Journal Essay

Lower for Longer: Saudi Arabia Adjusts to the New Oil Era

Gawdat Bahgat

Fall 2016, Volume XXIII, Number 3

Dr. Bahgat is a professor of national security at the Near East South Asia Center for Strategic Studies at the National Defense University, Washington, DC. He is the author of several books and numerous scholarly articles on the Middle East and American foreign policy.

Saudi Arabia, with the largest economy in the Arab world, is deeply dependent on oil exports (approximately 75-80 percent of total revenues). Largely due to high oil prices during most of the last decade, Riyadh was able to establish itself as one of the strongest and fastest-growing economies in the Middle East. According to a recent report by McKinsey Global Institute, the Saudi economy in 2003 was the twenty-seventh largest in the world; by 2014, it had risen to number 19. This economic expansion also eliminated national debt, accumulated huge reserve assets, raised average household income by about 75 percent, and created more than 1.7 million jobs.1 This astonishing economic performance was driven, almost exclusively, by public spending. The government and the public sector served as the engine of the rapid economic growth.

Though for years this fiscal policy and economic structure were seen as unsustainable, high oil prices provided few incentives to initiate serious economic reform. The sharp drop in oil prices since mid-2014, however, means that the day of reckoning has arrived. Fiscal surplus has turned into deficit, and the need for structural reform has become urgent. The huge stock of assets the state has accumulated makes the kingdom relatively better able than most other producers to alleviate the impact of the price drop. These assets are, unfortunately, rapidly eroding. Within this context, the government launched its Vision 2030 in late April and a National Transformational Plan (NTP) in early June. The main goal of these initiatives is to reduce the kingdom's heavy dependency on oil revenues and create a diversified and balanced economic structure.

The next section examines the dynamics of the global oil market in both the short and long terms. I argue that this cycle of low oil prices is different from previous ones. For one thing, low oil prices are projected to last for a long time. A return to a $100-dollar-per-barrel price range is not likely any time soon. The analysis proceeds to discuss the Saudi government's efforts to cope with persistent low prices and overcome the evolving economic challenges. Different options have been tried or are under consideration: borrowing from local and international markets, drawing down foreign reserves, introducing various forms of taxes, and rationalizing government expenditures by scaling back capital projects and cutting subsidies.2

THE NEW OIL ORDER

Volatility has been an underlying characteristic of oil prices in the last several decades, due to several factors. As in the case of other commodities, the price of oil reflects the equilibrium between supply and demand. Equally important, given that oil is considered a strategic commodity, geopolitics has always had a significant impact on production, demand, trade and pricing. Finally, oil companies are among the richest in the world and have always allocated substantial resources to improving and developing exploration and production technology.

The soaring oil prices that followed the 1973 Arab-Israeli war were driven by political developments in the Middle East. Arab exporters, led by Saudi Arabia, cut production and imposed an embargo on the United States and a few other countries for their support to Israel. A second oil shock in 1979-80 was triggered by the Iranian revolution and the Iran-Iraq War. Concerned about the stability of the Middle East and the interruption of supplies, major oil companies have invested heavily over the last four decades in developing other sources, such as the North Sea and the Gulf of Mexico. They have also invested in a new technique: hydraulic fracturing (fracking) combined with horizontal drilling.

The use of horizontal drilling and hydraulic fracturing in the United States has greatly expanded the ability of producers to profitably recover natural gas and oil from complex geological plays. Generally, under the combination of these technologies, water, sand and chemicals are injected into a horizontal borehole of the well at very high pressure to crack the shale rock and release the gas. This has allowed wider access to oil and gas in shale and tight formations where the density of the rock has blocked the migration of hydrocarbons to conventional oil and gas reservoirs. Although experimentation dates back to the twentieth century (the first well was fracked in the United States in 1947)3, efforts were intensified in the mid-1970s with a partnership of private companies, the Department of Energy and research institutions. This partnership facilitated the commercial production of gas and oil from shale rock. One of the earliest successful applications was led by the Mitchell Energy and Development Corporation in Barnett Shale and North Central Texas. Since the mid-2000s, this combination of hydraulic fracturing and horizontal drilling has been widely recognized in the United States and around the world as a "game changer."4

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