Politics Harden Saudi Oil Strategy

Copyright © 2021 Energy Intelligence Group
January 2016 John van Schaik

Saudi Arabia's strategy of allowing oil prices to balance the market is set to continue with gusto in 2016 with the added twist that Riyadh will almost certainly keep supplies at current high levels and possibly even increase them, which implies continued low oil prices. The economic and financial costs of the strategy may be higher than it expected, but the resulting political pain for Saudi rivals like Iran and Russia is a bonus that should only strengthen the kingdom's resolve to continue the policy -- even if oil prices stay below $40 for the rest of the year. Even before the sharply heightened political and diplomatic tensions with Iran over the Saudi execution of a Shiite cleric and Russia's direct intervention in the Syrian civil war in opposition to Saudi Arabia, the inherent logic of the Saudi strategy of defending market share was pointing toward high Saudi volumes and the possibility of expanded volumes as market opportunities arise. The Saudis might even expand their production capacity when demand requires. Saudi Oil Minister Ali Naimi has consistently said that his country will sell as much oil as clients need.

When Saudi Arabia led Opec to decide on Nov. 27, 2014, to let the market balance itself without any reduction in output, the thinking was that US shale companies would quickly buckle with an oil price below $80 per barrel. Now, with Brent and West Texas Intermediate around $35, some small US firms have indeed failed, and US oil production is down from its 9.7 million barrel per day pre-summer peak, but the shale sector has been far more resilient than expected. However, the lower-for-longer price scenario fits with Saudi Arabia's oil market objectives and it also fits well with its more activist foreign policy of the last year as it cuts deeply into the oil revenues for key rivals like Russia and Iran.

For sure, the Saudi market strategy comes at a big cost to its own income, but the gamble on the political front is that it is much more able to handle the financial pressure than its rivals. To gain market share and fill up global oil inventories in anticipation of intensified market competition and a possible oil price war, Saudi Arabia exported 7.35 million b/d of crude oil in 2015, which is 450,000 b/d more than it sold in the second half of 2014. Income from crude exports alone for all of 2014 was $245 billion with benchmark Dubai at an average $96/bbl. That is down to $135 billion in 2015 with Dubai at $51. The kingdom ran a budget deficit of $98 billion in 2015 and sees another deficit of $87 billion in 2016. But it has substantial financial reserves and borrowing options to handle these deficits.

The slow market reaction to low oil prices and the ongoing resilience of non-Opec production has only confirmed the economic necessity of the controversial Opec decision: the alternative would have been endless Opec production cuts effectively subsidizing high-cost, non-Opec output. The Saudis have reset the global mind-set on oil economics with their strategy of defending volumes rather than price. The basic economic idea is that Opec should capitalize on its proven oil reserves and maximize output of low-cost oil rather than subsidize high-cost producers.

However, the original policy of defending market share has already tilted toward one of expanding market share. While Riyadh does not want to be seen to be driving prices down with increased output and has consistently argued that it supplies only what customers desire, the fact is that it increased exports by over 500,000 b/d in the first half of 2015, targeting the key Asian import markets that are critical to both Russia and Iran (PIW Dec.14'15). Meanwhile, the extra oil on world markets last year caused oil inventories to rise sharply, creating an overhang of as much as 500 million bbl, of which about 175 million bbl are additional Saudi oil. Even before non-Opec producers had begun to significantly reduce their output, Saudi Arabia was actively expanding market share to provide replacement barrels. As non-Opec output slides, Saudi Arabia and others can be expected to continue to move in quickly to offset lost volumes even before there are any hints of a supply gap.

Taking this strategy to its full logical conclusion, Saudi Arabia and other Mideast countries, with their low physical production costs, can be expected to add production capacity in the coming years. And they can be expected to bring all that oil to market to fill in for non-Opec declines. Based on announced additions and current spare capacity, Mideast producers can add 7 million b/d in output by 2020, which should be more than enough to cover global oil demand growth over four years.

The Saudis have the ability to go to 15 million b/d in output capacity, and might well do that over time. Production at 10.2 million b/d can be sustained for another 75 years with current oil reserves. But the environmental necessity of climate change and likely decarbonization policies point to a shorter time span. What 2015 made clear from an economic and environmental perspective is that if anyone is going to sell oil in the next couple of decades, when oil is still the global fuel of choice, it is likely to be the producers in the Mideast, where the world's low-cost conventional reserves are concentrated.

The Saudi market share policy is also underpinning the kingdom's strategic political goals. That was not the purpose of its oil policy but it is turning out to be a clear bonus to Riyadh that stresses the global might and reach of Saudi Arabia. Muscular Russia, already hit by Western sanctions and low commodity prices in general, is seeing its government finances in disarray and its currency weaken further as a result of the low oil price. Oil Minister Alexander Novak claims the destabilized oil market is the work of the Saudis but refuses to cut back output to prop up prices as others will benefit more than Russia. Archrival Iran has seen oil income cut in half in the past 18 months from falling prices after experiencing a similar drop in 2012 when its crude export volumes were cut by nuclear sanctions. Iran's chances of benefiting significantly from the lifting of sanctions are now much reduced.

Iran's planned full return to the oil market when sanctions are lifted is being made more difficult now that Saudi Arabia and also Iraq have pre-emptively increased sales to key customers and filled up crude oil inventory tanks around the world. What's more, soft Saudi pricing is making it harder for Iran to add the desired 500,000 b/d without sharply discounting its sales -- lowering its own income and putting further downward pressure on oil prices.

Saudi Oil Minister Ali Naimi is urging Arab nations to invest in oil production capacity and help each other with the financing. In fact, Saudi Arabia is keeping a record number of drilling rigs active in the country. It says it is not adding capacity. But it would make sense for the Saudis to quietly work on expanding capacity. It fits the theory underlying its market strategy, and fits the fear that climate change policies will eat away at the market share of oil over time. Riyadh could announce to the world, when prices would creep over $50 or so, that it has another 1 million b/d added to capacity and that it will bring that oil to market. Such a move would keep prices lower for longer, allowing the countries with the lowest-cost reservoirs to tap their reserves at the expense of others, including its geopolitical rivals.

John van Schaik is team leader for oil markets and New York bureau chief at Energy Intelligence.

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