The Middle East is by far the most important region in terms of proved oil reserves. In 2015, the region held 803 billion barrels, accounting for more than 47 per cent of the world’s proved oil reserves. In 2015, the Middle East produced 30 million barrels per day (mb/d), accounting for around a third of the world’s total production. While in 2016 supply growth fell in most parts of the world following the decline in the oil prices since 2014, OPEC Middle East supply (that produced by Saudi Arabia, Iraq, Iran, Kuwait, UAE and Qatar) grew by more than 1.4 mb/d. Unlike many other oil-producing regions, the Middle East exports the bulk of its oil output, and thus the region still has a dominant position in the international trade of crude oil. In 2015, the region’s crude exports to the rest of the world reached 879.6 million tonnes, constituting more than 44 per cent of the world’s total imported oil. For some regions, such as Asia-Pacific, crude imports from the Middle East account for 66% of their total crude imports. The world’s available spare capacity has historically been concentrated in Saudi Arabia, which has allowed the country to act as a swing producer, filling the gap at times of oil supply disruptions. However, with the Kingdom producing at levels close to 10 mb/d recently, the available spare capacity has declined over time, especially when measured as share of global oil consumption. The Middle East’s reserves are also among the cheapest in the world to find, develop, and produce. The wedge between production cost and price in international market generates high rents for oil-rich countries that are recycled through the international financial markets. According to most projections, the Middle East is expected to play a key role in meeting medium to long-term global oil demand growth, most of which is projected to originate from non-OECD Asia. Meeting this demand requires that key Middle Eastern producers maintain a stable political, regulatory and investment environment and a well-functioning and adequately funded oil sector to expand output capacity and increase export levels. Political instability, lack of security, a weak regulatory and investment environment, and sanctions imposed by Western powers will undermine producers’ capabilities in expanding output capacity.
The Change in Demand and Supply Dynamics
The change in oil demand growth dynamics towards non-OECD Asia implies that there will be greater interdependence between the Middle East and Asia, which will be reflected in stronger economic and energy ties and perhaps in new strategic geopolitical alliances. On the supply side, the price collapse of 2015-16, and the close cooperation between Russia and OPEC (particularly Saudi Arabia), signify the growing interdependence between OPEC and the other producers. The wider interdependence between OPEC and other producers culminated in an agreement in November 2016 to cut the production of OPEC member countries by 1.2 mb/d and eleven Non-OPEC countries by 0.58 mb/d, led by Russia with 0.3 mb/d. While the West has become less relevant in shaping these increased interdependencies, the rapid rise in US shale supply has been an indirect but influential factor in increased interdependence. The rapid growth in US shale has generated a powerful supply shock and has fundamentally changed global crude oil trade flows. Relative to other sources of non-OPEC supply, US shale supply is more responsive to price signals given the short-term investment cycle and the low capital intensity of projects. Furthermore, US shale producers have achieved massive efficiency gains, which have placed them in the middle of the oil cost curve. But US shale is only a small part of non-OPEC supply and constitutes just one of the various sources needed to meet the expected oil demand increase, and cannot grow at low prices. The downturn has shown that at prices below $50/barrel, the output from key shale plays such as Eagle Ford and the Bakken have declined sharply and US output overall has fallen markedly from its peak in April 2015. The IEA projects, in its New Policies Scenarios, that US shale output will contribute the most in terms of growth between 2015 and 2030, but for US shale production to then fall between 2035 and 2040. Overall, the change from US shale between 2015 and 2040 is expected to reach 2.1 mb/d. In contrast, the change in Middle East OPEC output during this period is projected to reach 8 mb/d, with most of the increase coming from Iran, Iraq and Saudi Arabia. In short, despite the US ‘shale revolution’, the Middle East will retain its key importance for oil markets both in the medium and long term, especially in a low price environment. But the structural shift in supply due to the US shale has had the effect of reducing the oil price and lowering the revenues for key Middle East oil producers. The relatively elastic US shale supply curve adds further complexity to producers’ efforts to manage the oil market and to achieve a higher oil price given that the cost of US shale has declined to below producers’ break-even fiscal costs.
The Adjustment to Low Oil Price Environment
Thus, the two main immediate issues facing key oil exporters in the Middle East are whether the current decline in revenues is temporary or structural and whether their economies can adjust to a lower price environment. Regardless of the issue of whether the oil market has been subject to structural shocks and whether the world has entered the ‘new oil order’, there is general consensus that oil prices can’t be sustained at $100 for long and that it is in the long-term interests of Middle East producers with large reserve bases to avoid prices spiralling on the upside as high prices will generate strong demand and supply responses and accelerate oil substitution policies and change in consumer behaviour. In response to the decline in oil revenues and deteriorating fiscal positions, key Middle East producers have been forced to adjust their economies through implementing various measures, with each being different in its relative ease of implementation. These include reducing employment in the public sector and boosting non-oil sources of revenue, such as increasing administrative fees, introducing land taxes, rationalising government expenditure by reducing current expenditure, cutting energy subsidies, and scaling back capital projects. These adjustments have been painful and have resulted in the slowdown of their economies, particularly within their private sector. As with the case of the impact of oil prices on the breakeven price of shale, these measures have lowered the budgetary breakeven price of those producers, thus reducing their vulnerability. The measures implemented so far, however, have not been sufficient to address the long-term fiscal challenge, and more measures are on the way. While the key GCC oil exporters have built strong fiscal buffers, these have been eroded over time and are ineffective in dealing with structural shocks.
Economic reforms in Saudi Arabia, an inevitable evil?
The above adjustment and reform measures suggest that the implicit social contract between the ruling families and the citizens (in which the state has the privilege and responsibility to extract, manage, and trade the country’s hydrocarbon resources and then to distribute oil rents in various forms, including public employment and provision of cheap good and services) is not as rigid as originally perceived. Contrary to conventional wisdom, the social contract has proved to be sufficiently resilient to accommodate the limited reforms seen so far. The public has been surprisingly accepting of broader structural reforms and austerity measures, including cutting public sector employment allowances and increasing domestic fuel and electricity prices though from a very low base. This can be explained by a combination of low oil prices, fiscal pressures, concerns about economic inefficiencies and long-term fiscal sustainability, the inability of societies to form independent and effective political opposition, geopolitical dynamics, intra-regional rivalry, the fear that the chaos in neighbouring countries can spread to their own countries, and the absence of any credible and realistic alternative to the current regimes. The growing demographic pressures and the increasing number of entrants to the labour market, have also lowered citizens’ expectations and contributed to the acceptance of reforms. However, the social contract may not prove sufficiently resilient to accommodate further sharp energy price increases, faster and deeper structural reforms, and currency devaluations without the governments introducing compensatory schemes to offset the negative impact on household welfare and industrial competiveness. Therefore, governments may become more constrained in their choices as reforms accelerate, especially given that there is still a strong sense of entitlement among the citizens of the hydrocarbon-rich countries. Backing down on current reforms raises the risk of worsening the fiscal situation and undermining these countries’ macroeconomic stability, while pushing for deeper reforms raises the risk of wide popular opposition and erosion of regime credibility and legitimacy.
Prudent management of reforms
Therefore, navigating through reforms is a delicate task that may be subject to many bumps on the way. Poor reform management and weak governance structures can erode the credibility of ruling regimes and increase the risk of social unrest, but past experience shows that the ruling families have muddled through prolonged periods of low oil prices and they can survive few setbacks on the way, especially in the absence of credible organised opposition groups and the existence of a well-entrenched patronage system built over many years. But the failure to adjust to lower prices could have repercussions on the political, social and economic stability of some key oil exporters, with direct and indirect impacts on their energy sector, energy policy, and their capability to invest and increase their productive capacity. In a worst-case scenario, this may even result in supply losses if adjustment measures and reforms result in social and popular unrest and increased insecurity. In case of a large supply loss, crude stocks will draw fast and prices would increase. In other words, the developments in global oil markets are closely interlinked with the adjustment process and reform in key Middle East oil exporters. There is fundamental internal inconsistency in a scenario based on low oil prices or lower forever (as implied by the ‘New Oil Order’), higher investment requirements from the Middle East to meet rising global oil demand (as implied by the IEA World Energy Outlook), and rising political, social and economic instability due to the failure of key oil exporters to adjust their economies to lower oil revenues (as implied by many political analysts). Something has to give in.
The Scenario of a Structural Decline in Oil Demand
One scenario in which Middle East oil becomes less relevant is if global oil demand falls due to technological advances in the transport sector, change in consumer preferences, and/or climate change or energy security policies aimed at substituting away from oil. Despite robust global oil demand performance in recent years, which has grown by around 11 mb/d since the 2008 global financial crisis (between 2009-2016), there has been a flurry of recent studies predicting that oil demand will peak as soon as within the next decade. But even in a scenario of falling oil demand, the Middle East can continue to compete as it is the cheapest source of supply, and rather than reducing their dependency, importers’ reliance on Middle East oil supplies can actually increase. In such a world, oil revenues would decline, as the higher share will not be enough to compensate for the decline in the oil price. The increase in dependency of importing countries on Middle East oil however would be less of an issue, as this would reflect higher dependency on a commodity in decline with lower strategic value.In a scenario of structural decline in oil demand due to climate change policies or the penetration of electric vehicles and rapid changes in transportation dynamics, Middle East oil exporters would have limited options. Producers can decide to cut output and increase the oil price and try to capture larger share of oil rents while they can. High oil prices, however, increase the pace of demand reduction, induce government to accelerate their substitution policies, and would encourage supply growth in other parts of the world.
Economic diversification and pricing strategy
Another option is for producers to accelerate their investment and increase output (get as much as out of the ground as possible) to put downward pressure on the oil price to drive out higher-cost producers and induce a rebound in global demand. But such a strategy has a limited impact in terms of increasing revenues; the increase in market share will not compensate for the lower oil price and oil demand may not increase in response to cheaper prices, as the impact of government policies on demand may be stronger than the impact on oil prices. In face of structural decline in oil demand and oil revenues scenario, oil exporters have no option but to diversify their economic base and revenues away from oil to ensure a long-term sustainable growth and development path (this is a key issue for Saudi Arabia and Oman but less so for Kuwait and the UAE). Diversification, if successful, would also allow for a more flexible oil policy and long-term energy strategy planning. This has long been realised by all key exporting countries, as reflected in development plans from the 1970s and 1980s which centred on diversification, building human capital and promoting the role of the private sector and small and medium enterprise, but with limited success so far. In the current environment of heightened uncertainty and a lower oil price, there has been an increasing realisation among governments that the status quo is not sustainable and reforming the economy is a must in achieving long-term sustainability. This explains the increased sense of urgency to introduce new economic visions and transformational programmes such as Saudi Arabia’s Vision 2030. But even with such ambitious programmes, revenue from the oil sector is the main enabler of reforms, as it allows the government to invest in human capital and non-oil sectors and allows the government to mitigate the impact of structural reforms on low-income households to ensure a smooth transition to a more sustainable economy. The energy sector could also play a key role in diversification efforts through the extension of the value chain, by investing in refining and petrochemicals and establishing new related industries such as plastics—a strategy that had a limited success so far.
The Bottom Line
Thus, the future role of the Middle East depends to a large extent on the future role of oil in global economy, as well as the relative success of the countries of the region in diversifying their economies away from oil. While the jury is still out on the question of whether the world is approaching ‘peak oil demand’ any time soon, the impact of the reforms and adjustment measures on the reliability of output supplies, investment in the oil sector, and the region’s role as the swing oil producer will continue to be key as long as hydrocarbons remain the major primary energy source. Thus far, almost all projections still hold to this premise, whether in a carbon-constrained scenario or otherwise. For instance, in the IEA’s New Policies Scenario, oil demand continues to grow annually between 2015 and 2040, though at a slower rate than historical averages. Despite the fact that oil demand is still growing and few expect for oil demand to decline sharply anytime soon, there has been a shift in perception from ‘scarcity’ to ‘abundance’, and this is having wide implications on producers and consumers’ policies and their strategic relations. For instance, incorporating the premise of nearing ‘peak oil demand’ in the policies of oil-rich countries could lead to different output policies, investment patterns, and ill-advised and rushed diversification policies, which could impact future supply security. It will also result in the reconfiguration of existing geopolitical relations, especially if the West approaches the Middle East from the oil lens only, and if the incorporation of the premise of peak oil demand results in policies that are based on misguided assumptions that overestimate the role of non-hydrocarbon fuels in the future energy mix and the speed of transition to a low-carbon economy, underestimate the cost of such a transition, and underplay the role of key Middle East oil exporters in meeting future oil demand growth.