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Power Struggle

September 2011

As domestic power consumption rises and the price of oil exports remains high, government-subsidised petrol and gas prices in the Gulf will cause serious problems in the medium-term.
Ever since the emergence of the modern Middle East oil exporters with the price explosion of 1973, it was inevitable that the region's rulers would seek to dispense bounty - cheap oil and gas for domestic use - in a manner that would not hit anyone's pocket. This policy, though understandable, is set to catch up with regional governments - with catastrophic consequences.

As the modern ruling elites of Gulf states emerged in the latter part of the last century, they needed a pact to bolster their legitimacy and cement their populations' compliance. They did not have to look far: by introducing steep domestic discounts on hydrocarbon products for the most part marketed internationally, they could point to significant reductions in the daily cost of living for fellow nationals.

Since the late 1970s, subsidies for fuel and electricity in the GCC supported development growth, especially in industry. They were seen as beneficial in the short term, and growing populations sought 'tariff breaks' from the ruling elite who benefitted from growing petroleum incomes. "Early on crude oil and power generation feedstocks were inexpensive commodities, so subsidies imposed little strain on the Persian Gulf state economies," wrote Mike Moore, director, global oil and gas marketing at Colfax, a Columbia, Maryland-based pump manufacturer, earlier this year. "That's all changed!" he adds emphatically.

Subsidies take many forms, and in developed economies, are often defined as government payments to producers, such as farmers, to protect or bolster a market for a certain product. Normally, for example, in developed markets, agricultural or other types of producers receive cash subsidies from the government to prop up ailing production. Subsidies can also be 'in kind,' where a good is sold at below production cost, leaving the government to bear the costs of the 'transaction'.

The numbers were harmless in the early days. International benchmark Brent crude stood at $12.80 a barrel in 1976, a trough breached with an average price of $12.72 in 1998. Local discounts were not noticeably taxing in terms of lost export revenues in the 1970s; today, the opportunity costs are becoming startling.

Take petrol at the pump, a standard measure of domestic Saudi consumption. Recent data show Saudis pay $0.61 per gallon. In Kuwait it costs $0.85; the UAE $1.82. A gap then opens up; the US pays $3.79; the UK $8.06 and Turkey $9.99, said to be the world's highest, according to Germany's GTZ. Observers may wish to ponder the dynamics behind Venezuela's equivalent pricing, of $0.09.

The gas industry is faring no better. With Saudi Aramco's ascendancy as one of the world's largest oil companies by revenues, the troubling issue of gas was treated as an irritating side-show. Though Saudi Arabia's gas use has been steadily increasing, the issue of pricing has bedevilled investment in the industry precisely at a time when gas is most needed for industry and petrochemicals.

As the kingdom has thrown more of its weight behind petrochemicals manufacture, it has found that charging $0.75/mmbtu for ethane feedstock does not create the conditions for boosting expenditures for new exploration and production of associated, and in particular, non-associated, gas fields.

In the GCC, reliable figures for gas consumption do not exist. Flummoxed global analysts explain that a succession of power brokers in GCC countries - usually royal family members - have guarded gas feedstock allocations to different actors to bolster their power bases - to steel and aluminium plant owners, power generators, petrochemicals complexes with no central control over these allocations. The entire process has become steeped in double-talk and confusion.

The one GCC exception is Qatar, the only Gulf state to possess gas in quantities so abundant that it can meet anyone's demands. But its understandably self-interested strategy means that it is unwilling to dispense favours with no regard for economics. So, while gas from the Dolphin pipeline was priced at inception in 2007 in political deals with the UAE and Oman at no more than $1.50 per million British thermal units (mmbtu), Qatar, via Shell is charging the UAE $11/mmbtu for LNG consignments, the same as it charges for shipments to Japan. Desperate for gas, and with Dolphin supply limited, the UAE has no option but to accept the international market price.

The effects of subsidies remain benign today, but will cast a growing shadow with the passage of time. Four key areas are likely to become problematic in the next 10-20 years: the increasing rate of domestic consumption, the costly loss of potential exports, an obvious lack of efficiency with which energy is used in the region, and the opportunity cost of funds for new exploration and production.

A key feature of subsidised markets is that the quantity supplied by definition increases. In this case, the unwelcome consequences are that domestic demand is beginning to rise inexorably and regional analysts are sounding the alarm. HSBC said in a recent report that Saudi Arabia is likely to burn
1.2m b/d of crude this year for electricity generation, almost double 2010's figure. Jadwa is forecasting domestic Saudi oil consumption at 5.5m b/d in 2030, leaving only 6m b/d for export.

One side effect of subsidies is the mind-set that responsible energy use is a problem facing the rest of the world, but not the GCC, says one analyst. Perhaps the most shocking outcome of GCC energy policy is a rarely cited ratio, the amount of energy used to produce $1,000 of GDP. According to Jadwa, in 2009, it took the energy equivalent of 1.3 b/d of oil to generate $1,000 of GDP worldwide, 1.2 b/d in China, but 13.6 b/d in Saudi Arabia. That's over 10 times as inefficient. In the GCC, the usage of hydrocarbon inputs is the most inefficient on earth.

Gas is the preferred fuel for power generation throughout the GCC, given the cleaner and cheaper processes involved. Clearly, if Saudi Arabia continues to charge such low rates for electricity consumption, the ability of the industry to fund new projects for power generation will dwindle. Indeed, a credit assessment of the Saudi Electricity Company by Moody's in April noted that the sector required investment of almost $100 billion "on power plants and the grid to meet increasing electricity demand" by 2020. The industry's ability to find such funds is not a foregone conclusion.

To cap it all, it is clear that the Arab Spring has not created the conditions where the removal or diminution of subsidies could be countenanced. Some analysts say that Saudi Arabia's rulers are worried the whole powder keg could explode with one false move. As one analyst put it: "We too believe that price reforms are likely to be only gradual and should mainly take the form of higher electricity tariffs and higher hydrocarbon feedstock prices for industrial users."

Various solutions to the problems in Saudi Arabia, shared also by most other GCC members are proposed. It is clear that the drive to improve natural gas exploration and production is fundamental to an improvement in Gulf energy policies. Although vast tracts of Saudi Arabia remain unexplored,
a reassessment of gas's importance, and an improvement in the financial terms on which IOCs are invited in would be a good place to start. So gradual progress on removal of subsidies is a must.

Jim Krane, writing in The Gulf Intelligence last year, put forward three "policy alternatives," including raising the price of electricity, making buildings more energy efficient (mandatory standards on new construction, denser housing), and enacting green appliance standards, such as "banning the sale of inefficient air conditioners, dishwashers and washing machines".

Next time you fill up your car, remember cheap petrol's cost in other, unseen, terms.

Lowest road transport retail prices, US cents/litre, Nov 2010

Rank	COUNTRY	Gasoline	Diesel
1	Venezuela	2.3	1.1
2	Iran	9.7	1.6
3	Saudi	12	6.7
4	Libya	17	13
5	Qatar	19	19
6	Turkmenistan	22	20
7	Kuwait	23	21
8	Oman	31	38
9	Algeria	32	19
10	Yemen	35	23
13	UAE	47	71
14	Egypt	48	32
Average wholesale price ex subsidies/tax	60	62
22	US	76	84
23	Iraq	78	56
29	Russian Federation	84	72
49	Jordan	104	73
53	China	111	104
56	Lebanon	113	77
60	India	115	82
63	South Africa	119	114
92	Brazil	158	114
104	Israel	185	187
112	UK	192	198
119	Turkey	252	203
Source: GTZ, HSBC
selected natural gas prices
Country	Delivery	Price per mmbtu ($)
Abu Dhabi	Dolphin Pipeline	1.25
Oman	Dolphin Pipeline	1.44
Dubai	Dolphin Pipeline	1.5
US Henry Hub	Nymex (Futures)	4
USA	LNG	5.15
South Korea	LNG	10.21
Taiwan	LNG	10.98
UAE (LNG)	Qatargas 4 (Shell)	*11.00
Japan	LNG	11.5

Source: LNG Shipping Insight (Drewry), March 2011; Bloomberg; Emarat. *Approximate

© Gulf Business 2011