For Saudis, The Fragile Bubble of Carbon is Fading
February 27, 2017
One read of the Saudi refusal to prop up the price of oil in recent years, is that they see the writing on the wall, and understand that selling oil cheaply today may be a better choice than not being able to sell it at any price tomorrow.
This reality, is, of course, the driving force behind the for-the-moment successful attempt by Russia to dominate world resources – that’s the meaning of their Hail Mary play attack on the US election – transiently ascendent, with helpers in the FBI, the media, and, knowingly or not, the US Republican Party.
A lot of people have been watching the progress of a Saudi plan to offload its fossil assets and change course toward renewables. Appears they may already be seeing the outlines of the carbon bubble.
Saudi Arabia has said oil giant Saudi Aramco is worth more than $2 trillion, enough to consume Apple Inc. twice, and still have room for Google parent Alphabet Inc.
The kingdom may have to settle for less. A lot less.
Industry executives, analysts and investors told Bloomberg their analysis — based on oil reserves and cash flow projections under different tax scenarios — suggests Aramco is worth no more than half, and maybe as little as a fifth, of that amount. This means Saudi Arabia would earn a fraction of the $100 billion implied by its valuation if it sells 5 percent to the public in 2018, as planned.
For example, Wood Mackenzie Ltd. came up with a rough valuation of Aramco’s core business of $400 billion, according to clients who attended a private meeting at the oil consultant’s City of London office this month and asked not to be named. The Edinburgh-based company, popular for its analysis and valuation of energy companies and assets, declined to comment.
An Aramco spokesperson said the oil producer doesn’t comment on rumors or speculation.
While there’s a lot of guesswork involved in sizing up a company that’s never divulged financial statements and may have its tax rate cut before the initial public offering, this valuation gap reveals the hurdles Saudi Arabia could face in preparing for the post-oil era.
A profitable IPO is meant to anchor a sovereign wealth fund that will, if things unfold as envisioned, generate enough investment income at home and abroad to dominate state revenue by 2030. Demand for oil will peak just before then, according to Royal Dutch Shell Plc projections, as alternative fuels and electric cars gain popularity, putting Middle East energy producers on shakier footing.
Saudi Arabia is a country near-synonymous with the oil industry, but now the kingdom is moving to end what it calls its “addiction to oil” with a new plan.
The plan, known as Vision 2030, was announced Monday by Deputy Crown Prince Mohammed bin Salman, the fast-rising 31-year-old said to be at the helm of Saudi Arabia’s plans to modernize its economy. In an interview with al-Arabiya news channel conducted in his palace in Riyadh, Mohammed said that under the plan, the country will exist “without any dependence on oil” by 2020 and would soon be a “global player” on the world investment stage.
That would mark a big change. Since large quantities of oil were discovered in the then-nascent Saudi kingdom in 1938, the oil industry has come to dominate the country’s economy. Revenue from the industry earned the Saudi government billions and enabled the ruling royal family to offer generous benefits to Saudi citizens. In recent years, the oil industry had accounted for an estimated 90 percent of the government’s income.
However, as oil prices plunged from $100 a barrel in 2014 to less than half that amount in 2015, the kingdom’s coffers have been hit badly. Last year, the country ran a deficit of $98 billion, about 15 percent of its gross domestic product. There are widespread fears that without reining in its profligate spending, Saudi Arabia risked financial disaster: A report from the International Monetary Fund released in October warned that the government could run out of money within five years.
Saudi Arabia’s decision not to cut oil production, despite crashing prices, marks the beginning of an incredibly important change. There are near-term and obvious implications for oil markets and global economies. More important is the acknowledgement, demonstrated by the action of world’s most important oil producer, of the beginning of the end of the most prosperous period in human history – the age of oil.
In 2000, Sheikh Yamani, former oil minister of Saudi Arabia, gave an interview in which he said:
“Thirty years from now there will be a huge amount of oil – and no buyers. Oil will be left in the ground. The Stone Age came to an end, not because we had a lack of stones, and the oil age will come to an end not because we have a lack of oil.”
Since its formal creation in 1960 the members of OPEC, and specifically Saudi Arabia (and in reality the Kingdom’s control over global oil markets is much larger than that 16% of reserves implies as its more than 260 billion barrels are among the easiest and cheapest to extract and before enhanced recovery techniques accounted for a much larger share of global reserves) have used excess oil production capacity to influence crude prices. The primary role of OPEC has been to support price stability. There are notable exceptions – like the 1973-1974 oil embargo and a period of excess supply that undermined prices and crippled the Soviet Union in the 1980s (though whether this was a defined strategy or serendipity remains in some question), but at its core the role of OPEC has been to control oil prices. As recent events show, OPEC’s role as the controller of crude oil pricing is coming to an abrupt end.
In acting as global swing producer, OPEC relied has heavily on Saudi Arabia, which can influence global prices by increasing or decreasing production to expand or reduce available global supply. Saudi Arabia can do this not only because it controls an enormous portion of global reserves and production capacity, but does so with crude oil that is stunningly inexpensive to produce compared to the current global market. A change, however, has occurred in Saudi Arabia’s fundamental strategic approach to the global oil market. And this new approach – to refuse to curtail production to support global prices – not only undermines OPECs pricing power, but also removes a vital subsidy for global oil producers provided by the Saudi’s longtime commitment to price support.
The widely held conventional theory is that the Saudis want to shake the weak production out of the market. This strategy would undermine the economic viability of a meaningful amount of global production. The theory assumes that this can be done in some kind of orderly bring-down of prices where the Saudis can find an ideal price below the production cost of this marginal oil production but still high enough to maintain significant profits for the Kingdom while this market correction plays out. The assumption is that following the correction there will be a return to business as usual along with higher prices, but with Saudi Arabia commanding a relatively larger share of that market. An alternative rationale is that Saudi Arabia is fighting an economic war with oil; a strategy designed to economically and in turn politically cripple rival producers Iran and Russia because the governments of these countries that depend on oil exports cannot withstand sustained low prices and will be significantly weakened.
While there may be some truth to both of these theories, the real motivation lies somewhere closer to Sheikh Yamani’s 2000 prediction. Saudi Arabia has embarked on an absolute quest for dominant market share in the global oil market. The near-term cost of grabbing that market share is immense, with the Saudis sacrificing potentially hundreds of billions of dollars if low prices persist. In a world of endless consumption, this risk would be hard to justify merely in exchange for a temporary expansion of global market share – the current lost revenue would take years to recover with a marginally higher share of global supply.
But in a world where a producer sees the end of its market on the horizon, then every barrel sold at a profit is more valuable than a barrel that will never be sold. Current Saudi oil minister Ali al-Naimi had this to say about production cuts in late December: “it is not in the interest of OPEC to cut their production whatever the price is,” adding that even if prices fell to $20 “it is irrelevant.” Implied, if not explicitly stated, is that Saudi Arabia wants its oil out of the ground, regardless of how thin its profit margin per barrel becomes.