Saudi Oil Policy and the Global Oil Market

Bassam Fattouh

JOGMEC, TOKYO, 20 FEBRUARY 2017

Oxford Institute for Energy Studies

The Demand Side Has Not Been the Culprit So Far

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Oil Demand Growth Remains Robust Despite Some Weak Pockets

Global Oil Demand, y/y change, kb/d

Source: EIA, Energy Aspects

Demand growth exceeded expectations and carried most of adjustment in 2015; in 2016 oil demand registered another strong annual growth (1.6 mb/d); Oil demand growth expected to remain robust in 2017

Growth in Demand in 2016 and 2017, y/y mb/d

In 2016, a mixed bag for global demand with a strong Asia and moderate US offsetting weakness in LatAmand Middle East; In Asia, it is no longer only about China

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Shift in Products Demand Dynamics

Demand growth has not been about diesel as Asian economies rebalance from investment towards consumption but diesel demand did pick in the last two months of 2016 as economic activity picked up

Global Gasoline and Diesel Demand, y/y change, kb/d

Asian diesel demand, y/y change, mb/d

The slowdown in diesel demand growth has been mainly driven by China

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Shifts in Products Demand GrowthGlobal Demand by product, y/y change, mb/d

Petrochemicals is becoming increasingly a main source of liquids demand growth

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Global Jet Fuel Demand, y/y change, kb/d

Jet fuel demand growth remained robust throughout the last two years

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Non-OPEC Supply Outside US Has Fallen But Some Surprises on the Upside (and the Downside)

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In 2016, Shift in Adjustment to non-OPEC Supply

Non-OPEC Supply Outside US, y/y change, kb/d

After robust growth in the environment of high oil prices, the y/y change in non-OPEC supply has turned negative in almost every part of the world, but projects sanctioned in the high oil price environment continued to come online offsetting some of the declines in 2016Q4.

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China Crude oil outputmb/d

Colombia Crude oil outputmb/d

In Some Countries, Declines have been Sharp and Will Take Time To Reverse

Source: Energy Aspects, IEA

China’s oil output has been in decline due to cuts in capex and the re-organization of the oil sector

Following period of rapid expansion, Colombian output has fallen sharply as a result of cuts in Capex and disruptions 8

But Pockets of Non-OPEC Supply Growth

Russian oil output, mb/d

Russia has defied expectations of output fall benefiting from massive devaluation of currency, change in the tax system, start-up and the ramp-up of new projects which offset decline rates in mature areas but this could change if the government changes the tax system

Strong growth in pre-salt output in Brazil as new projects come online which is offsetting declines in the mature Campos Basin

Campos vs. Santos y/y change, mb/d

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Many Projects Sanctioned in Period of High Oil Price Still Coming on-line

Source: Energy Aspects

More than 2 mb/d of new projects coming online in 2016 sanctioned during the period of $100 + environment. The pipeline of new projects will slow down as investment is cut.

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Non-OPEC Upstream Oil Projects Pipeline, kb/d

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US Shale Has Declined but Perhaps Less than Originally Expected

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The US Supply Response Has Been Strong

Despite efficiency gains, US shale and been fastest to respond to the decline in the oil price with growth turning negative in 2016; But the decline peaked in September

US Crude Production, mb/d US Crude Production, y/y change, kb/d

US crude production has been leading the declines within non-OPEC

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Sharp Supply Cuts in Some Parts within OPEC

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The Fiscal Crisis-Output Disruption Channel

Nigerian oil output, thousanb/d Venezuela oil output, mb/d

Attacks on oil infrastructure in the Niger Delta intensifies as government’s ability to pay-off militants weakens

Poor planning, lack of investment, fall in umber of rigs, equipment theft, and payment delays to service companies impacting Venezuela’s output

Source: Energy Aspects

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What about Middle East OPEC? The Key Dynamic Shaping the Oil Market in 2016

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Strong Middle East OPEC Supply Growth

Source: OPEC, Energy Aspects

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Middle East ex-Middle East

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OPEC and non-OPEC output, y/y change, mb/d

As non-OPEC supply started to decline in 2016, most of these declines were offset by growth in OPEC supply

Within OPEC, it has also been a story of two subgroups: The Middle East and the Rest

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The Phases of Saudi Oil Policy

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Phase 1: Cut Output in Face of a Temporary Shock

World Liquid Fuel Consumption and OPEC supply, y/y change, mb/d

Following the collapse in oil demand in the aftermath of the 2008 financial crisis, OPEC implemented one of the biggest cuts in its history with Saudi Arabia accounting for the bulk of the output cut

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OPEC Supply

Saudi Arabia Supply

Saudi Arabia also sent a very strong signal about its preferred price of $75/B and the market stabilized at that price for the second half of 2009 and for most of 2010

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Brent Crude Spot Oil Price, $/B

Source: EIA18

Phase 2: Increase Output in Face of Exogenous Supply Shock

OPEC and non-OPEC Disruptions (LHS) and Saudi Oil Output (RHS), thousand b/d

The market witnessed some serious supply disruptions following the Arab Spring and imposition of sanctions on Iran. Saudi oil output mirrored closely the supply disruption: First surge in output in 2011 following the Libyan disruption; Second surge in output following the sanctions on Iran. As disruptions eased towards the end of 2014, Saudi Arabia’s output fell down but remained at above 9.5 mb/d.

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Source: EIA, Energy Aspects19

Strong Supply and Demand Responses at a Price of $100

Source: EIA, Energy Aspects

‘$100 is a fair price for everybody – consumers, producers, oil companies’; But too ‘high international oil prices are bad news. Bad for Europe, bad for the US, bad for emerging economies and bad for the world’s poorest nations and that Saudi Arabia will act to lower soaring oil price’

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At $100 price, both demand and supply responses were very strong and visible, especially the response of US shale which added more than 1 mb/d in 2013 and exceeding 1.8 mb/d in 2014 Q2

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Global Oil Demand US Supply

Global Oil Demand and US Supply, y/y, thousand b/d

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Phase 3: Pursue Market Share Strategy

• Faced with two options: Cut output or Leave it to prices to clear the market

• Opted for latter strategy– Size of market imbalance in 2014 was relatively large

– Unwillingness to act unilaterally to balance the market; fundamental principle shaped by 1980s experience

– Difficulty of reaching an agreement within OPEC and non-OPEC producers as threshold of pain was still low (and hence willingness to act also is low) and many countries having ambitious plans to increase productive capacity

– Saudi Arabia built strong fiscal buffers during the boom years and belief that Saudi Arabia can withstand a lower oil price for long

– US shale introduced a new set of structural uncertainties (unlike the 2008 temporary shock)

Source: Fattouh, Poudineh, and Sen (2016)21

Increase Output and Maintain Market Share

Saudi Arabia Oil Output, thousand b/d

In 2015, Saudi Arabia was one of the main contributors to output growth adding more than 400,000 b/d; in 2016, Saudi output reached a historical record of close to 10.8 mb/d

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Saudi exports remain elevated and it seems there is implicit policy of maintaining crude exports above the 7 mb/d mark to increase revenues

Saudi Arabia Crude Oil Exports, thousand b/d

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Source: JODI, MEES, Energy Aspects22

Saudi Arabia also Competing in Products Markets

Saudi Arabia Refining Runs, mb/d

Saudi Arabia refining runs at record levels as the new refineries ramp-up output

Exports of products (particularly diesel) have been on the rise and Saudi Arabia is competing in products market

Saudi Arabia Products Exports, mb/d

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Gasoline Exports Diesel Exports Jet Exports

Source: JODI23

Phase 4: Purse an Agreement to Cut Output

August 11, 2016 9:30 am

Saudi energy minister hints at effort torebalance oil market

Saudi Arabia showed willingness to freeze output and cooperate with other producers following the sharp fall in oil price in the start of 2016, but the signal was not always clear

Source: Financial Times, Reuters, OPEC

Saudi Arabia increased its output in 2016 reaching a record level in August; Can’t be explained only by rise in domestic demand during summer

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Potential Explanations for Shift in Policy• The market already rebalancing and the cut would have a

bigger impact on prices in a tighter market– Also resolve a key market uncertainty regarding US shale

• Cost of strategy changed– Cumulative cost since November 2014 has grown faster than

cumulative benefits wiping out the net gain from market share strategy

– When the game was first played, Saudi Arabia may have overestimated its tolerance to the costs associated with adopting a market share strategy

– When the game was first played, Saudi Arabia may have underestimated the cost of adopting a market share strategy as not all information was available at the time of the decision

Source: Fattouh and Sen (2016)25

Saudi Economy Badly Hit By Lower Oil Revenues

Annual Rates of Private and Non-Oil Sector, %

The growth in the private and non-oil sector has stalled putting at risk Vision 2030 which relies heavily on a vibrant private sector

Saudi Arabia Foreign Reserves, Billions US$

The fiscal buffers eroded faster than originally expected

Source: SAMA

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Particular Sectors Badly Hit

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Total Oil Demand, y/y, Thousand b/d

Total oil demand has fallen for the first since many years

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Gross Fixed Capital Formation has collapsed in 2016

Annual Growth Rates of Gross Fixed Capital Formation, at current prices, %

Source: General Authority for Statistics, JODI27

Despite Adjustments, the Fiscal Challenge Remains• Adjustment in a low price environment

– Drawn down on foreign reserves – Increase domestic lending– Tap international debt markets – Increase domestic energy prices– Reduce capital spending – Reduce current spending – Boost non-oil revenues – Devaluation (Not on the table so far)

• Measures have not been enough to address fiscal challenge– Massive increase in expenditure during boom years + Yemen war

• Longer-term measures– Vision 2030, National transformation programme, diversification

• But dilemma: Diversify from the sector which remains the engine of growth of the economy and the main source of revenues needed to diversify the economy 28

Saudi Arabia’s Vision 2030

Summary of Vision 2030 goals

A very ambitious plan to diversify economy away from oil and increase role of private sector. Such plans are not new and diversification has been a feature of every five-year development plans since the 1970s. How is it different this time?

Source: Saudi Government29

NTP 2020 and the Saudi Energy Sector

NTP set some goals for energy sector with many of these targets continuation of current policies; But the energy sector can’t be isolated from the general transformations in the economy.

Source: Saudi Government30

The Oil Price and Potential Risks

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Factors that will Shape Saudi Arabia Behaviour

• If there is no adherence to the agreement by other countries, then most likely outcome is a shift in Saudi policy towards recapturing market share (one should not take for granted the extension of the agreement)

• If US shale response is big and fast and substitutes for OPEC output cut, Saudi Arabia could shift back to market share strategy (current decision to cut output would result in loss of market share without any durable impact on prices and hence lower revenues)

• If US shale response is moderate and does not substitute for output cut, then most likely outcome is extension of the agreement in order to accelerate withdrawal of stocks which is the key objective of the current OPEC agreement

• If the market tightens (for instance due to a disruption), would Saudi Arabia attempt to put a cap on the oil price on the upside by increasing output?

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US Shale Response on the Upside: How Fast? By How Much?

US Rig Count

The rig count in the US has recovered sharply in the last few months

After some sharp cuts in E&P spending in 2015 and 2016, investment will flow back in 2017

Source: Baker Hughes, Barclays

2015 2016 20172016-2015

2017-2016

US IOCs 49,667 33,146 33,080 -33% 0%

NAM Large-Cap E&Ps 40,851 22,434 35,438 -45% 58%

NAM SMID-Cap E&Ps 25,799 15,521 22,216 -40% 43%

NAM Small / Private E&Ps 1,289 776 1,307 -40% 68%Int'l IOCs/NOCs 8,250 5,836 6,286 -29% 8%

Total 125,856 77,713 98,327 -38% 27%

North America E&P Spend by Customer Type, Million US$

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Conclusions• Saudi oil policy shaped by multiple factors

– Domestic factors: Durability of fiscal buffers, financial resilience, fiscal sustainability, impact of lower revenues on the domestic economy

– OPEC dynamics: Ability to reach a credible agreement with other producers and implement it

– Market conditions: Nature of the shock• 2008: Temporary demand shock• 2011-2012: Exogenous (temporary) supply shock• 2014-onwards: US shale introduced new set of uncertainties

• As these change and/or as new information becomes available, Saudi oil policy will also change

• OPEC cut important for resolving some key market uncertainties

• As in 2016, OPEC behavior will be the key factor shaping market dynamics in the short to the medium term

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