Turmoil in the Desert

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By G. Allen Brooks 2016-07-12 20:42:36

(Article originally published in May/June 2016 edition.)

Saudi Arabia’s struggles unhinge global oil markets.

Since oil was discovered in the Middle East in 1908, the region’s importance within the global petroleum industry has mushroomed. Middle Eastern oil gradually supplanted Russian oil and eventually even the prolific oil output of the U.S. that was credited with helping win World War II.

Today, non-stop religious tensions in the Middle East have become economic wars over shares of the oil market. This struggle arises within the context of other world leaders pushing to shrink the consumption of oil. Some of these leaders, cheered on by environmentalists, would love to see an end to the Age of Petroleum, but only if it is replaced by the Age of Carbonless Energy. 

Managing Transitions

For many countries in the Middle East, their past, present and likely their future as well are tied to the continued consumption of crude oil and natural gas. Their challenge is how best to transition from a dependence on fossil fuel to a more diversified economy. The highest profile country struggling with this transition is Saudi Arabia. Its struggle is compounded by the transitioning of the royal family’s leadership from the last of the aging sons of the founder of the House of Saud to the next generation of grandsons. 

The leadership shift began in January 2015 when King Abdullah bin Abdulaziz, one of the 44 sons of Abdulaziz ibn Saud, the founder of Saudi Arabia, died and was succeeded by his brother, King Salman. In accordance with the succession plan in place since King ibn Saud died in 1953, the oldest living son assumed the throne. That plan was followed by King Salman, but a few months later he overthrew the royal succession order by dismissing his half-brother, Crown Prince Muqrin, and replacing him with his nephew, Crown Prince Mohammad bin Naif. King Salman also installed his son, Prince Mohammad bin Salman, as Deputy Crown Prince and second in line to the throne. 

Prior to making these changes, King Salman secured the blessing of the Allegiance Council, made up of the remaining brothers and other senior members of the royal family, which helped dampen internal criticism from other factions within the royal family. With little fanfare, the generational shift in the leadership of one of the most significant countries in the world was made by placing two third-generation family members in line for the throne. The impact of this shift upset some royal family members, who agitated for ousting King Salman or at least restoring another son of King ibn Saud to the succession order. 

The problem is that almost all of the remaining sons are old, feeble, sick or otherwise unable to effectively lead the country. As it is, there remain health questions about King Salman, which may explain the speed with which he is moving to realign the country’s leadership. Handing leadership to the third generation is roiling the country’s politics. However, it reflects the importance King Salman places on the need to facilitate the economic transformation of Saudi Arabia, the magnitude of which few nations have ever attempted and certainly none with such a pivotal role in the global economy.

The Challenge of Low Prices

We have now reached the 18-month mark in the current oil market collapse. Perhaps more important is the fact that we have experienced two years of oil prices well below those that prevailed during the prior three years. That fondly remembered era of $100 a barrel oil created instant wealth for many oil producers, both exporting countries and exploration and production companies.

High oil prices suggested to market participants that we were firmly ensconced in a high-oil-price environment. Visions of continued high prices as far into the future as one could see, coupled with the successful development of technology that allowed producers to tap heretofore unproductive or uneconomic formations, encouraged further investment. The era of cheap capital spurred high drilling and production activity globally. It was, in short, a classic market boom. 

This boom proved more successful than previous ones in generating greater supplies of crude oil, natural gas and associated liquid fuels. From an environment characterized by industry struggles to find more reserves and grow output, the world suddenly was faced with a seemingly endless supply of fossil fuels. At the same time, demand growth eased, which caused inventories globally to grow. 

The supply and demand imbalance became visible in late 2013, but the industry’s optimism about the need for greater oil supplies kept producers drilling and producing. As the first half of 2014 unfolded, industry experts worried that global oil demand was not growing as fast as had been projected, especially in China. Global economies were, in fact, struggling to grow despite the cheap money being pumped into them. 

A One-Commodity Economy

For those who have attempted to understand oil market dynamics within OPEC from the perspective of Saudi Arabia, it has now become clear that the country’s leadership – both that of the late King Abdullah and now King Salman – understood that as a one-commodity economy, despite how valuable that commodity is, the risk of its being displaced, or at a minimum having its role in the global economy reduced, was growing.

Understanding that risk is important because 47 percent of Saudi Arabia’s population is under 24 years’ old. That demographic suggests Saudi Arabia’s society is a potential powder keg for a regime intent on keeping its subjects content with monetary grants. How the government deals with this potentially explosive social challenge is of great concern since it will impact the Kingdom’s oil policy.

Back in 2015, the realization that oil prices were falling despite continued optimism throughout the petroleum industry led to the shocking decision at OPEC’s November meeting to let market forces set the price. Saudi Arabia led that move by abandoning its role of balancing the market by cutting production. The world was aghast that decades of history were rejected. 

Industry observers began inventing conspiracy theories to explain Saudi Arabia’s actions.  Clearly, it was waging war against oil shale producers in the U.S., who had boosted global supply by four million barrels a day. Then it was to punish Saudi Arabia’s arch Middle East enemy – Iran. Those scenarios evolved after conspiracy theorists exhausted the idea that Saudi Arabia was trying to undercut Russia’s oil industry, which had become the world’s largest and was supporting Iran. 

As we are now learning, Saudi Arabia has been concerned about the long-term demand for crude oil – the country’s only real source of income – for a decade. The release by WikiLeaks of numerous U.S. State Department cables showing that Saudi Arabia was worried about the surge in climate change actions, not only in the U.S. but in other countries as well, demonstrated why the kingdom was concerned about high oil prices. Those prices encouraged more supply, especially from high-cost areas, made renewable fuels more competitive and, most importantly, slowed consumption growth. 

The Low-Oil-Price Solution

A solution for ensuring Saudi Arabia’s oil future was to reduce the price. That would help boost flagging demand growth while slowing output growth. But it was also clear that lower oil prices would create severe distress among many of Saudi Arabia’s fellow OPEC members, weakening its power within the organization. So Saudi Arabia’s plan for its future – a transition to an income stream no longer dependent on the price of crude oil – became even more important. 

Unfortunately, many people failed to see that future emerging. It wasn’t until Deputy Crown Prince Mohammad bin Salman unveiled the government’s Vision 2030 plan a few weeks ago, a plan that will reduce the government’s total dependence on oil for its revenues, that people began understanding how serious Saudi Arabia was about radically transforming its economy. 

The recent removal of Saudi’s long-time oil minister, Ali Al-Nami, the 80-year-old head of the oil ministry and a prior long-time leader of Saudi Aramco, the state oil company, crystalized the country’s vision. The announcement of his leaving, among 50 royal decrees enacting various leadership and organizational changes in support of the recently unveiled economic plan, set pundits working overtime trying to fathom why this change and why now. 

Al-Nami had tried for a decade to retire. In fact, he was asked by the Supreme Council in November 2010 to name some possible successors as it contemplated his retirement. Al-Nami’s successor, Khalid al-Falih, the head of Saudi Aramco, was one of two names on that 2010 list of possible replacements. Al-Falih is reportedly very closely aligned with Deputy Crown Prince Mohammad. He immediately announced that Saudi Arabia’s oil policy would remain the same as before. A few days later he announced plans to increase Saudi’s oil output to match rising global demand. 

These actions signal Saudi Arabia is planning for an extended period of modest oil prices as it transitions its economy in anticipation of the ending of the Age of Petroleum. The shift presents a long-term challenge to the international oil business that will bear watching for months and years to come. – MarEx

The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.