A number of factors are pushing Saudi Arabia to raise its crude-oil production capacity, but the wide range of potential outcomes suggests that such an increase is a risky strategy for the kingdom and the global environment, according to a new article by an expert from Rice University’s Baker Institute for Public Policy.
Most notably, a rise in Saudi crude-oil output could trigger a damaging period of global oversupply, said Jim Krane, the Wallace S. Wilson Fellow for Energy Studies in the Baker Institute’s Center for Energy Studies. This glut could be exacerbated by future carbon taxes and other policy restrictions on fossil fuels, he said. Krane’s paper is published in the journal Energy Policy.
As recently as 2015, Saudi energy officials dismissed suggestions that the kingdom would seek to raise its crude oil production capacity above its theoretical maximum of 12.5 million barrels per day (m b/d). However, that stance has evolved. Public statements from officials at Saudi Aramco—operating since May 2016 under a new oil minister—indicate that the company expects to increase oil production above recent historic highs. Further ahead, the company is considering investments to increase its capacity beyond the current maximum 12.5 m b/d thresh- old.
Saudi Arabia finds itself in an energy demand quandary. At home, the kingdom needs oil and natural gas for transportation, industrial production and electricity generation. Each of these sources of domestic demand is increasing, propelled by rising populations, growing incomes and subsidized end-user prices that, despite a recent adjustment, remain among the lowest in the world. Internationally, Saudi Arabia also faces conflicting priorities for its crude oil. It finds itself oscillating between cutting crude oil production to prop up prices and maintaining high levels of exports to defend its share of the crude market from competing suppliers. Meanwhile, the kingdom’s national oil company, Saudi Aramco, is in the midst of doubling a crude oil refining business that could see it compile ownership stakes in as much as 10 m b/d of capacity. That amount is roughly equal to all of Saudi Aramco’s current oil production.
As the kingdom endeavors to satisfy these competing demand sources, it increasingly sacrifices one of its most important strategic assets, the spare oil production capacity that it uses to balance markets in times of disrupted supply. Saudi Aramco’s spare capacity has most likely slipped below 2 m b/d in recent years.
An increase in Saudi oil production could also be incentivized by expectations that restrictions on burning of fossil fuel will intensify in the future, as importing states impose policies aimed at mitigating greenhouse gas emissions causing climate change. The Saudi government has announced plans to diversify its economy, thereby reducing its exposure to climate risk, by selling a 5% portion of Saudi Aramco, via an initial public offering (IPO) of ownership shares. Climate risk could also weigh into a decision to raise output. If policymakers believed that threats to monetizing oil reserves will grow stronger in the future, they may opt to increase oil output in the present, a phenomenon described as the “green paradox”. In other words, if the long-term outlook for fossil fuels looks risky, a short-term strategy becomes more attractive. Thus the kingdom’s energy policymakers find themselves revisiting a pressing question: Should Saudi Aramco invest in oil production capacity beyond 12.5 m b/d?—Krane (2017)
Krane suggested that perhaps the biggest risk is that additional Saudi capacity will not be needed and the investment will be unproductive. Overcapacity could also undercut oil prices and encourage a long-term equilibrium of lower prices based on higher market exposure to low Saudi production costs.
Further, in theory, higher oil production also shortens the time horizon to full depletion. BP estimates that at current rates of production, the kingdom’s reported reserves base will last 59 years. An increase in production would push forward that figure, which could reduce oil-funded subsidies for future generations of Saudi citizens.
Krane said an output increase would also affect the ultimate tally of cumulative oil revenue collected by the Saudi government. A glut causing oil prices to drop past the point offset by higher export volumes, would put the kingdom in a worse position, he observed.
Perhaps most worrying, a rise in Saudi crude-oil output could trigger a damaging period of global oversupply, Krane said.
A glut could be exacerbated by future carbon taxes and other policy restrictions on fossil fuels. This could play out in a number of ways. It might deter Saudi competitors from investing in higher-cost resources, pushing more expensive oil out of the market. It could also signal to other producers that the risk of stranded assets is serious enough to warrant accelerated monetization of in-ground resources. A glut of cheap crude oil would undercut conservation initiatives as well as competing technologies and energy sources, including those associated with lower carbon emissions. Thus a decision to raise Saudi production capacity could generate consequences that trigger the green paradox: enhancing the attractiveness of oil, delaying the peaking of crude-oil demand and intensifying damage to the climate.
In the long term, the oil business appears to be moving toward a period of increasing risk. Oil producers understand that the imperative of reducing emissions of climate-warming greenhouse gases endangers the leading position of fossil fuels in the global energy balance. An array of policy obstacles and investment disincentives is creating hurdles for the fossil fuel sector. While a compatible replacement for oil-fueled transportation does not yet exist, the threat of climate change compels individuals and governments to work toward oil substitutes, irrespective of prices. This understanding ought to prompt some holders of large reserves to try to monetize those resources on an accelerated pace, lest they lose value or become stranded. Recent statements and actions within the Saudi oil sector suggest that these threats are being taken seriously. Regardless, the costs and risks inherent in raising production capacity render the outcomes uncertain.—Krane (2017)
Jim Krane (2017) “Beyond 12.5: The implications of an increase in Saudi crude oil production capacity,” Energy Policy, Volume 110, Pages 542-547 doi: 10.1016/j.enpol.2017.08.052