The oil price cycle of the last decade has exposed once more some of the enduring structural economic weaknesses in countries for whom oil and gas revenue constitutes a significant proportion of exports and fiscal revenue. As the most prominent producing region in the world, the impact of the change in oil prices has been particularly acute in the Middle East. Across the Gulf Cooperation Council countries, for example, average net incomes from oil and gas fell by 45% in 2015-18 compared to their highs in 2010-14. Across the region, the public debate on the need to diversify oil and gas dependent economies has once again gathered steam, with several countries, including Saudi Arabia, Kuwait and the United Arab Emirates announcing ambitious reform programmes aimed in large part at reducing their dependence on hydrocarbons revenue. Recognition of the need for economic diversification is not new; it was identified as a strategic necessity in development plans across the region as early as 1970. But success in achieving this objective has been limited, partly because the urgency with which reform was pursued has tended to follow the oil price cycle, diminishing when prices rose.
Future uncertainty in the energy markets
Future uncertainty in the energy markets means that, now more than ever, this pattern needs to be broken. On the supply side, the shale revolution in the United States has changed the calculus across energy markets. By 2025, projections in the IEA’s (2018) World Energy Outlook suggest, the US could account for one in every five barrels of oil produced globally and one-quarter of the world’s natural gas production, and the nature of the short-cycle investments associated with this production increases the potential of price volatility in the short and medium term, which could impact budgets in oil dependent economies. On the demand side, improved efficiency and the move towards electrification of cars are making a dent in oil demand in the transportation sector, which currently accounts for over half of all oil consumption. Increasing public perception of the challenges of climate change and the growing policy push towards energy transitions add to the uncertainty around future oil demand, providing further incentive for producer economies to enact changes now that will increase their resilience in the future.
In the International Energy Agency’s recently-released Outlook for Producer Economies, we assessed what the impact of a lower oil price environment would be on producer economies. We found that if oil prices trend lower because of increased supply, decreased demand, or a mixture of the two, the impact on producer economies will be stark: across the Middle East, per capita income would be 50 per cent lower by 2040 than in a scenario where demand keeps growing and prices remain robust. The cumulative lost income from oil and gas to 2040 would reach $6.5 trillion (equivalent to almost three years of the region’s current total gross national product).
The reform agenda for producer economies is, of course, much wider than energy, encompassing a range of issues including the need to improve the general business environment and the conditions for private-sector growth, and the introduction of prudent counter-cyclical fiscal policies that smooth price and revenue fluctuations. But one question we wanted to answer in the Outlook for Producer Economies is: how can the energy sector adapt to ensure that it acts as a platform for development, rather than a crutch for an unbalanced economy? Some of the most promising options are described below.
Capturing more value from hydrocarbons
Across the Middle East, producers have already made significant efforts to move downstream in an effort to capture additional value from hydrocarbons resources. The Middle East currently accounts for around 10% of global refinery runs, and that share is set to increase as several large-scale projects, such as the Jubail, Yanbu and the Jizan complex in Saudi Arabia, are already under construction across the region. Countries are not limiting this increase in capacity to their home territories, and several are pursuing growing markets, notably in Asia. Saudi Aramco recently reached agreements to invest in refineries in China, India, Indonesia, Malaysia and the United States, while the Kuwait Petroleum Corporation is looking at investments in India’s Bina Refinery.
There are several motivations behind this downstream drive, including a wish to extract more value from the oil the region produces, and to secure outlets for crude exports. The expansion increases revenues for each barrel produced, and thereby also risks increasing dependency on oil revenue. However, downstream earnings typically move in a different direction from upstream earnings – they tend to be higher when crude oil prices are low, and vice versa – so they also provides a hedge against lower oil prices.
Producers across the Middle East are also pursuing large investments in petrochemicals complexes. Beyond the attraction of potentially higher and more resilient margins, the likelihood of a robust outlook for petrochemicals products in all scenarios means that these offer a degree of hedging against the possibility of a contraction of oil demand as a result of a rapid uptake of electric vehicles or higher levels of efficiency improvements in a transitioning energy world. Indeed, even though there is growing attention on reducing single-use plastics and increasing plastic recycling, especially in advanced economies, the impact of these trends is more than offset by surging demand in developing economies and the increasing use of plastics in place of other materials such as wood and metal.
Middle East chemicals production is expected to double between today and 2040 – allowing the region’s share in global chemicals production to increase by four percentage points, reaching 17% by 2040 on the back of feedstock cost advantage and the high level of efficiency of newly built facilities. A corollary of this increase in downstream activity is that, out of a 6.5 mb/d incremental increase in oil supply to 2040 from the region, only 800 kb/d is exported as crude (with additional 2.1 mb/d passing through refineries and 3.6 mb/d being used in petrochemicals production).
Using natural gas strategically in support of diversification
In several prominent oil producers, natural gas has been considered a sometimes-convenient byproduct of oil extraction, and the unique opportunities it could offer in sustaining an industrial base have often been overlooked. There is a pressing case for a fundamental rethinking of the strategic importance of natural gas, including where it is likely to bring the best value within the energy system, especially in countries where there are strains on the gas balance. For example, there is a strong economic case across the Middle East for faster deployment of solar photovoltaic (PV) technology to displace gas as well as oil in power generation, which would increase the availability of gas for use in value-added industries. On the supply side, to fully harness the potential of gas, some countries will need to reassess their pricing policies to incentivize upstream activity, and review the priority sectors for gas consumption. Some progress has been made recently, with Saudi Arabia and the United Arab Emirates both taking steps to increase local gas prices, but these remain significantly below the cost of imported liquefied natural gas.
Tapping the potential of renewables
The anticipated growth in demand for electricity in a number of producer economies raises questions about the economic viability of the current mode of electricity supply. Across the Middle East, for example, a 5.7% per year increase in electricity demand has translated to a doubling in the region’s oil consumption for power generation over the last 20 years, reaching around 1.8 mb/d in 2017. This diverts oil away from exports towards inefficient domestic consumption and incurs a significant opportunity cost – especially significant in periods when global spare production capacity look thin.
At present, peaking capacity in many parts of the Middle East is provided by oil-fired plants, often burning crude oil directly or using heavy fuel oil. In Saudi Arabia, for example, the daily load curve in summer reaches almost twice its peak in winter months because of air conditioning use. This means that 20-25 gigawatts out of a total of 88 gigawatts of capacity are used only for around half the year. These are mostly oil-fired plants, and they increase daily liquids burn by as much as 500 kb/d in peak summer periods relative to winter months. In the future, without a significant improvement in efficiency over time, and considering the large anticipated increase in the use of air conditioners across the Middle East (demand for space cooling alone could skyrocket from 135 terawatt-hours (TWh) today to over 300 TWh in 2040), the peak will grow significantly, giving a measure of the imperative for a more efficient electricity system going forward.
Solar resources are abundant and are ideally suited to meeting this peak (daily demand for cooling peaks in the early afternoon, matching the normal peak in solar PV output). At present, this potential is almost entirely untapped, with the 1.2 GW of solar capacity making up less than 0.5% of total generation capacity in the Middle East (compared to over 90 GW of oil-fired capacity). But fast-falling costs for solar PV mean that, even if oil were priced for generation at $40/barrel, unsubsidised solar would be displacing it quickly on a cost competitive basis.
Although the economic case for renewable power is compelling, reaching deployment levels that reflect this will depend on removing barriers to their uptake. However, at current levels of deployment, concerns about the impact of variable renewables on grid stability in the Middle East are limited, although care will be needed to ensure that network planning matches plans for new utility-scale renewable projects. Most GCC countries in particular have generation fleets that are flexible enough already to enable a much higher penetration of renewables, and the rise in electricity demand for desalination could provide a further synergy for renewables, providing the option of being used as a demand response facility, helping to ensure an outlet during periods of excess electricity production.
Phasing out subsidized use of energy to improve its efficiency
According to estimates by the IEA, fossil-fuel consumption subsidies totalled around $105 billion across the Middle East in 2017. Artificially cheap energy encourages wasteful consumption. Primary energy demand in the Middle East has grown at 4.4 per cent per year since 2000, a rate that is more than double the world average. Among other things, this has meant that two in every five new barrels of oil production have been consumed domestically during this time. Economies across the region are now among the most energy-intensive in the world—the United Arab Emirates, the least intensive in the region, requires 10 per cent more energy to generate a dollar of economic output than the world average.
Beyond the fiscal burden and the impact on consumption, subsidies also distort broader investment incentives across the energy sector. Low natural gas prices, for example, have reduced the incentive for private companies to invest in new exploration and production projects in parts of the Middle East.
Besides accommodating the fact that low-cost energy is deeply embedded in the social contract in many producer economies, successful reform must also reconcile the need to reform prices with the imperative of sustaining or even enhancing industrial competitiveness. Across the Middle East, even without subsidies, most oil and gas producers would still have a comparative advantage in energy, since a low production cost base can provide a stable low domestic price. The implications of pricing reform for energy consumers can be mitigated substantially if reform is paired with enhanced energy efficiency measures. Raising fuel and electricity prices reduces the payback period for products with higher efficiency, and helps raise public awareness of the links between efficiency and the cost of the energy they consume; but a push is typically required on the supply side to ensure that more efficient products are available on the market.
Ensuring adequate investment for a dynamic upstream sector
The ability to maintain oil and gas revenues at reasonable levels provides an important element of stability for the economy as a whole, especially when market conditions are tough. In this regard, though it may sound counter-intuitive in the narrative on economic diversification, it remains crucial for producers to attract investment and maintain or improve the productivity of their upstream sectors. Occupying the bottom end of the oil supply cost curve, Middle East producers could remain integral producers even in a Paris-compliant energy landscape where oil demand peaks imminently and falls to around 70 million b/d by 2040. Some GCC producers, led by Saudi Arabia and the United Arab Emirates, have already also shown that through intensified efforts to eliminate gas flaring and methane leakage, they are also extremely competitive on the basis of greenhouse gas emissions intensity, a factor that could differentiate suppliers of oil in the future.
Supporting the development of cleaner and more efficient energy technologies
The Gulf Cooperation Council’s producers have world-leading expertise in energy technologies; in addition to their potential in renewables, they are also well positioned to develop new approaches that reduce or minimize the lifecycle emissions of oil and gas. The argument becomes particularly compelling when synergies are found between industries. This is already happening to some extent, for example, in the United Arab Emirates, where over 40 million standard cubic feet per day of carbon dioxide are being captured at the Al Reyadah steel plant and piped to be used in enhanced oil recovery. This has the added benefit of freeing up much-needed natural gas that would otherwise be used for the same purpose. Oman is pioneering the use of large concentrating solar projects for enhanced oil recovery. There are large-scale opportunities to use solar energy to meet the Middle East’s increasing demand for clean water through desalination. This is a particularly crucial area, with the production of desalinated seawater in the region projected to increase almost 14-fold by 2040. The shift from thermal processes towards electricity-fed reverse osmosis has the dual benefits of reducing hydrocarbons combustion for water while also providing an outlet for excess renewable power at certain times in the day (thereby reducing the problem of curtailment). It should not be assumed that the comparative advantage in energy of today’s major producers will diminish in the energy transition.
Although the risks are not evenly distributed across producers, demographic pressures and uncertainties on both the supply and demand sides mean that the imperative is growing for countries that rely on oil and gas revenues to reorient their economies. The transformation process will no doubt be complex and challenging, but the way it unfolds will have profound implications for the producer economies themselves, and the global energy system and energy security more broadly. This is because the prospects for stability in oil markets are increasingly linked with those for the reform agenda in producer economies. Venezuela provided a cautionary example of how developments in one producer economy can have serious implications for global balances. Price cycles are likely to continue to be a feature of commodity markets, and may even become more frequent given the increased prominence of short-cycle shale investments in the global supply picture. Periods of higher prices can provide relief but also bring with them a considerable risk, particularly if they ease the pressures for change at the same time as they increase the incentives for large consumers to accelerate the policy momentum behind alternatives to oil and gas. This risk means that successful transformation of producer economies, underpinned by a strong energy sector, is of fundamental importance to actors well beyond those countries themselves.
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