FEATURE ENERGY ENERGY FEATURE BEYOND

What are the implications of an increase in Saudi crude oil production capacity? BY JIM KRANE

COMBINATION OF FACTORS IS encouraging A to consider raising crude oil production capacity beyond the current ceiling of 12.5 million barrels per day. The kingdom has managed to maintain a constant share of global crude oil markets, even as it copes with growing domestic demand for oil and a spate of investments in refineries, inside and outside the kingdom. Longer term, the threat of peak global oil demand – perhaps in response to “Saudi Arabia finds itself – enhances the attractions of a shorter time horizon to depletion. However, an oscillating between increase in Saudi crude oil production cutting crude oil would have consequences for markets and competing forms of energy, as well production to prop up as for the kingdom's geopolitical stature. prices and maintaining The wide range of potential outcomes suggests that a major capacity increase is high levels of exports a risky strategy. to defend its share of THE BACKGROUND the crude market from As recently as 2015, Saudi energy officials competing suppliers” dismissed suggestions that the kingdom

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would seek to raise its crude oil production “Even though costs based on what we see as projection and capacity above its theoretical maximum are among the world’s call on Saudi oil, we don’t see anything of 12.5 million barrels per day (m b/d). like that, even by 2030 or 2040. So the However, that stance has evolved. Public lowest, Saudi Arabia has need to build the facilities and drill wells to statements from officials at pursued a long-term produce 15 million or have the capability – operating since May 2016 under a new for 15 million is not there,” Al Naimi said oil minister – indicate that the company depletion strategy that during a speech in Washington. expects to increase oil production above was designed to promote “Based on all projections that I have recent historic highs. Further ahead, the seen, including ours, there is no call on company is considering investments to domestic fiscal and us to go past 11 (million), 11.5 (million) increase its capacity beyond the current political stability” by 2030 or 2040.” maximum 12.5 m b/d threshold. Three years on, Al Naimi has retired and Saudi Arabia finds itself in an energy been replaced by former Aramco CEO demand quandary. At home, the kingdom Khalid Al Falih, who heads an expanded needs oil and for transporta- Ministry of Energy, Industry and Mineral tion, industrial production and electric- Resources. Shortly after Al Falih’s ascen- ity generation. Each of these sources of sion, Aramco’s new CEO, Amin Nasser, domestic demand is increasing, propelled publicly stated what Aramco officials have by rising populations, growing incomes long said in private, that the 12.5 m b/d and subsidized end-user prices that, MSC would be maintained “for now,” but despite a recent adjustment, remain could be expanded in the future. among the lowest in the world. Internationally, Saudi Arabia also faces A MONTH LATER, AL FALIH SAID MUCH conflicting priorities for its crude oil. It finds itself oscillating between cutting THE SAME THING. crude oil production to prop up prices Sources of pressure on Saudi production and maintaining high levels of exports capacity include the following: to defend its share of the crude market • An increase in global demand in from competing suppliers. Meanwhile, response to the sustained period of low the kingdom’s , oil prices since late 2014. Saudi Aramco, is in the midst of doubling • The perception that non-OPEC produc- a crude oil refining business that could see ers have deferred so much capital it compile ownership stakes in as much investment since late 2014 that, without as 10 m b/d of capacity. That amount is sufficient Saudi spare capacity, future roughly equal to all of Saudi Aramco’s tightening in oil markets could trigger a current oil production. damaging price shock. As the kingdom endeavors to satisfy • The kingdom’s limited ability to these competing demand sources, it constrain growth in domestic hydro- increasingly sacrifices one of its most carbon consumption. Recent subsidy important strategic assets, the spare oil reforms and an emphasis on substitut- production capacity that it uses to balance u Aramco pumps around 10 million barrels of oil per day (bpd) ing natural gas for oil in the domestic markets in times of disrupted supply. economy appear to have slowed, but not Saudi Aramco’s spare capacity has most “Global efforts to makers believed that threats to monetiz- in 2008, then-Oil Minister Ali Al Naimi ing for rising domestic consumption. Al eliminated, demand growth. likely slipped below 2 m b/d in recent ing will grow stronger in the announced the kingdom’s intent to raise Naimi rejected the notion. He said Saudi • The erosion of spare production capac- years. An increase in Saudi oil production reduce future, they may opt to increase oil output oil production capacity to 15 m b/d. Al Aramco had no need to move beyond the ity, in particular via recent downstream could also be incentivized by expectations use in response to in the present, a phenomenon described Naimi reversed course a few months later maximum sustainable capacity (MSC) of investments that, combined with other that restrictions on burning of fossil fuel as the “green paradox”. when prices plummeted amid the global 12.5 m b/d, a level that the company deter- demand sources, could challenge the will intensify in the future, as importing climate change are a In other words, if the long-term outlook financial crisis. Since then, suggestions mines it could sustain after a six-month kingdom's capability to continue as states impose policies aimed at mitigat- major worry among for fossil fuels looks risky, a short-term that the kingdom might move beyond period of capital and operational invest- dominant global supplier of raw crude. ing causing strategy becomes more attractive. Thus its long-time 12.5 m b/d maximum have ment. Saudi Aramco declared that it had • Longer term, future demand could be climate change. oil producers” the kingdom’s energy policymakers find been rejected. achieved the 12.5 m b/d MSC under the undermined by climate-driven disincen- The Saudi government has announced themselves revisiting a pressing question: In 2013, a senior member of the ruling late King Abdullah, who approved invest- tives to oil and the emergence of substi- plans to diversify its economy, thereby Should Saudi Aramco invest in oil produc- Al Saud family, the former intelligence ments to raise capacity from about 9 m tute fuels and technologies. Worries about reducing its exposure to climate risk, by tion capacity beyond 12.5 m b/d? chief and US ambassador Prince Turki b/d at the beginning of his tenure. premature peaking of global oil demand selling a 5% portion of Saudi Aramco, via Al Faisal, said that the kingdom planned “I don’t know what (Prince Turki) could incentivize stepped-up production an (IPO) of owner- $100bn A CHANGE IN THINKING to increase capacity to 15 m b/d by 2020. means by 15 million. He may be think- and shorter-term depletion strategies. ship shares. Climate risk could also weigh The capital Saudi Aramco could raise in its During the period of markets that He said the increase was needed to raise ing… that Saudi Arabia is capable of doing In summary, if Saudi Aramco intends into a decision to raise output. If policy- initial public offering (IPO) by end-2018 saw prices reach an all-time high of $147/b export levels to 10 m b/d while allow- it, building capacity to 15 million. Now, to maintain all of its commitments to its

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to producing and selling it at times when returns in financial markets are low. The result could be manifested in a green para- dox scenario, where producers accelerate extraction so that resources can be mone- tized before value is lost. Such price war behaviour implies an increase in supply and reduced prices, which winds up enhancing the attractiveness to consum- ers of the restricted product. Climate-focused scholars have sought to quantify the amount of potentially stranded resources by calculating “burn- able” fossil fuels as a portion of global reserves, measured by the carbon - eters implied by limiting climate change to 2 °C. McGlade and Ekins find that some 431 billion barrels of global oil reserves, 33% of the total, must remain unburned – along with even greater proportions of natural gas and coal – for humanity to adhere to the 2° limit. The authors forecast that the Middle East will see a greater-than-aver- age proportion rendered unburnable, 38% or 263 billion barrels, due to the modest pace of Middle Eastern oil extraction rela- tive to reserves. From this perspective, Saudi prudence looks risky. However, few forecasts of climate effects find that oil demand will be displaced without concerted policies that use legal or economic means to constrain consumption. Such policy action is diffi- cult to predict. Without it, oil substitutes in transportation will be held back by short- comings in energy density, cost per mile, range, and even carbon content. While u Low oil prices might also enhance oil dependence among emerging economies electric vehicles and battery technologies are improving, so are internal combustion myriad demand sources – while protect- at balancing an oversupplied market and tion over the optimal pace of depleting some future point, when Aramco can no gence of threats to the long-term value of engines. Further, new innovations, such ing the kingdom’s strategic supply role boosting prices. There are also practi- reserves. Even though costs are among longer enhance recovery or add reserves, crude oil, especially in oil's viability as a as autonomous vehicle technology, could – the company may decide to intensify cal financial questions about investing the world’s lowest, Saudi Arabia has Saudi output is supposed to decline at a transportation fuel. provide a structural increase in demand upstream investment, increasing produc- in infrastructure that may never be fully pursued a long-term depletion strategy gradual rate that allows the kingdom time Global efforts to reduce fossil fuel use by reducing the time constraint on driv- tion capacity to 13, 14 or 15 million barrels deployed. However, a convergence of that was designed to promote domestic to diversify its economy for . in response to climate change are a major ing and allowing vehicles to be used for per day. Longer-term threats reinforce this demand and revenue pressures, along fiscal and political stability. The kingdom The late King Abdullah gave voice to worry among oil producers. Expectations longer periods. In short, oil is unlikely to logic, implying that accelerated monetiz- with long-term risk factors, point to the limits oilfield depletion to 2–3% per year, this strategy in 2008 when he report- of a robust and intensifying anti-fossil fuel lose its primacy in transportation with- ing of reserves may be pragmatic. possibility that the kingdom’s production which has allowed it to consistently deliver edly ordered new reserves left for future campaign could bring about a breakdown out concerted government policies that ceiling is under reconsideration. around 13% of global supply since 2000. generations. “I keep no secret from you of the Hotelling rule, under which storing impose heavy penalties on emissions or RATIONALES FOR RAISING SAUDI ARABIA'S Production decisions in the kingdom Saudi Aramco calibrates output from that when there were some new finds, I oil underground is financially preferable favor alternatives. OIL PRODUCTION CAPACITY are subject to painstaking delibera- individual fields so that recoverable oil told them, ‘No, leave it in the ground. With Even without a viable substitute, oil is exhausted gradually, over a minimum grace from God, our children need it.’” “Simultaneous growth demand is still subject to reduced growth, Why would Saudi Arabia seek to increase of 30 years. The market effect of Saudi At the time, limiting production was not and, perhaps, decline. A 2016 report from oil and gas production capacity? At the restraint has been to constrain the king- just useful for safeguarding resources, it in Saudi Arabia’s power predicts that the world time of writing, Saudi Arabia had reaf- dom’s contribution to global supply and also fit with Saudi policy of exploiting generation and industrial could see total oil demand reach its zenith firmed a 2016 commitment to cut oil $2tr force oil prices up, while allowing higher- market power to maximize profit. That as soon as 2021. The IEA forecasts that production by nearly 500,000 b/d, as part The estimated value of Saudi Aramco, cost “fringe” producers to meet remain- calculus could change, however, if Saudi sectors has triggered gasoline demand may already be near- of an OPEC-led supply restriction aimed according to industry experts ing demand with more expensive oil. At energy policymakers believed in the emer- competition for gas” ing a plateau, as efficiency gains and

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electric vehicles compensate for growth in the developing world. Whenever it happens, demand for oil is likely to tail off Supply and demand Saudi share of world oil production gradually, requiring production to continue for decades. Increasing capacity and competing for market share is just one of a number of possible peak demand response options for Saudi Aramco. Van de Graaf and Verbruggen argue that producer coun- tries facing declines in global consump- tion might also agree to coordinate and share the market through agreed-upon output quotas, or seek compensation from importing countries for stranded reserves and lost income, or simply diver- sify their economies. ADJUSTING TIMELINES TO DEPLETION If a price war or market share strategy gained favor in , a decision to increase production tempo could be a rational one, albeit with negative conse- Saudi fears of plateauing demand demand are strong. Inside the kingdom, hegemony by Iran, a long-time strategic quences for the climate. A shorter time would provide an alternate rationale for refining and other downstream industries competitor. Raising its profile in global horizon to depletion would, all else recent – and future – increases in output. support job creation through petrochem- would increase Saudi constant, reduce global oil prices and By forcing prices lower, Saudi Aramco icals and industries based around plas- power and autonomy within OPEC and increase demand, while also reducing might actually delay the onset of peak tics, all of which require crude oil, refined help revitalize its strategic relationship Riyadh's risk of carrying stranded assets demand, prolonging oil’s dominance in products such as naphtha, or associated with the United States, perhaps helping that could not be marketed. Stepped- transportation while capturing market natural gas and liquids that are produced renew US commitments to its external up Saudi oil production might actually share from higher-cost producers. Low alongside crude. security. Otherwise, as mentioned by transfer stranded-asset risk to higher-cost prices might also enhance oil depend- Increased crude oil production implies Krane, a declining role in crude markets producers. Potential losers could include ence among emerging economies, leading increased supplies of associated natural implies a diminishing of the kingdom's deepwater offshore, Canadian , states into path-dependent investment gas, which could provide some relief to strategic importance. Venezuelan extra heavy, and other higher- in oil-intensive transportation systems the kingdom’s intensifying gas shortage. cost resources. If climate poli- and settlement patterns that lock in long- Simultaneous growth in Saudi Arabia’s SIGNS THAT POINT TO AN INCREASE cies encouraged competition based on term demand. power generation and industrial sectors carbon intensity, Saudi crudes would gain At the same time, an increased supply has triggered competition for gas, which Several academics and financial analysts further advantage, due to lower carbon of crude oil would allow Saudi Aramco to the kingdom neither imports nor exports. have written about creeping domestic oil content than competing crudes. Saudi continue increasing its stake in refining An increased supply would also allow demand in Saudi Arabia. Articles have crudes typically lie at the low end of the capacity toward 10 m b/d. The refining Saudi power generation to shift away from extrapolated current growth into the lifecycle carbon scale, with 460 – 500 kg of u Crown Prince is spearheading Saudi Arabia’s Vision 2030 diversification plans strategy appears to be aimed at captur- expensive liquid fuels like crude oil and future, suggesting that Saudi Arabia could CO2 per produced and combusted. ing and retaining markets for Saudi crude, diesel fuel, which still comprise roughly forfeit its spare production capacity and Other crudes exhibit carbon intensities lenge” to Saudi Arabia and those of an especially heavier grades that are incom- half of power generation feedstocks. then divert oil from export into the domes- as much as 50% higher, particularly the “Saudi Arabia has adviser who predicted that global demand patible with common refining configura- Forthcoming investments in wind and tic market before mid-century. synthetic crudes produced in ’s taken steps to insulate would peak by 2025. Al Falih reiterated tions built around lighter, sweeter crudes. solar power may provide additional relief. Reduced exports can be avoided oil sands, where emissions per barrel can its economy from these concerns in June 2016, saying that By designating refining capacity for Saudi Saudi Arabia would also accrue geo- by either halting growth in domestic extend beyond 700 kg. “we as human beings cannot be compla- crudes, Aramco’s strategy could provide strategic advantages from taking a demand, or by increasing production Al Naimi and associates have voiced stranded assets and cent and assume that oil will continue to some insulation from competing supply in more dominant role in global crude and capacity. If further progress in reining in fears for at least a decade about the long- falling oil demand” fuel the world forever.” the event of a decline in demand. Owner- products markets. The kingdom sees domestic demand proves difficult, boost- term resilience of oil demand amid pres- Saudi Arabia has taken steps to insulate ship of refineries in the United States, itself fending off a challenge for regional ing capacity may be necessary. By doing sure from climate action, substitute tech- its economy from stranded assets and fall- , and already so, Saudi Aramco could replenish its spare nologies and fuels, as well as US political ing oil demand. Aside from the planned allows Aramco to protect market share capacity regardless of continued increases rhetoric around “energy independence.” selloff of a 5% stake in the kingdom's in those countries, while the company in domestic consumption, even as the US diplomatic cables released by WikiLe- paramount national asset, Saudi Aramco, has begun negotiating additional refin- company maintains export commitments. aks document some of these concerns, as 13% Riyadh has invested in nonoil industries as ing joint ventures in Indonesia, and 100bn Raising output would take years and do Al Naimi’s public statements describ- Saudi Arabia’s contribution to well as lower-emission uses of oil, petro- Malaysia, large developing countries in The barrels of oil Saudi Arabia has require immense investment into oil ing climate action as an “existential chal- the global oil supply since 2000 chemicals in particular. which expectations for future petroleum depleted since 1990 processing capacity, including pipelines

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and storage. At the time of writing, poli- It could also signal to other producers “Finally, one must In the long term, the oil business cymakers in Saudi Arabia and other major that the risk of stranded assets is serious appears to be moving toward a period of exporters were curtailing capital spending, enough to warrant accelerated monetiza- address lingering increasing risk. Oil producers understand cutting subsidies and announcing plans to tion of in-ground resources. A glut of cheap questions about the that the imperative of reducing emissions cut state employment. At the same time, crude oil would undercut conservation of climate-warming greenhouse gases the Saudi government has issued debt initiatives as well as competing technolo- size of Saudi Arabia’s endangers the leading position of fossil to fund budget deficits. Nevertheless, a gies and energy sources, including those remaining oil reserves” fuels in the global energy balance. An array number of signs suggest that the king- associated with lower carbon emissions. of policy obstacles and investment disin- dom may consider a capacity-enhancing Thus a decision to raise Saudi produc- another estimate places proven reserves centives is creating hurdles for the fossil program of capital spending. tion capacity could generate conse- at just 88 billion barrels, with “probable” fuel sector. While a compatible replace- Consider that Saudi crude oil produc- quences that trigger the green paradox: and “possible” reserves – including yet- ment for oil-fuelled transportation does tion is already near historic highs. Output enhancing the attractiveness of oil, delay- undiscovered resources – adding a further not yet exist, the threat of climate change has risen by 7% since 2014, from an aver- ing the peaking of crude oil demand, and 188 billion barrels. compels individuals and governments age of 9.7 m b/d in 2014–10.4 m b/d in intensifying damage to the climate. An Since most of the kingdom’s major to work toward oil substitutes, irrespec- 2016. The effects of the production cut alternate possibility is that by raising fields were discovered at least 40 years ago, tive of prices. This understanding ought have reduced Saudi oil output since Janu- production, Saudi Aramco could publi- the enduring consistency in reserve esti- to prompt some holders of large reserves ary 2017 to around 10 m b/d. In 2015, cize its fears the world is readying to move mates suggests that new oil discoveries are to try to monetize those resources on an Saudi Aramco released plans to spend , inadvertently encouraging probably not the only source of growth. accelerated pace, lest they lose value or $33bn a year to 2025, a total of $334bn, investment in alternate technology such Other factors for reserve growth probably become stranded. Recent statements on upstream investment. as electric vehicles. also include “field appreciation,” based and actions within the Saudi oil sector The program represents a significant Finally, one must address lingering on improved recovery and understanding suggest that these threats are being taken increase on typical yearly investment of questions about the size of Saudi Arabia’s of field capacity, and a relaxed criteria for seriously. Regardless, the costs and risks $17bn and appears to have survived the remaining oil reserves, a key determi- estimating “proven” reserves, perhaps by inherent in raising production capacity difficult fiscal environment and changeo- nant of any plan to sustain raised levels including formations normally considered render the outcomes uncertain. ver in national and company leadership. of production for a period sufficient “probable” and “possible.” The largest segment, 42%, is earmarked to warrant the investment. The king- Worldwide, some 80% of “proven” oil for drilling. The number of oil-directed dom has reported its proven reserves reserves do not comply with financial ACKNOWLEDGMENTS wells would increase nearly 50% from in the range of 260 billion barrels since reporting requirements of securities Reprinted from Energy Policy 110, pages 850 in 2015 to 1,250 in 2025. Some 280,000 1990, when it abruptly raised its official exchanges. Reporting and classifications 542-547 by Jim Krane, Fellow for Energy workers will be needed. Aramco, with reserves figure from 1989 levels of 173 requirements grow more strident when a Studies, Baker Institute for Public Policy, 62,000 direct employees, would require billion barrels. Since 1990, Saudi Arabia firm offers shares on a financial exchange. Rice University, 6100 Main Street, large-scale hiring or contracts with has depleted roughly 100 billion barrels Thus the promised Aramco IPO could , TX 77005, USA. With assis- services firms. without affecting reserves figures. Most prompt a detailed accounting of reserves, tance from Elsie Hung, Michael Maher Finally, an increase in production independent reports of Saudi reserves depending on jurisdictional requirements and Yasser Faquih. Copyright 2017, with capacity fits the risk-inclined policy u Khalid A Al Falih, Saudi Minister of Energy, Industry and Mineral Resources and chairman of Aramco repeat opaque government estimates. But of listing locations. permission from Elsevier. approach of Crown Prince Muham- mad Bin Salman, who has emerged as zon to full depletion. BP estimates that, An output increase would also affect the kingdom’s key day-to-day decision- at current rates of production, the king- the ultimate tally of cumulative oil reve- maker. Prince Muhammad Bin Salman dom's reported reserves base will last 59 nue collected by the Saudi government. Black gold Saudi crude oil production since 2002 has launched several initiatives – from the years. An increase in production would If a glut caused oil prices to drop past the aforementioned fiscal reforms to a major push forward that figure, which could point offset by higher export volumes, the military intervention in Yemen – that devi- reduce rent allocation for future genera- kingdom would be worse off. In short, ate from the kingdom's traditional caution tions of Saudi citizens. policymakers must weigh whether the risk in regional and domestic affairs. of a loss in revenue is outweighed by the “Perhaps most worrying, risk of stranded assets. Post-IPO, future shareholders may also balk at a huge capi- RISKS, OUTLOOK AND CONCLUSION a rise in Saudi crude tal investment program, particularly if the An increase in Saudi production capac- oil output could trigger outlays interfered with short term returns ity also carries serious downside risks. or dividend payments. Perhaps the biggest is that additional a damaging period of Perhaps most worrying, a rise in Saudi Saudi capacity will not be needed and global oversupply” crude oil output could trigger a damaging the investment will be unproductive. period of global oversupply. A glut could Overcapacity could also undercut oil be exacerbated by future carbon taxes and prices and perhaps encourage a long- other policy restrictions on fossil fuels. term equilibrium of lower prices based This could play out in a number of ways. on higher market exposure to low Saudi 260bn It might deter Saudi competitors from production costs. In theory, higher oil Saudi Arabia’s reported oil reserves, investing in higher-cost resources, push- production also shortens the time hori- in barrels ing more expensive oil out of the market.

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