A plan to "break free" from oil

A plan to "break free" from oil

Bassam Fattouh and Amrita Sen
Share
The new strategy aims to diversify the Kingdom's economy. The development of gas will accelerate, while renewables will continue to account for a small part of the energy mix. Proceeds from black gold will still remain central

In late April, the Council of Ministers in Saudi Arabia approved an ambitious new strategy for the kingdom, known as Vision 2030. The vision is based on three main pillars, which are intended to help transform the Saudi economy and society by 2030.

-The central role that Saudi Arabia plays in the Islamic and the Arab world.  
-An aim to transform Saudi Arabia into a global investment powerhouse.  
-Exploiting Saudi Arabia’s key strategic location to turn the country into a global trade hub connecting the three continents of Asia, Europe and Africa.

The vision does not contain specific details about implementation, but is built around three general themes—a vibrant society, a thriving economy, and an ambitious nation. A key goal of the thriving economy theme is to build a well-diversified economy which is less dependent on oil. To achieve this, Vision 2030 focuses on developing human capital through better education, particularly early childhood education. Another target is to boost the role of small and medium enterprises (SMEs) and to increase their contribution to the economy. Another key element is maximising the country’s investment capabilities, which involves restructuring the Public Investment Fund (PIF) and transferring the ownership of Saudi Aramco to the PIF, with the aim of creating the largest sovereign wealth in the world. It also involves the privatisation of government services such as healthcare and education, with the government increasingly playing the role of the regulator. Through these and other initiatives, Saudi Arabia aims to achieve some very ambitious goals including:

-Moving the economy from the current position as the 19th largest economy in the world into the top 15.
-Increasing the private sector’s contribution from 40% to 65% of GDP.
-Raising the share of non-oil exports in non-oil GDP from 16% to 50%.
-Increasing non-oil government revenue from Saudi Arabian Riyal (SAR) 163 billion to SAR 1 trillion.  
-Expanding the local share of oil and gas sector activity from 40% to 75%.
-Growing PIF assets, from SAR 600 billion to over 7 trillion.
-Increasing foreign direct investment from 3.8 percent of GDP to 5.7%.

Vision 2030 recognises that in order to achieve these goals, a major institutional shake-up is needed. The Saudi government therefore has, in parallel, announced a set of programmes, which include the National Transformation programme, the programme for Strengthening Public Sector Governance, the Privatisation programme, the Public Investment Fund Restructuring programme and the Saudi Aramco Strategic Transformation programme. The details of each of these programmes are only slowly emerging, with the National Transformation programme approved in early June, providing more information on the implications for the energy sector.

Changing the oil minister does not imply a change in oil policy

While such broad visions are hardly new (in 2005 Saudi Arabia published the Long-Term Strategy 2025, which included various goals including reducing the dependency of the economy on oil revenues) and diversification has been at the centre of each successive five-year development plan since the 1970s, there is much optimism that this time, the plan will be implemented (at least partially). The huge concentration of economic power in the hands of the Deputy Crown Prince Mohammed bin Salman, his willingness to take risks, the breadth of the reforms announced, and an effective communication campaign have given Vision 2030 more credibility than previous initiatives.
Thus, it is no surprise that the announcement of Vision 2030 managed to capture the imagination of global markets. For many oil analysts, the replacement of veteran oil minister Ali Al-Naimi by Khalid Al-Falih, the creation of the enlarged Ministry of Energy, Industry and Mineral Resources, and the announcement of the Saudi Aramco Strategic Transformation programme and plans to publicly list a minority stake in Saudi Aramco were taken as clear signs of a drastic shift in energy policy. One effect of the recent announcements has been to introduce much greater uncertainty about the foundations and direction of Saudi oil policy, with many analysts arguing that Saudi Arabia would abandon its policy of maintaining spare capacity and boost its output. This would put a cap on oil prices in the near-term while it will increase its oil productive capacity which is bearish in the long-term, especially given that this may be taken as a signal that Saudi Arabia is moving beyond oil and rushing to monetize its reserves in a carbon constrained world.
While the recent organisational changes are substantial, the impact on oil policy and the energy sector is likely to be more subtle than current expectations, not least as the last few years have already seen some deep transformations in the energy sector, including initiatives to generate more value added through investing in downstream assets and integrating refineries with petrochemicals, increasing the role of gas in the energy mix, deploying renewables into the power system, improving efficiency in energy use, and more recently increasing domestic energy prices.

A more credible strategy than in the past

While such broad visions are hardly new (in 2005 Saudi Arabia published the Long-Term Strategy 2025, which included various goals including reducing the dependency of the economy on oil revenues) and diversification has been at the centre of each successive five-year development plan since the 1970s, there is much optimism that this time, the plan will be implemented (at least partially). The huge concentration of economic power in the hands of the Deputy Crown Prince Mohammed bin Salman, his willingness to take risks, the breadth of the reforms announced, and an effective communication campaign have given Vision 2030 more credibility than previous initiatives.
Thus, it is no surprise that the announcement of Vision 2030 managed to capture the imagination of global markets. For many oil analysts, the replacement of veteran oil minister Ali Al-Naimi by Khalid Al-Falih, the creation of the enlarged Ministry of Energy, Industry and Mineral Resources, and the announcement of the Saudi Aramco Strategic Transformation programme and plans to publicly list a minority stake in Saudi Aramco were taken as clear signs of a drastic shift in energy policy. One effect of the recent announcements has been to introduce much greater uncertainty about the foundations and direction of Saudi oil policy, with many analysts arguing that Saudi Arabia would abandon its policy of maintaining spare capacity and boost its output. This would put a cap on oil prices in the near-term while it will increase its oil productive capacity which is bearish in the long-term, especially given that this may be taken as a signal that Saudi Arabia is moving beyond oil and rushing to monetize its reserves in a carbon constrained world.
While the recent organisational changes are substantial, the impact on oil policy and the energy sector is likely to be more subtle than current expectations, not least as the last few years have already seen some deep transformations in the energy sector, including initiatives to generate more value added through investing in downstream assets and integrating refineries with petrochemicals, increasing the role of gas in the energy mix, deploying renewables into the power system, improving efficiency in energy use, and more recently increasing domestic energy prices.

Changing the oil minister does not imply a change in oil policy


To begin with, the replacement of Ali Al-Naimi as oil minister represents a change of personnel but not of policy. The current policy is based on a fundamental principle: Saudi Arabia will not act unilaterally to rebalance the market. Since 1986, Saudi Arabia has refused to act unilaterally (in 1998, it cut in agreement with OPEC and non-OPEC, and in 2008, it agreed to cut collectively with other OPEC members in the face of a financial market shock). Al-Falih has reiterated this position, arguing that Saudi Arabia "is not going to withdraw production to make way for others. If other producers are willing to collaborate, Saudi Arabia is willing to collaborate. But Saudi Arabia will not accept the role, by itself, of balancing a structural imbalance". In the absence of an agreement on collective cut, Saudi Arabia has opted for a market share strategy with the aim of pushing out high-cost producers.
The output freeze deal discussed in Doha in April—which was perceived as a departure from this policy—is the source of much of the market’s confusion. Doha mattered because it signalled a potential shift in tactic, which, if it had succeeded, could have been the start of more cooperation between producers. The Doha agreement failed for a variety of reasons, but this did not prevent the Saudis from participating in efforts to reach an agreement on a collective production ceiling at the June OPEC meeting.  The latest OPEC meeting also confirmed the view that the kingdom is not about to destabilise the market and increase production to flood the market regardless of the demand for Saudi crude. Al-Falih went as far as to state categorically in a press interview that "[t]here is no reason to expect that Saudi Arabia is going to go on a flooding campaign".

Oil revenues will remain central to Saudi Arabia's economy

During an interview with western media outlets, MbS alleged that the Kingdom is indifferent to whether the price of oil is $30 or $70. Not surprisingly, this was interpreted as meaning Saudi Arabia no longer cares about oil prices and its output policy is no longer tied to a desire to maximise revenues. An extreme interpretation was that Saudi Arabia might even welcome a low price environment, as that would make it easier to push through the substantial reforms contained in Vision 2030.
Yet, the fact remains that the Saudi economy, including the non-oil private sector, still relies heavily on government spending that is fueled by oil revenues. Furthermore, political stability is directly linked to the ability of the government to distribute rent to the population, including creating jobs in the public sector. As recently emphasised by the Saudi energy minister Khalid Al-Falih, the objective of reducing reliance on oil "does not mean that the kingdom's opportunities of optimising its benefits from its natural resources, including oil, will receive less attention in the current economic phase than in previous phases. Increasing our oil revenues will help us to build a range of other economic sectors in the Kingdom, besides international investments."
Despite the size of its fiscal buffers, low oil prices have been painful for the kingdom. Saudi Arabia has been drawing down on its foreign reserves, increasing its borrowing, exploring schemes to increase taxes including VAT, rationalising government spending, cutting energy subsidies and scaling back spending on capital projects. These adjustments are already having their impact on the economy with growth slowing down, stock markets falling from their high levels, the Saudi Riyal peg coming under pressure, and households’ adversely affected by the rise in energy prices and higher inflation.
One also cannot assume that further reforms such as entirely removing energy subsidies will not risk strong public opposition. Indeed, the recent increase in water charges is a case in point, as the water and electricity minister was fired following public complaints over a surge in prices, with MbS describing the ministry’s implementation of the new water tariff as ‘unsatisfactory’. It is true that the implicit social contract has proved to be elastic and sufficiently malleable to accommodate the recent energy price increases. However, it may not prove sufficiently resilient to accommodate further price increases. The Saudi government is already rethinking the subsidy reform programme and has plans to introduce compensatory schemes to offset the loss of income for households in low-income brackets to gather support for the reforms.

There are no plans yet to increase productive capacity

Closely linked to the swirling expectations of a big increase in Saudi output has been the belief the Kingdom is preparing to increase productive capacity. But even if Saudi Arabia were to decide to expand capacity, this is expensive and takes time and requires massive investment in calibrating the whole system, including increasing the capacity of processing plants, building storage facilities and pipelines. To put things in perspective—in 2004, when Saudi Arabia had a productive capacity of 11 mb/d, Al-Naimi announced the ministry had developed plans to gradually increase Saudi Arabia’s sustainable production capacity to 12.5 mb/d. The expansion of 1.5 mb/d took six years, and was completed in 2010. Back then, Al-Naimi also said that scenarios to raise the capacity to 15 mb/d had been studied and could be set in motion if global demand required it. But given the large uncertainty engulfing oil markets, Saudi Arabia will exercise the option to wait and not invest. In fact, the recently approved National Transformation programme stated that capacity would stay at 12.5 mb/d through 2020.
In an environment of high uncertainty about global oil demand due to climate change policies, many have argued that Saudi Arabia will be keen to run down its oil reserves rapidly. While this is certainly a concern for a country like Saudi Arabia given its massive reserve base, there is a general belief that barring technological breakthrough, oil will be in demand for decades to come as a transport fuel and as a feedstock for petrochemicals. But even in carbon-constrained world, Saudi Arabia will be able to compete, given the low cost of its oil reserves and given its stable economic and political environment and the competence of Aramco to develop these reserves. However, this strategy of increasing production to capture larger market share from a declining pie does not compensate for the loss of revenue from lower oil prices, and therefore overall Saudi revenues will most likely fall in a carbon-constrained world.
There have also been suggestions that in this new global oil order, Saudi Arabia has no incentive to keep its official policy of maintaining spare capacity. But there may be a strong case for Saudi Arabia to play a more proactive role on the upside. One of the lessons for Saudi Arabia policy makers of the latest cycle is that a high oil price environment will accelerate supply and demand responses, especially as environmental concerns intensify, and therefore in the long-term, it is in the kingdom’s interest to prevent prices from rising to high levels, putting a cap on the oil price. To achieve this, Saudi Arabia would need to maintain healthy spare capacity and develop market tools to help influence the price on the upside. So far, there is no indication whatsoever that Saudi Arabia has abandoned its policy of maintaining spare capacity, which is still considered to be a cornerstone of world oil market stability.

The focus on developing natural gas reserves will accelerate

Another area of policy continuity is the goal of using more natural gas domestically rather than liquid fuels. The share of natural gas in total domestic energy consumption has risen from 23 percent in 1980 to over 41 percent last year. One of the key objectives is to increase the share of natural gas to more than half of total primary energy demand to satisfy the increasing demand from the new petrochemical plants and to reduce crude burn in the power sector, to free up crude oil for exports by mainly developing its domestic reserves without excluding the possibility of importing gas. According to the National Transition programme, the target for dry gas production capacity is an almost 50 percent increase to 17.8 bcf/d by 2020.


The Vision 2030 reiterated Saudi Arabia commitment to renewables with plans to add 9.5 GW of renewable energy by 2023. However, no legal and regulatory frameworks for the deployment of renewable energy have yet been established. Even if the Kingdom achieves the new ambitious target, it is important to put things in perspective. The country has a meager 25 MW of renewable-energy generation capacity (mostly solar photovoltaic) installed as per the end of 2015 and even with the newly announced target, renewables would constitute just 5 percent of the country’s electricity consumption, as demand continues to grow too. For the foreseeable future, the rise in electricity in demand will be met mainly by oil- and gas-fired power plants.

The drive for downstream integration will continue

Turning from the power sector to the downstream, Saudi Arabia has been increasing its refining capacity significantly in recent years. Many factors can account for this drive. The most important motivation is that Saudi Arabia has been forced to import expensive petroleum products, as domestic demand has outstripped refining capacity in certain petroleum products such as gasoline and diesel. Investment in refining is also still considered by many policymakers as a key step towards creating added value by converting crude oil into refined products and establishing the link between the upstream sector and petrochemicals, which in turn provides opportunities for diversification and downstream integration into the full value chain, including the development of new industries. Saudi Arabia has been increasingly encouraging their petrochemical industries to diversify the feedstock mix away from ethane towards refined products such as naphtha, butane, and propane. In addition to increasing feedstock availability, the use of refined products provides opportunities to produce more sophisticated petrochemical products that are needed to extend the value chain and generate employment opportunities. Finally, the limited availability of gas for use in the power sector and infrastructure issues have resulted in continued reliance on liquid fuels for power generation, further increasing domestic demand for liquid products.

Renewable energy will be a very small part of the Saudi energy mix

The Vision 2030 reiterated Saudi Arabia commitment to renewables with plans to add 9.5 GW of renewable energy by 2023. However, no legal and regulatory frameworks for the deployment of renewable energy have yet been established. Even if the Kingdom achieves the new ambitious target, it is important to put things in perspective. The country has a meager 25 MW of renewable-energy generation capacity (mostly solar photovoltaic) installed as per the end of 2015 and even with the newly announced target, renewables would constitute just 5 percent of the country’s electricity consumption, as demand continues to grow too. For the foreseeable future, the rise in electricity in demand will be met mainly by oil- and gas-fired power plants.

The drive for downstream integration will continue

Turning from the power sector to the downstream, Saudi Arabia has been increasing its refining capacity significantly in recent years. Many factors can account for this drive. The most important motivation is that Saudi Arabia has been forced to import expensive petroleum products, as domestic demand has outstripped refining capacity in certain petroleum products such as gasoline and diesel. Investment in refining is also still considered by many policymakers as a key step towards creating added value by converting crude oil into refined products and establishing the link between the upstream sector and petrochemicals, which in turn provides opportunities for diversification and downstream integration into the full value chain, including the development of new industries. Saudi Arabia has been increasingly encouraging their petrochemical industries to diversify the feedstock mix away from ethane towards refined products such as naphtha, butane, and propane. In addition to increasing feedstock availability, the use of refined products provides opportunities to produce more sophisticated petrochemical products that are needed to extend the value chain and generate employment opportunities. Finally, the limited availability of gas for use in the power sector and infrastructure issues have resulted in continued reliance on liquid fuels for power generation, further increasing domestic demand for liquid products.

Saudi Aramco IPO will face many hurdles

While many of these themes represent a continuation, and perhaps acceleration, of existing policy objectives, one new element of Vision 2030 caused a significant stir—the public listing of Saudi Aramco. No exact timeline has been announced, but 2017 has been mentioned as a desired target. The potentially biggest IPO in history is likely to be fraught with challenges.
Saudi Aramco does not own the reserves; it has the monopoly to produce from reserves. Thus, any valuation will not be based on the value of the reserve base, but most likely on the discounted cash flows into the future, which depends on the profit per barrel and the quantity of oil produced. The profit per barrel will depend on the level of taxes and royalties Saudi Aramco pays back to the government; if the taxes and royalties that go to the finance ministry are high (as they currently are), then the valuation will be low. The fact that the government can increase taxes on Saudi Aramco also introduces ‘sovereign risk’, and hence the comparisons with private companies such as ExxonMobil do not hold, as one cannot apply the same discount rate to Aramco’s cash flows given the higher level of risk.
But the hurdles don’t stop here.  Given the size of the IPO, a listing in foreign exchange may be required, as the small size of the Saudi stock exchange can’t absorb such a high value IPO.  However, listing outside the kingdom would raise the possibility of ‘frivolous lawsuits’ against the kingdom. Also, as Saudi Aramco loses the status of a ‘national oil company’, it could be subject to anti-trust suits.
In many ways, the question is less about how much cash the IPO raises, but whether the IPO will result in a shift in the fundamental behaviour of the Kingdom. Shareholders do not value spare capacity and would encourage faster development of reserves than a government. Given the IPO will put less than 5 percent of the company in the public, the minority shareholder will likely have no influence over such key decisions. Also, it is obvious that the separation of Aramco from the energy ministry is hardly simple. In fact, there was an attempt earlier to separate the two by removing Al-Naimi as the Chairman of Saudi Aramco, but we are back to the old system now with Al-Falih as the Chairman of the Aramco board and the energy minister, highlighting the complexities in separating the two.

Change but a slow and bumpy one

This point about complexity is broadly true for almost all of the topics explored above. However, these immense challenges don’t mean that there would be no change in Saudi Arabia. Structural reforms are much needed to shift the economy to a more sustainable path and even if only a small part of the vision is being implemented, the Saudi economy will look very different in 2030 than it is now. In this transition, the energy sector will continue to play a key role. But amidst all the excitement, one also needs to be aware of the challenges ahead and the time it takes to implement such changes, particularly in a conservative society and in an oil-based economy where the sense of entitlement among citizens is high and institutional capacity to undertake deep reforms is low. Furthermore, structural reform is rarely a linear process, and there will be bumps on the way. Transforming the economy doesn’t just create winners; there will also be losers who need to be protected by the government to maintain public support for these reforms. This is key to ensuring a smooth transition to the ‘vibrant’ economy.

Go to Oil 32