The Fuse

Report: Low Oil Prices Forcing Saudi Arabia to Shift from “Rentier” State to Modern Economy

by Leslie Hayward | March 24, 2016

Much has been written about how Saudi Arabia’s decision to preserve market share is impacting global oil markets and producers around the world. But the internal fallout from this decision on the Kingdom’s own politics and economy has been explored in less depth. A report released today by the Atlantic Council’s Jean-Francois Seznec finds that across the board, Saudi Arabia is moving away from its longstanding structure as a “rentier” state, into a more modern economy. Low oil prices are a critical cause of this shift. “The state’s dependence on crude oil is now severely constrained. Change to a more modern form of fiscal funding through taxes, and transparency in state revenues, is needed to continue managing the country’s finances,” writes Seznec. “Admittedly, complete changes will not come overnight.”

“The country is moving away from being the epitome of a rentier state to resembling more closely the economies of the more developed nations of the G20, of which Saudi Arabia is a member.”

The principal changes taking place are the reform of domestic fuel subsidies, the cleaving of Saudi Aramco away from the Ministry of Petroleum and Minerals, changes in management of the country’s downstream sector to create domestic manufacturing jobs, the introduction of a value added tax (VAT), and the potential privatization of some Saudi Aramco assets. In sum, the country is shifting towards seeing its energy assets “as less of a right and more of a resource that must be reasonably managed,” writes Seznec.

There are two potential outcomes to the country’s dramatic decline in oil revenues. On one hand, now provides a tremendous opportunity for the country to evolve in ways that will provide for a more efficient government and reform the system in which certain elites “effortlessly benefit from oil revenues.” Saudi Arabia is already more than an oil juggernaut. It is also industrializing and becoming a major producer of chemicals, fertilizer, aluminum, cement, and other energy intensive products—low oil prices create an opportunity to further the Kingdom’s broader industrialization.

On the other hand, low oil prices create risks that could destabilize the country. Saudi Arabia could deplete its cash reserves in as few as five years, and the official deficit for 2015 was $98 billion—a figure that doesn’t include all of the military expenditures undertaken during the ongoing wars in Yemen and Syria. Including those wars, there is the possibility that the total deficit is about $120 billion. Accordingly, “The state has to find alternative sources of income, reduce expenses through subsidy cuts and tax increases, and impose curbs on the royal family’s ability to access what should be state funds earned from oil.” According to Seznec, “Theses changes potentially carry heavy social risks, which could lead to instability. When the pressures from large swaths of unemployed youth and from groups within and especially outside the Kingdom who are seeking to overthrow the present Saudi system are added to the mix, the world could end up facing a volatile situation in a land that provides 10 percent of the world’s crude oil.”

In a conversation about his research with The Fuse, Seznec clarified that a “lower for longer” price scenario does not necessarily increase the odds of instability. “Not in the next 5 years. The Saudis have enough cash on hand, and barring a major catastrophe of some sort (which could happen) I think the Saudis will survive. They can manage their economy and they can keep people satisfied, even at a deficit of $100 billion per year.”

That said, pressure on the Saudi budget will remain high and reforms are likely to continue, because of the responsiveness of U.S. shale supply to higher prices.

Cooperating with Russia

The report also emphasizes that Russia is among the most vulnerable of the other major oil producers to the low price environment. Russia’s cash reserves are roughly $320 billion, while Saudi Arabia’s are almost double, at some $616 billion, with the ability to raise another $250 billion from internal institutions.

This increases the likelihood of a joint Russia-Saudi cut of approximately 1 million barrels per day to shore up prices, according to the report. Seznec tells The Fuse that domestic support for the current talks of a production freeze between various OPEC member states, Russia, and a few other oil producers is “strong” in the Kingdom.

“There is support because it means that the Saudis will not be producing more than 10.2 or 10.3 million barrels per day, and they have the capacity to go up to 12,” says Seznec. “So it’s not going to change anything for them, except that they will make more money: They make $3.8 billion for each dollar that oil prices increase. The worst-case scenario is that oil prices go up slowly—but they will go up.”

Downstream Aramco IPO likely within a year

“What they’re trying to do with the privatization of Saudi Aramco is that the royal family is dependent on the state, rather than the state being dependent on the royal family.”

Saudi Aramco is generally regarded as the region’s most reliable oil supplier and the world’s best managed national oil company. Observers are aware that the company operates in a fiscally conservative manner, with personnel policy based on merit, and the company is very transparent on information regarding production, refinery runs, and product shipments, etc. However, it is less transparent on fiscal issues, even though Seznec argues that the company’s finances would compare favorably to most large international oil companies. However, “the most likely explanation for Saudi Aramco’s lack of financial transparency is that it wants to hide how much money is siphoned off to the royal family.” Right now, in a time of low oil prices while citizens are being asked to make sacrifices on highly subsidized gasoline, gas, water, and electricity, most Saudi citizens would likely find it unfair if the royal family continues to have unchecked access to oil revenues. “Thus, the privatization of Saudi Aramco would change the relationship of the royal family with the rest of society,” says the report, revealing whether the family is making sacrifices alongside the rest of the country.

“What they’re trying to do with the privatization of Saudi Aramco is that the royal family is dependent on the state, rather than the state being dependent on the royal family,” Seznec tells The Fuse.

Privatization of Saudi Aramco assets could take a number of forms, but among the most likely is the possibility that some of the company’s downstream assets would be separated and minority stakes would be made available to investors. There is little disagreement that controlling interest will remain in the hands of the state. According to Matthew M. Reed, Vice President of Foreign Reports, “It’s a safe bet that the government will remain the number one shareholder for these companies even if they go public.”

In such an outcome, Seznec writes, Saudi Aramco “would still be large, and it would not be any more transparent than it is now. The true change would come when the core company starts issuing share and sells a percentage to the public.” Of critical importance is the fact that Saudi Aramco itself does not own the actual crude oil reserves—they belong to the state. Aramco manages long-term leases to extract and sell the crude that is owned by the Kingdom.

“The Saudis can afford to take their time and do it right,” says Reed. “A limited IPO makes more sense because Aramco is so big and the company is so essential to the economy and the state. Valuing it would be tricky. Going public with downstream would raise billions of dollars by itself, while preserving the government’s sole ownership of oil assets.”

The odds of an IPO for downstream or even upstream assets in the near term is “very strong,” Seznec tells The Fuse. “I don’t know who will organize it, but I think the downstream IPO could come quickly—within a year.”