Expert: Crude-oil production increase a risky strategy for Saudi Arabia

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.

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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 outlined his insights in “Beyond 12.5: The Implications of an Increase in Saudi Crude-Oil Production Capacity,” which was published in the journal Energy Policy. The article discusses rationales and pressures for raising Saudi Arabia’s oil production capacity, namely growing domestic demand for oil, a spate of investments in refineries inside and outside the kingdom and the threat of peak global oil demand. It also analyzes signs that point to an increase and the potential risks and outcomes.

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, Krane said. 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, he said. Further ahead, the company is considering investments to increase its capacity beyond the current maximum 12.5 million threshold.

Reasons for an increase include:

• An increase in oil demand inside the kingdom as well as globally since late 2014.
• The perception that non-OPEC producers have recently deferred so much capital investment that if oil markets tighten in the future, it could trigger a damaging price shock.
• Saudi Arabia’s spare oil production capacity has eroded, in particular due to recent downstream investments that, combined with other demand sources, could challenge the kingdom’s capability to continue as a dominant global supplier of raw crude oil.
• Longer term, future demand could be undermined by climate-driven disincentives to oil and the emergence of substitute fuels and technologies. Worries about premature peaking of global oil demand could incentivize stepped-up production and shorter-term depletion strategies.

“Perhaps the biggest (risk) is that additional Saudi capacity will not be needed and the investment will be unproductive,” Krane wrote. “Overcapacity could also undercut oil prices and perhaps encourage a long-term equilibrium of lower prices based on higher market exposure to low Saudi production costs. 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. “If a glut caused oil prices to drop past the point offset by higher export volumes, the kingdom would be worse off,” he wrote. “In short, policymakers must weigh whether the risk of a loss in revenue is outweighed by the risk of stranded assets. Post-initial public offering (by Saudi Aramco), future shareholders may also balk at a huge capital investment program, particularly if the outlays interfered with short-term returns or dividend payments.”

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,” he wrote. “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,” Krane said. “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.”