Hidden Energy Crisis in Saudi Arabia. London: Chatham House. 

Saudi Aramco, Evaluations Preliminaires des Risques Climatiques, Report November 2019, Callendar Climate Intelligence.

UN World Population Prospects 2019, https://population.un.org/wpp/Publications/Files/WPP2019_Highlights.pdf.

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