The Competitive Advantage of Low Cost Middle East Oil

Barring any ground shifting developments that could impact the outlook for the world energy market, readers of the annual long-term market outlooks issued by various parties around the World, do not usually expect to see major changes in the reference scenarios between one year and the next. Potential future developments that may drastically change the assumptions underlying the reference scenario, such as the advent of new technologies, their rate of adoption, new energy impacting policies, political & security developments among others, are usually relegated to sensitivity studies and presented as alternative scenarios to the base case.

Therefore, the notable change in the assumption made by British Petroleum (BP), in its recently released 2017 Energy Outlook, about the distribution of market share between OPEC and Non-OPEC producers has come as a surprise and raised a few important issues.

In its 2016 Energy Outlook, BP assumed that OPEC will, for the foreseeable future, defend a market share of 40%, which approximates its historical share. This assumption was also shared by the US Energy Information Administration (EIA) in its 2016 Long-term Energy Outlook. In a sharp turnaround, OPEC’s assumed share in global supply growth jumped to 70% in the 2017 Outlook. The shift was justified by stipulating future growth will be driven by “holders of large-scale, low cost resources, especially in the Middle East, US and Russia, as these producers are assumed to respond to the growing abundance of oil resources by asserting their competitive advantage”.

The growing consensus in the energy industry about the abundance of oil resources has apparently been a primary motive behind the new assumption on OPEC’s market share. The dialogue has shifted from earlier concerns about peak oil to opposite expectations of peaking demand. The 2017 Outlook featured oil abundance as a key issue, next to the impact of electric cars on oil demand, the implications of the growth of LNG for the global gas market, and China’s changing energy landscape.

As per the 2017 Outlook, technically recoverable oil reserves are estimated to be around 2.6 trillion barrels, of which 1.7 trillion barrels (65%) are in the Middle East, CIS, and North America. This abundance in resources contrast with slowing growth in oil demand. Under most scenarios, cumulative global oil demand up to year 2050 amounts to less than half of today's estimated technically recoverable reserves. The extent to which global supply behavior changes is a key uncertainty, as the authors of 2017 Outlook point out, as this will “depend on: (1) The cost and feasibility of the low-cost producers increasing supply materially over the Outlook; (2) the extent to which prices respond to increased supply of low-cost oil and the implications this has for producers’ economies; and (3) the ability of higher-cost producers to compete by varying their tax and royalty regimes.”

The above uncertainties will be important in defining future market share. It is believed however, that the interplay between the oil price on the one hand, and the economies of the low-cost producers, on the other, will be the most consequential factor of relevance to the low-cost producers in the Middle East. For most of these producers, the ability to compete for market share is not necessarily a function of their cost of production, but the fiscal break-even price of oil needed to meet their revenue requirements. Protecting and growing their market share require an ability to sustain, for a relatively long period, an oil price level below the production cost of competing producers. Their real competitive advantage is inversely proportional to the difference between the fiscal break-even price and the cost of oil production. The lower that difference is, the more impact their cost advantage will have.

Due to relatively high dependence on oil revenues and low degree of economic diversification, the fiscal break-even prices of oil for Middle East producers, as estimated by the IMF, are presently well above their oil production cost, and more importantly are above the production cost of most competing nontraditional oils such as: shale oil, deep water oil, oil sands, among others, Figure 1.

The fiscal break-even price for most ME producers have risen consistently since the beginning of the Century until the middle of 2014, in line with the extended period of accelerated growth in international oil prices and sustained growth in oil demand. This has resulted in windfall of oil export revenues flowing to the treasuries of oil exporters. The countries of the Gulf Cooperation Council (GCC), as an example, consistently grew their budget expenditures at high rates, while also increasing their surpluses. This has led to increased entrenchment of the welfare state, stronger coupling between the oil and the non-oil economy, increasing levels of revenue requirements to operate and maintain the growing capital stock, and reduced incentives to pursue meaningful economic, social, and political reforms. The collapse of the oil price in 2014, brought this long-term growth trend in revenues to a sudden end, quickly reversing the fiscal balance, and once again have namely put economic reforms at the top of the development agenda, Figure 2. Consequently, for these producers to defend, let alone grow their market share in a future of abundant supply, they need to substantially reduce their dependence on their oil income.

The response of the ME producers to the retreat in oil prices that started in 2014, particularly in the GCC countries, was relatively quick and unprecedented in scope and objectives. Formerly prepared studies and plans for fiscal reforms and economic transformation, left collecting dust in the archives of government ministries of economy, planning and finance, were expeditiously retrieved, revised, updated and dressed in new cloth of urgency. This was reminiscent, for those familiar with the historical developments of the Region in the mid 1980’s, of former attempts at economic reforms, when oil prices fell in response to then growing non-OPEC supply, which caused serious fiscal stresses and other socio-economic challenges. One would assume that the commitment towards reforms will be stronger this time around, considering the forecast moderating growth in the demand for oil and the abundance of its supplies.

The unprecedented scope and objectives of fiscal reforms and economic transformation programs announced by these countries over the past two years, support the validity of the above assumption. For instance, The National Transformation Program 2020, announced by Saudi Arabia in 2015, includes ambitious and far reaching objectives, such as: tripling non-oil revenues, balancing the budget by 2020, weaning the Kingdom off its addiction to oil, taxing the income of foreign workers, and introducing a Value-Added Tax (VAT) in concert with other GCC members in 2018, among others. Furthermore, Saudi Arabia plans to gradually raise domestic energy prices to international prices/cost recovery levels over the next 5 years, with the caveat of introducing a compensation mechanism for lower-income households as a prerequisite for further price increases. It also plans on providing support to increase energy efficiency to offset the impact of higher prices. The Kingdom also plans to contain the government wage bill, considered high by international standards, by reducing civil service employment by 20 percent by 2020, among other measures, all per the IMF. Similar measures are planned in other GCC countries given the common challenges that they face.

The above measures seem to focus on the right issues that burden fiscal management and drastically constrain the path towards sustainable development. These issues, such as: high levels of direct and indirect subsidies, heavy budget dependence on oil revenues, and a bloated public administration, are however only symptoms of underlying structural distortions that were shaped by long running economic and social policies. The inertia of the existing socio-economic system has attained such a level, where changing its trajectory would require taking painful decisions, sustained commitment for change not subject to the whims of the oil market, and require a long time to realize.

The economic, social, and political feasibility of raising domestic energy prices to “international levels” heavily depends on the successful implementation of the offset measures intended to reduce the burden of higher prices. These measures however, require long time to implement and realize their benefits that can extend to decades. Energy conservation programs require the availability of managerial, administrative, and technical infrastructure operating at the national and local levels of government, along with an effective public-private partnerships and cooperation by the consumers. They need to cover millions of residential commercial and other facilities. Furthermore, prices need to be at the right level at the onset of these programs to assure the consumers of their benefits and insure their cooperation. Given the size of these subsidies (Figure 3), and the wide gap between present and targeted price levels, it is believed that closing this gap, even gradually, will require much longer time than planned.

Reducing the dependence on oil income will not be possible without reforming the indirect subsidy regime which is embodied in the substantial transfers to the non-oil sector of the economy. Those transfers compensate for all the services provided either for free or at prices below the cost of service in almost all oil exporting countries of the Middle East. These transfers are reflected in the recurrent balances of the non-oil sector, which are substantially in the red, Table 1. Price reforms in the services sectors such as, water, transport, health, education, among others, become essential if the coupling between oil revenues and the non-oil economy is to be weakened. These issues raise questions of social and political feasibility, while delaying these reforms will entail facing rising future recurrent revenue requirements for operating and maintaining the capital stock whose size has rapidly expanded over the past two decades.

Rationalizing civil service employment, as contemplated by some producers, will be a major challenge and unlikely to be met soon. The main difficulty stems from the reasons behind the over-sized government sector, which has been the employer of last resort for the nationals entering the workforce. Without such recourse, those job seekers would otherwise have been among the unemployed. This is mainly due to the mismatch between the professional qualifications of the national workforce on the one hand, and the skills required by the economy on the other. Consequently, while the nationals dominate the government sector, non-nationals migrant workers dominate the ranks of the workforce in the private sector.

The issue of mismatch between the outcomes of the educational system and the needs of a modern economy was correctly diagnosed very early in the course of economic and social development, but necessary educational reforms were not adopted in some of these countries, mainly due to opposition of influential segments of society, and according to a Report by Carnegie Endowment Organization on the educational reforms in Saudi Arabia and Kuwait “it seems that long educational histories have made the bureaucratic legacy an impediment to far-reaching initiatives, while ideological disputes prevent the emergence of new ideas”.

Delaying the reforms have precipitated a potential unemployment crisis due to rapidly rising tide of new graduates entering the work pool, which can only be mitigated by expanding government employment. Consequently, the need to deal with the growing threat of potential unemployment gradually became the focus of policy, with the fundamental causes rooted in the educational system taking a back seat to more immediate concerns.

The reforms to the education system undertaken relatively recently by countries like Saudi Arabia and Kuwait are laudable and considered giant steps in the right direction. However, concerns persist about “a fundamental misalignment of needs and expectations that makes it hard to improve outcomes”. Notwithstanding the skepticism about the reforms, and assuming their full success in closing the skill gap in the future, it is believed that the impact on the labor market will be gradual and will only be fully realized over the long term.

Absent from the various plans for decreasing dependence on oil revenues is any mention of defense and security expenditures that constitute substantial part of total public sector expenditures and a sizable share of the Gross Domestic Product (GDP) of Middle East oil producers. Per the Stockholm International Peace Research Institute (SIPRI), military expenditures in 2014 constituted about fourteen percent of (GDP) in Oman, eleven percent in Saudi Arabia, six percent in UAE, and five percent in Kuwait and Iraq, Figure 4. The combined military expenditures of the Gulf Countries (Iran, Iraq, Kuwait, Oman, and UAE) reached 140 billion dollars in 2014. This is three and half times their level in 2004, Figure 5. It is doubtful that these countries would have been able to sustain such levels and rates of growth of of military expenditures in the absence of high oil export revenues. Consequently, achieving the objective of reduced reliance on oil income would require a transition to an era of peace and tranquility, which would entail unprecedented evolution in intra-region relations; a transition from the current state of confrontation to an environment of peace and cooperation.

Therefore, given the complexity of the challenges facing the oil producers of the Middle East, the cost of oil production will be one of many other highly uncertain factors that will determine their competitive advantage and consequently their future share of the World energy market.

KZ

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