August 04, 2018

Saudi Arabia Is in a Double Bind on Oil Prices

31 July 2018
Source: Chatam House

Saudi Arabia may have prevailed at the latest OPEC meeting, but its biggest challenge when it comes to balancing production and prices is domestic.

Jessica Obeid

Academy Fellow, Energy, Environment and Resources Department (2017-18)

Saudi and foreign investors attend the kingdom's Global Competitiveness Forum in 2016 in Riyadh. Photo: Getty Images.

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At the OPEC meeting held in Vienna on 22 June, Saudi Arabia successfully pushed for an increase in oil production, despite opposition from Iran, Iraq and other smaller producers within the organization. But this victory may yet prove hollow, as the kingdom’s biggest challenge when it comes to balancing production and prices is domestic.

On the one hand, keeping oil prices low helps secure Saudi Arabia’s market share, satisfy the US and increase pressure on Iran. On the other, it is in its interests to keep potential revenues at a level that will maximize the value of its intended initial public offering (IPO) of a stake in Saudi Aramco, the world’s largest oil company, as well as boost the prospects of Vision 2030 – the wide-ranging economic diversification plan closely associated with Crown Prince Mohammed bin Salman.

The case for lower: allies, enemies and market share

Saudi Arabia is implementing critical domestic reforms at a time of severe political upheaval across the Middle East. It cannot afford to antagonize the US, much less a president who evidently does not behave like his predecessors in the White House. Donald Trump lashed out at OPEC in a number of tweets in the weeks prior to the Vienna meeting, when oil prices were above $74 a barrel; he knows what irks the US electorate, and clearly has an eye on prices at the pump in the run-up to November’s mid-term elections.

But this is not only about American drivers. Saudi Arabia shares the US’s interest in curbing Iran’s revenues from oil sales. 

Riyadh has been keen to tell the world that reinstating sanctions against Iran will not disrupt global energy supplies or impact fuel prices because it will step in and increase production to make up the shortfall. Its aim is to safeguard against its adversary retaining significant revenue from higher oil prices if, despite US sanctions, Iran remains able to export any oil at all, in order to intensify economic pressure that will, in the Saudi calculation, drive further domestic instability in Iran.

Moreover, there is the risk that higher oil prices would result in Saudi Arabia losing market share to clean-energy sources.

The global pursuit of decarbonization is being driven not just by the imperative to act on climate change, but also in part by states’ efforts to hedge against supply disruptions and improve energy security in the face of unstable oil supplies and prices. Higher oil prices could lead to more serious and focused decarbonization efforts, potentially giving the edge to non-hydrocarbon alternatives and undermining the overall financial environment of the oil and gas industry.

The case for higher: the Saudi Aramco IPO and Vision 2030

The long-awaited sale of a portion of Saudi Aramco – closely linked to the overall success of Vision 2030, and emblematic of the opening up of the Saudi economy – has been billed as the world’s biggest IPO, with the ambition that the listing will put the value of the company overall at some $2 trillion.

But investors are concerned about factors such as the competitiveness of the eventual payout and the considerable uncertainty of investing in a declining core industry at a time when major oil firms are diversifying. They will need to see the prospect of sustained high oil prices in order to have confidence that there will be worthwhile returns on oil investments at least within the next decade.

International firms in non-oil sectors are also wary of investing in Saudi Arabia until they witness the reforms as set out in Vision 2030 kicking in and the barriers to private-sector participation removed.

According to the IMF, Saudi Arabia needs an oil price greater than $80 a barrel (and in the range $85–$87 for the current year) in order to balance its budget. As such, the economy has suffered as a result of lower oil prices since the latter part of 2014.

Pumping more oil and moving in on Iran’s market share may increase revenues and help to narrow the budget shortfall – forecast at 7.3 per cent of GDP in 2018, itself an improvement on the 8.9 per cent recorded in 2017 – and ease pressure on public spending. But this is a highly risky strategy.

Saudi Arabia has set itself an ambitious revenue target of $209 billion in the budget for 2018, as well as an expansionary spending target of $261 billion – a record high – in an effort to pull the economy out of the recession recorded in 2017. However, much will depend on whether foreign direct investment, which dropped to just $1.42 billion last year (from $7.45 billion in 2016) returns sooner rather than later.

If investor confidence doesn’t pick up, the kingdom will have to resort to its usual fix – using oil revenues to increase public spending – to boost the economy. This is exactly the vicious circle that Saudi Arabia is trying to break with the implementation of Vision 2030 and its diversification efforts specifically to reduce dependence on oil. 

Furthermore it may also find itself in the position of having to impose further taxes to allow additional public spending. But previous levies (such as ‘dependents taxes’ for expatriates, and VAT), together with cuts to subsidies, are already taking their toll, particularly on the private sector. In this context, the authorities must consider the likely impact of additional revenue-raising through taxes on Saudi Arabia’s ability to continue to attract workers from abroad to fill existing skills gaps, as well as on critical efforts to increase Saudi participation in the private sector over the longer term.

Saudi Arabia may have prevailed at the latest OPEC meeting, but its various domestic and external interests will not all be served equally well by what the agreed increase in production means for oil prices. Without a coherent long-term strategy that reconciles these interests, the kingdom risks falling short of its far-reaching ambitions.

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