Saudi Arabia's sway over global oil markets may be assured for now but it is at home that some of the energy industry's greatest strategic challenges lie
The oil world's giant, Saudi Arabia, resembles Gulliver, the giant whose puny opponents vainly try to tie it down. Three times in recent history the kingdom has risen to the challenge of maintaining its primacy in world oil markets. Now it is being called on to do so a fourth time. External challenges are nothing new, but this time the Saudis for the first time face real problems in their domestic energy situation.
In 1986, Saudi Arabia increased production sharply to punish quota cheating by its Opec partners. The resulting price crash ushered in a decade and a half of austerity in the Middle East, and unintentionally helped trigger the fall of the Soviet Union. After Saddam Hussein's 1990 invasion of Kuwait, the Saudis opened the taps again to make up for lost production from the two countries and finance the war to expel the Iraqis. And in 1998, the Saudis met increasing production from Venezuela with a price war, inducing new president Hugo Chávez into a sharp reversal of his predecessor's policy.
This time, the US in particular is looking to Saudi Arabia to help execute its economic campaign against Iran, a reliance which constrains American perceptions of their freedom of political action in the Middle East. Riyadh, historical adversary of Tehran, is happy to comply, though taking the chance to play up its altruism and avoid challenging the Iranians too openly. Chinese premier Wen Jiabao took care to visit Saudi Arabia on his Gulf tour in January, one key aim being to gain reassurance on oil supplies.
Originally, the US and EU [European Union] sanctions against Iran, imposed over its alleged nuclear weapons programme, were intended to reduce the number of legitimate buyers of Iranian oil, and so give others the chance to extract discounts. But, with a shift in approach, and financial and insurance-related sanctions having a more serious impact than expected, Iranian exports appear to have fallen by some 300 000 barrels per day (b/d) in March, almost 15 per cent.
On top of political interruptions to exports from South Sudan, Yemen and Syria, this pushed oil prices to $127 per barrel. In 2011, the Saudis were too slow to react to the loss of Libyan production during the overthrow of Colonel Gaddafi. In 2012, they have pushed output to 9.9 million b/d, only just short of the 1980 record. The number of rigs drilling for oil has risen sharply and the Saudis' Gulf allies Kuwait and Abu Dhabi are also pumping at multi-decade highs.
Veteran oil minister Ali al Naimi sought to calm markets in mid-January by saying "We can easily get up to 11.4, 11.8 [million b/d] almost immediately in a few days .... All we need is to turn valves." He announced that, within three months, the kingdom could reach 12.5 million b/d. A further 22 million barrels are stored in Okinawa (Japan), Rotterdam (The Netherlands) and Siri Kerir (in Egypt), and tanks up to 190 metres underground at various places within Saudi Arabia itself. Practically all Opec spare capacity is now held by the Saudis, and the narrow margin of safety has been instrumental in driving prices to their recent highs.
Nevertheless, al Naimi has later suggested that markets are well-supplied and that the Saudis are not finding takers for their additional production - if true, an indication that the additional oil is simply over-priced.
Fears over a blockage of the Strait of Hormuz seem to have cooled. But it is worth noting that the Saudis can send some five million b/d to the Red Sea via the Petroline pipeline, which could be expanded relatively cheaply to 11 million b/d, given some time. This puts them in a much stronger position than Gulf neighbours Iran, Kuwait and Qatar, entirely dependent on Hormuz.
The late Matthew Simmons, a sceptic on Saudi oil capacity, wrote in his 2005 'Twilight in the Desert' that "We could be on the verge of seeing a collapse of 30 or 40 per cent of their production in the imminent future, and imminent means sometime in the next three to five years - but it could even be tomorrow." Instead, as we have seen, the kingdom has been able to increase production rapidly when it sees the need.
Expansions to the offshore Zuluf, Safaniyah and Berri fields and onshore Khurais and Shaybah could add another 2.45 million b/d of production capacity. In January, plans were announced to explore frontier areas, including the Red Sea, with hopes of discovering 100 billion barrels, on top of current official reserves of 264 billion barrels.
With 700 billion barrels thought to have been originally in place under Saudi Arabia, improving the amount that can be recovered by just one per cent can replace two years of Saudi production. Though the fields are maturing and recovery is becoming technically more complex, extraction costs remain exceptionally low by global standards.
Saudi Arabia is thus well able to meet the oil challenge from Iran, whose oil industry is limping along under sanctions and mismanagement. Iraq, despite all its well-known political and security problems, may be a different matter. With production growing strongly, and ambitious expansion plans underway, Iraq is already poised to overtake Iran's exports. Within a few years, the Saudis may face something they have not seen since the Shah's Iran in the 1970s: a credible Opec competitor.
Al Naimi said in 2009, referring to the postponement of plans to develop the giant heavy oil field Manifa, "If you have a spare capacity of 4.5 million and you are idling at less than eight, do you need Manifa?" But he may now be wondering whether that was the right decision. Additional spare capacity would be very welcome, enabling Saudi Arabia to put more pressure on Iran while retaining some leverage against Iraq and insurance in case of outages elsewhere.
And slowness in expanding capacity allowed prices to go dangerously high in 2008 and again this year, threatening the world economy, and spurring intense interest in developing alternatives to oil and improving efficiency.
Internally, Saudi Arabia faces challenges too. Its domestic oil consumption is soaring due to low, government-set prices for fuel, electricity and water, and its policies of energy-intensive industrialisation. Up to one million b/d of crude oil is burnt to meet peak demand for air-conditioning in the Gulf summer. On current trends, Saudi Arabia could be consuming 6.5 million b/d domestically by 2030, two-thirds of its current production.
Major plans for new oil refineries at Jubail, Yanbu and Jizan in the south-west will mainly go to meet domestic demand. New petrochemical projects face a challenge to secure gas allocations from Saudi Aramco, which is developing its own petrochemical arm to avoid leaking value to others.
Aramco, one of the region's most effective national oil companies, has stepped up its efforts to develop new gas supplies. Its first discovery of "non-associated" gas (gas which is not a byproduct of oil), Karan, started production last summer, and two more large gas projects, Wasit and Shaybah, are on their way. The increase in oil production, yielding more associated gas, has also helped. Nevertheless, even this relief is only temporary in the face of demand growing at seven per cent each year.
Aramco is also considering 'unconventional' gas developments, similar to the shale resources that have been so successful in the US. Meanwhile, exploration by partners such as Shell and Lukoil in the Rub' Al Khali ('Empty Quarter') has been mostly unsuccessful, with the discoveries to date being geologically challenging to develop.
At current domestic prices of $0.75 per million British thermal units (compared to $2.30 in the US and $16 or more for supplies to Japan), these finds will not be commercial. Gas imports from neighbouring Qatar appear politically impossible, and it is not inconceivable that the kingdom might have to follow the lead of Kuwait, Dubai and Abu Dhabi in importing costly liquefied natural gas (LNG).
The kingdom has announced major schemes for solar power, with 5 gigawatts planned (likely cost around $12.5 billion), and nuclear power, to supply 20 per cent of its electricity capacity at a cost of $112 billion by 2030. Yet there has been very little attention to the fastest and cheapest source of energy - improving efficiency. This would require politically difficult hikes in electricity and water prices for consumers and industry.
High oil prices and rising production in recent years have brought a windfall, allowing the Saudi government to retire almost all its debt and accumulate some $560 billion of foreign assets. In 2011, it ran a budget surplus of $81.6 billion.
However, these comfortable figures hide some disturbing truths. Last year's budget was increased by 39 per cent to $214 billion, in the first part of King Abdullah's package of measures to assuage domestic discontent. $130 billion of additional spending is pledged largely on measures that, however socially necessary, are economically unproductive: unemployment benefit, salary increases, new government jobs, housing, religious organisations. Saudi Arabia is also likely to contribute the lion's share of the $25 billion in aid offered by the Gulf Co-operation Council (GCC) to Bahrain, Egypt, Jordan and Oman, as well as influencing events in Yemen and perhaps Syria.
Saudi Arabia still remains the giant of the oil world. It has shown its indispensability to the western sanctions campaign against Iran. It faces major challenges externally - less from Iran than from falling demand, rising shale oil production, and Iraq. But these are challenges of a familiar type, which it knows how to address.
The bigger problem lies within. Saudi policymakers have one to two decades to tackle domestic energy challenges and begin the shift to a radically different economic model, not reliant on hydrocarbon earnings to drive growth. Gulliver is rising impressively to the challenge today; next time may not be so easy.
Robin M. Mills is Head of Consulting at Manaar Energy, and author of The Myth of the Oil Crisis and Capturing Carbon.
© The Gulf 2012
