To Drill or Not to Drill

Current trends in the global energy market don’t look good for Saudi Arabia. First, the International Energy Agency projected in November 2012 that the United States will surpass the Gulf petrogiant as the world’s top energy producer by 2020. Then, last week, it revealed that North America, buoyed by the rapid development of its unconventional oil industry, is set to dominate global oil production over the next five years. These unforeseen developments not only represent a blow to Saudi Arabia’s prestige but also a potential threat to the country’s long term economic well-being — particularly in the post-Arab Spring era of elevated per-capita government spending.

But if the kingdom’s outlook is decidedly bleak, its official response has been muddled. Within a period of just five days last month, two senior Saudi Arabian officials laid out starkly different versions of their country’s oil production plan. In an April 25 speech at Harvard University, Prince Turki al-Faisal, a former head of Saudi Arabia’s top intelligence agency and the current chairman of the King Faisal Center for Research and Islamic Studies, announced that the kingdom is set to increase its total production capacity from 12.5 million barrels per day (mbd) today to 15 mbd by 2020, an amount that would easily make it the world’s top oil producer once again. But five days later, in a speech at the Center for Strategic and International Studies in Washington, DC, Saudi Arabian Minister of Petroleum and Mineral Resources Ali al-Naimi conveyed an entirely different message, rejecting Turki’s statement out of hand. "We don’t see anything like that, even by 2030 or 2040," he said. "We really don’t need to even think about 15 million."

So what are we to make of this 2.5 mbd discrepancy? Considering the world’s dependency on petroleum and the projected growth in global demand for oil, it’s certainly not chump change. In fact, 2.5 mbd is roughly equivalent to the entire production capacity of major oil producers like Mexico, Kuwait, Iraq, Venezuela, and Nigeria. Whether or not Saudi Arabia plans to ramp up its production, in other words, is relevant to virtually every household on the planet.

One might be tempted to dismiss Turki’s grandiose projection on grounds of technical ignorance and defer to the man who is actually in charge of the country’s oil industry. That is certainly one way to read the official inconsistency. But in Saudi Arabia, how much oil to produce is first and foremost a political decision. Unlike Naimi, a petroleum engineer who climbed up the ladder of Saudi Aramco, Turki is a member of the royal House of Saud, and when it comes to politics, his views are not less important. The dispute between the two boils down to a major strategic decision Saudi Arabia will have to make in the coming years: whether to drill more or to drill less.

With no revenues from personal income tax and 40 percent of its 28 million citizens under the age of 15 — not to mention a male population that is mostly employed in the bloated public sector — Saudi Arabia is heavily dependent on oil revenues to provide cradle-to-grave social services to its people. And the financial liability has only gotten heavier since the Arab Spring forced the regime to fight public discontent with ever more gifts and subsidies. To make things worse, Saudi Arabia is the world’s sixth — sixth! — largest oil-consuming country, guzzling more crude than major industrialized countries such as Germany, South Korea, and Canada. With so much of its oil consumed at home, the kingdom has only 7 mbd to export — even as government expenditures are on the rise.

All this is to say that in order for Saudi Arabia to guarantee its economic viability, it must ensure that the breakeven price of oil — the price per barrel it needs to balance its budget — matches the country’s fiscal needs. This breakeven price — the "reasonable price" or, as the Saudi Arabian euphemism has it, the "fair price" — has risen sharply in recent years. "In 1997, I thought 20 dollars was reasonable. In 2006, I thought 27 dollars was reasonable," Naimi explained in March. "Now, it is around $100 … and I say again ‘it is reasonable.’"

According to the Arab Petroleum Investments Corporation, the breakeven price is currently $94 per barrel, less than the current spot price for Brent crude. (Iran needs oil to be at $125 per barrel to break even, which explains the feud between Iran and Saudi Arabia within OPEC.) But absent deep political reforms that create new sources of income, the breakeven price will surely grow. According to Riyadh-based Jadwa Investment, one of the world’s most important knowledge bases on Saudi Arabia’s economy, by 2020 the breakeven price will reach $118 per barrel. At this point, the Saudi Arabia Monetary Agency’s cash reserves will begin to drain rapidly and the breakeven price will soar to $175 a barrel by 2025 and to over $300 by 2030. And this cuts to the heart of the dilemma: In order to balance its budget in the future, Saudi Arabia will need to either drill more barrels and sell them for lower prices or drill fewer barrels — actively reducing global supply — and sell each at a higher price.

This is the crux of the Turki-Naimi debate. Both officials understand the centrality of oil revenues to the survival of the House of Saud, but they differ on how best to come up with the money. Turki believes that Saudi Arabia should grow its production capacity in sync with the growth of the global economy. But Naimi, the person who will actually be charged with meeting this goal, prefers to keep capacity as it is and, if needed, even let it slide. If history is our guide, Naimi’s way will prevail. Since 1980, as the world economy grew by leaps and bounds, oil prices more than quadrupled in real terms. Yet Saudi Arabia, which sits atop of one fifth of the world’s economically recoverable reserves, has barely increased its production capacity.

Another potential explanation for Naimi’s reluctance to grow capacity is that he knows what Sadad al-Husseini, the former head of exploration at Saudi Aramco, allegedly told the U.S. consul general in Riyadh in 2007. According to a leaked cable published by WikiLeaks, Husseini said that Saudi Arabia may have overstated its oil reserves by as much as 40 percent, meaning that production at current levels is unsustainable.

If Husseini’s claim is true, it means there is only one way for the kingdom to make ends meet: Keep prices high by stalling the development of new capacity while adjusting the production of oil downward to offset any growth in supply emanating from the American oil boom. It also means, contrary to popular belief, that the current rise in U.S. domestic production will have minimal impact on global crude prices, and hence on the price we pay for gasoline at the pump. Oil is a fungible commodity and its prices are determined in the global market. If the United States drills more, Saudi Arabia will simply drill less, keeping the supply/demand relationship tight and prices high.

The Turki-Naimi dispute is not an academic one but one with potentially serious implications for the future of the world economy. Whether or not Saudi Arabia likes it — and it almost certainly does not — the global energy market is about to get more competitive

. In a competitive market, oil should be supplied by all producers roughly in accordance with their geological reserves and marg

inal costs. There is something profoundly wrong when the United States, which sits atop barely two percent of global conventional oil reserves, produces more barrels per day than Saudi Arabia, a country with reserves ten times bigger.

Saudi Arabia presents itself as a responsible producer sensitive to the needs of consuming countries. These needs are surely growing. It would only be appropriate for the kingdom to grow its capacity in kind by making additional investments. Should Saudi Arabia decide not to do so, the United States should use its vast reserves of cheap natural gas as a trump card. Once cars and trucks sold in the United States are capable of running on fuels made from natural gas and its products — whether compressed natural gas itself, liquid fuels such as methanol, or natural-gas derived electricity — the price of transportation fuel will be determined by free and diversified commodity markets, not decisions made in Riyadh.

A system in which oil consumers are forced to pay a rising "reasonable price" per barrel in order to fund Saudi Arabia’s ever-growing fiscal obligations is unsustainable, especially in a time when most cash-strapped countries are looking for ways to reduce their own fiscal obligations. As the world moves gradually toward more reasonably priced methods of powering vehicles, the kingdom would do well to drill into the brains of its people — and that includes women — as vigorously as it drills into the ground.