How Important is Saudi Oil?

by Sarah Yizraeli

Twice, in 1979-81 and in 1985-86, Saudi Arabia was the oil-producing country that pursued an active, even aggressive, policy designed to shape the global oil market. In the first round, oil prices went up three-fold, though not further, thanks to Saudi efforts. In the second instance, to recapture lost market share, Riyadh instigated a price war that resulted in a severe drop in prices. Saudi Arabia could fill this role because of its unrivaled position in the world oil market, one that resulted from a combination of factors: huge production capabilities, a moderate pricing policy, the size of its reserves, and its relations with the West. Could there be a third time? In other words, could Saudi Arabia again shape the oil market in a way that would have a pronounced effect on the world economy, or does that belong to the ever-more distant past?

The reply is determined primarily by two factors: the role of oil in the world economy and the role of Saudi Arabia in the oil market. It is the Saudi misfortune that both are declining. In the next decade it appears that the unique role of Saudi oil will be confined to maintaining a surplus that covers possible temporary shortages. Important as this is, from a Western point of view, it means that concerns about Saudi security will be less acute.

I. Oil in the World Economy

After the oil crises of 1973-74 and 1979-80, consumers were intent not to undergo a third time of troubles. This led to two major developments, both of which implied a significant drop in oil consumption: finding ways to conserve energy and developing a range of alternate energy sources (such as coal, natural gas, and nuclear power).

Until the energy crisis of the 1970s, world oil consumption had risen at a brisk pace. Indeed, demand continued to rise for several years after the initial 1973-74 price rise, as economies took time to adjust. In 1970, the world's crude oil production amounted to 47 million barrels per day1 (b/d); it grew quickly to 60 million b/d in 1980,2 despite a weak world economy. Over the next two decades oil demand growth slowed sharply, such that in 1998 world demand for oil reached approximately 72 million b/d.3 (See table 1, page XX.) In other words, oil use rose more during the stagnant economy of the 1970s (13 million b/d) than during the vibrant growth of 1980-1998 (12 million b/d).

Furthermore, whereas most of the demand growth through the 1970s came from the Western industrial countries (North America, Western Europe, and Japan), oil demand in those countries barely rose after 1980; note that oil demand in the former Soviet Union fell 4 million b/d in 1980-98, The vast majority of the demand growth – 9 million b/d – came from Asia outside of Japan. Due to more efficient technologies and the growth of industries that use little oil (like computers), Western industrial economies are no longer sucking up more oil as they grow. The shift to non-oil energy sources has been especially consequential in the slow growth of oil demand. Oil accounted for 49 percent of the West's total consumption of primary energy in 1972 but just around 40 percent in 1990. These trends are expected to continue over the next two decades. According to the U.S. Department of Energy, oil will constitute 38 percent of total energy consumption in 2000 and 37 percent in 2020. The most rapidly growing source of energy is expected to be natural gas, which will increase its share from 23 percent of the primary energy consumed in 1990 to 27 percent by 2020.4

The pace of substitution with alternative energy sources may accelerate in coming years, especially if non-oil fuels become more widely used for transportation - a sector which today relies almost exclusively on oil. New technologies for converting natural gas to liquid gasoline, or methane to synthetic crude, are already under development.5 These technologies might diminish OECD use of oil for transportation from the approximate average of 7 million b/d during the 1970s and 1980s to 5.5-6.5 million b/d by 2010.6 To be sure, economic development and increased urbanization in other parts of the globe may mitigate this trend, balancing out most of the projected decline in oil-fueled transportation.

However, a note of caution about oil projections is in order. Forecasts of oil demand and of prices tend to be based on a linear extrapolations of current trends. Assessments invariably reflect the situation when they are made more than the date they intended to describe. Zaki al-Yamani, the long-time Saudi petroleum minister (1962-86), once captured this deficiency as follows: "When there's a surplus in the market, you tend to see the future in that light. When there's a shortage, it's difficult to talk about a surplus in the future without facing a barrage of disbelief."7 Interest groups such as some Western politicians, industrialists and some oil companies that had a stake in developing oil fields in the western hemisphere, skillfully manipulated this impulse in the wake of oil crises in 1973-74 and 1979-80 to spread fears of another oil crisis.

That said, the best guess at the moment is that the decline in oil's share of world energy use and the discovery of new oil fields around the world reduces the ability of oil producers such as Saudi Arabia to affect oil prices. Consumers can shift from oil to other energy sources or they can switch to deliveries from other oil fields. Oil's declining share, combined with energy's declining importance in the world economy, diminishes the economic impact that oil producers have on the economy.

II. Saudi Arabia in the Oil Market

Increasing non-Saudi oil supplies. The Persian Gulf's share of world oil production has gone down and up dramatically over the past two decades. Production in 1976 came to 37 percent of the world total and by 1985 was estimated at just 17 percent of world output. This trend then reversed itself, though not to the point of returning to the mid-1970 levels; in 1996 the Persian Gulf produced 27 percent of world oil. Saudi Arabia's standing in the oil market has been even more volatile, going from 15 percent of world output in 1976, to 16 percent in 1980, 6 percent in 1985, and 13 percent in 1996.8 The relative decrease in Western consumption had a particularly negative impact on Persian Gulf oil exporters. OECD countries imported 27 million b/d in 1973 but only 21 million b/d in 1997, of which about one-third imported from the Persian Gulf. 9

The Saudi share of the world oil market is under challenge from several sources, and especially from the Latin American and West African producers, from the untapped oil fields in Iraq, and from the reservoir of the Caspian Sea. While none of these new oil-producing areas alone can match Saudi reserves and production, together they will undoubtedly erode Saudi competitive advantage during the next decade. Longer term, they – and especially Iraq – might emerge as competing hubs to Saudi Arabia. In 1976, Latin America, Western Europe, and Asia combined produced a mere 16 percent of global oil; in 1996, they produced 33 percent of world oil. Conversely, as noted above, the same twenty-year period saw the Persian Gulf production decline from 37 percent to 27 percent in 1996.10 The new crude sources also has a major impact on global trade patterns; Europe and North America increasingly relied on the North Sea and the Americas while Asian countries increase their dependency on the Gulf's oil.

Efforts to reduce dependency on Gulf oil will persist at least over the next decade as investments in energy flow to develop new oil fields and to alternative energy sources. The volume of investment will depend on economic feasibility, which is ultimately contingent on crude price levels. Should prices fall below $10 per barrel (the current international average price of finding and developing a new barrel of oil), investments will subside, helping Gulf oil. If prices rise above $10 per barrel, the profitability of investing in new sources is assured.

Caspian oil. Caspian Sea reserves deserve special note. Once estimated to be in the range of 100 to 200 billion barrels,11 these numbers have dropped dramatically, with the usual figure from optimists being now 30-60 billion barrels; pessimists speak of only 20-30 billion. (By way of contrast, Saudi Arabia's proven reserves are 265 billion barrels, and unproven reserves are many billions more.) Recent estimates of Caspian production are also far more modest than earlier ones. In 1998, Alexander Blokhin, the Russian ambassador to Azerbaijan, estimated that in the year 2015 the Caspian Sea repository will generate between 2 million b/d and 4 million b/d, or 3.5 percent to 7 percent of world production (as compared with a production capacity of 36 percent in the Persian Gulf). Other estimates expect 2 million b/d in 2005 and 4 million in 2010.12

Even these numbers are a matter of conjecture, for the logistical challenges to get Caspian oil to market are so high. Pipelines to transport it already exist in Iran and Russia but the U.S. government wishes to avoid both of those countries so that their governments do not get a stranglehold on the Caspian oil, preferring instead to lay new pipelines through Azerbaijan, Georgia, and Turkey (to the west) or a second network through Afghanistan (to the east). China signed an agreement with Kazakstan in 1997 for the construction of a 2,000-mile pipeline linking Kazakstan with western China. Western specialists are dubious about the economic feasibility of such a pipeline, but China seeks to ensure a long-term oil supply, and Kazakhstan wants to reduce its dependence on Russia to convey oil.

More broadly, Washington views the Caspian Sea independent of the Persian Gulf, just as do some other Western governments, and to a lesser extent, the Saudis, and other pro-Western Gulf producers. This thinking conforms to a desire to prevent the creation of an oil producers' bloc (based on the geographical proximity between the Gulf and the Caspian regions) that might play as a pressure group controlled by unfriendly states such as Iran. In contrast and for the same reasons as well as economic considerations, Iranian thinking, echoed in some Western and Asian circles, views the Caspian repository as the northern part of the Gulf reservoir. From a logistic standpoint, the rationale behind this thinking is the desire to channel the flow of Caspian oil through existing Iranian pipelines, hence reducing its cost.

Technology. Technology also diminishes Saudi centrality. New technologies facilitate oil detection and drilling, reduce production costs, and so erode the price advantage previously held by the Organization of Petroleum Exporting Countries (OPEC) and Persian Gulf producers in general, Saudi Arabia in particular.13 These technologies also enable the exploitation of areas formerly off-limits for reasons of remoteness and economic unfeasibility.

Special political relationships. Saudi Arabia's position market may be jeopardized if the industrialized countries revert to their pre-1960 policy (before OPEC was established and before nationalization started) of ensuring sources of oil through special political relationships with select producing countries. France, Russia, China, and Japan might invest in the development of new fields in Iraq or Iran to ensure future supplies. That American companies are banned from investing in these two countries gives their foreign competition an advantage in exploiting ground-floor opportunities. Should this come to pass, the French or other companies will be less dependent on Saudi oil.

The same goes for the United States. According to early 1997 projections of the U.S. government14, by the year 2010, the combined production of the Americas will increase by approximately 5 million b/d, to the point that the Americas as a whole will produce 26 million b/d. With consumption projected at 35 million b/d, the Americas will produce three-fourths of their oil needs in 2010. That last quarter will be covered in part by imports from West Africa and the Persian Gulf, especially Saudi Arabia, the UAE, and Kuwait. The United States may well attempt to secure its future energy primarily from Latin America or central and west Africa (which it recently declared to be strategic oil regions),15 and this could reduce U.S. reliance on Saudi Arabia.

U.S. oil imports from Saudi Arabia peaked in 1991, reaching levels of 1.7 million b/d (an exceptional amount, covering the temporary disappearance of both Kuwaiti and Iraqi oil from the market); the annual imports of Saudi oil by the United States during the past two decades, averaged 1.2 million b/d. Already in 1996, Saudi Arabia lost its top ranking as a U.S. supplier to the combination of Venezuela, Canada, and Mexico. In May 1998, the U.S. imports from Saudi Arabia dropped to 1.17 million b/d while imports from Venezuela, Mexico and Canada exceeded 1.32 million b/d each. The decline in U.S. imports from Saudi Arabia can be attributed in part to a round of cuts on the part of oil producers, spearheaded by the Saudis, to push up prices.16 According to U.S. forecasts, this situation will persist until the period 2005-10. After this time, increasing U.S. oil demand will confront only modestly increasing supply from the Americas. Until then and given the strategic importance of its relationship with the United States, Riyadh will no doubt try hard to retain its American market share.

The needs of the global and American market after 2010 will be an important factor permitting Saudi Arabia roughly to double its production between 2000 and 2020.17 Most of the projected demand will come from the Asian market. This means that Saudi Arabia, as well as other Gulf producers, will ship the major part of its oil to this market. This shift in trade patterns will have a significant impact on Saudi Arabia, which for two decades has served as the linchpin supplier of oil to the United States.

Saudi Arabia as Stabilizer

The impact of changes in the energy market and in global consumption patterns have taken their toll on Saudi Arabia's position. The country has already lost some of its market share to new oil producers and, unless a strategic shift in oil policy occurs, this trend will probably be exacerbated during the next decade.

Still, Saudi oil policy has been consistently oriented towards providing Western oil requirements at more economic prices and easing apprehensions of oil shortages. Despite dramatic changes in the oil market, Riyadh remains committed to preventing shortages in the global oil market by maintaining spare production capacity (to help cope with unexpected shortages of oil supplies). In 1983, Saudi Arabia had surplus capacity estimated at 6 million b/d, 10 percent of world demand, which was about half of the global total surplus. To be sure, Saudi surplus capacity has declined since then, but it remains substantial. In 1997, Saudi Arabia's spare capacity was estimated at only 3 percent of the world oil demand, but it provided two-thirds of the total world surplus.

Maintaining so much spare capacity requires Saudi Arabia to forego production of 2.3 million b/d in 1997.18 According to Zaki al-Yamani's Center for Global Energy Studies, the cost of keeping oil facilities in a state of constant preparedness requires a further annual expenditure of around $100 million.19 As long as prices remain strong and world demand rises, the Saudis appear prepared to make these sacrifices. But the late 1998-early 1999 drop in oil prices surfaced a Saudi demand that at least the major oil producers share the burden of maintaining spare capacity.20 In practical terms this means that all the major oil exporters, and not only the Saudis or OPEC, will be required to reduce their output if prices are to be kept strong.

Despite the industrialized countries quest to diversify oil sources and decrease dependency on Persian Gulf oil, U.S. forecasts continue to allocate the role of accruing spare oil capacity almost exclusively to the Gulf states and OPEC. One estimate forecasts the entire stockpile (2.8 million b/d) of spare capacity for the year 2020 will remain within OPEC countries; 2.5 million b/d of that will derive from the Gulf region.21 These projections reveal the dilemma concerning Saudi Arabia: while OECD countries readily rely on the Saudis to cover shortages, they try to curtail their current dependency on Saudi oil.

Projected trends also point out that, despite a reduced role for the Persian Gulf as a source of oil imports for the United States and Western Europe (at least until 2010), the region will maintain its standing as the major reservoir of oil reserves. Some 2/3 to 3/4 of the world's known reserves are located in the Persian Gulf, a figure that has hardly changed over the past two decades and is unlikely to change over the next two decades. This implies that Saudi Arabia remains important to the Western economy, despite its declining share in American and European oil supply.

Saudi Oil Policy

The Saudi share of the global oil market has fallen by over 30 percent in the last fifteen years.22 As a result, some elements in Saudi Arabia are thinking about the implications that will follow when their country losses its status as the world's largest oil exporter. They are examining two major questions: How important is it that Saudi Arabia retain its distinction as the largest oil exporter; and what constitutes a minimum level of production?

Answers to these questions have never explicitly been stated and appear to be a matter of dispute. Some of the leadership is ready to give up the "world's largest" adjectives so long as oil revenues cover Saudi requirements. Others, more attuned to global oil demand or the impact of oil price fluctuations on the development of energy alternatives, are more conscious of the link between Saudi production and that of other producing states. This internal division becomes clear when oil prices are low and oil revenues do not cover budget expenditures (as was the case in 1998), but it is less conspicuous when prices increase. In the absence of a clearly defined oil strategy, Saudi policy will waiver between these two poles and can be expected to be more directly influenced by the outcome of factional jousting than strategic thinking.

Market share and price levels are the traditional mechanisms to optimize oil production. If the Saudis currently cannot increase price levels, they can increase market share, though this will place downward pressures on oil prices, thereby aggravating the original problem. An attempt to increase prices, on the other hand, will entail production cuts. Curtailing production may result in additional losses of market share, especially if other oil producers refuse to cooperate in this effort. In either case—low prices but high output or low output but high prices—Saudi Arabia has to settle for less than it had twenty years ago, when prices and output with both high.

Another option is for Saudi Arabia to join forces with other oil producers to raise prices. With oil sales comprising about 80 percent of its revenue, Saudi Arabia itself can ill afford to keep prices down. However, under current market conditions it is doubtful that OPEC can be successful at raising prices more than temporarily. An alternative forum can be created by organizing all major oil producers throughout the world, excluding the smaller OPEC producers who have been increasingly able to influence OPEC policies. Joining forces with the increasingly important non-OPEC oil producers may yield significant advantages for Saudi Arabia.

Yamani has been an ardent advocate of the market share approach. Through his London-based Center for Global Energy Studies, he advocates concentrating on a long-term policy of enlarging market-share by lowering oil prices23. Hani al-Yamani, Zaki's eldest son, takes this strategy to an extreme; in his opinion, the decline in the centrality of oil as a source of energy and the price reductions which ensued is an irreversible process which will continue unless Saudi Arabia regains control over the oil market. Rather than letting market forces shape Saudi Arabia, he claims that Saudi Arabia should take the initiative and shape market forces. He proposes to step up Saudi production to 20 million b/d over a five-year period, lower oil prices to about $10 per barrel and obtain long-term contracts to recapture a market share.24 In his view, this policy will preempt the development of new oil fields and alternative sources of energy by rendering them economically unfeasible. This, in turn, will increase demand for Saudi oil.

While Hani's proposal may be too radical for Saudi decision makers, ‘Ali al-Na‘imi, the Saudi petroleum minister, did suggest to OPEC in June 1998 the creation of a new core group of major producers to shape oil policy. Unlike Hani's proposal, this one admits that Saudi Arabia cannot single-handedly solve the problem of losing oil revenues and requires the assistance of other producers. It does not, however, necessarily indicate a preference for the oil price over the market share alternative.

Saudi Arabia can defend its position by flooding the market, as suggested by Hani al-Yamani, or by creating a shortage by cutting oil production. At present it appears that Saudi policy makers are reluctant to resort to either of these extreme remedies. They will likely prefer a middle road, at least for the short-term, to recoup oil revenues that will enable the country to keep pace with the growing needs of its society. Most likely, the short-term Saudi oil policy will combine the two paths, with an emphasis on higher oil prices.

Implications for the West

Changes in world energy use have reduced the role of energy in the world economy and the role of oil in the world energy picture. Furthermore, changes in the world's oil production pattern have undermined the Gulf's centrality as the main source of oil for the West. Plus, some Saudis – such as Hani al-Yamani – argue that the country should dramatically increase its oil output, which suggests the West has little reason to fear another oil price shock like those of 1973 or 1979-80. At the same time, the Gulf's position as the main source of global reserves remains unchallenged, suggesting that Gulf security may still be a matter of concern to the West.

The validity of old perceptions regarding Western dependence on Gulf oil is questionable, as is the notion that the West must protect Gulf oil. Graham Fuller and Ian Lesser contend that the Pentagon allocates huge sums ($30-60 billion annually) for the Gulf's defense, while oil exports from the Gulf to the United States were less than this amount (only approximately $30 billion).25 Even if the opinions expressed by Hani al-Yamani on the one hand and Fuller and Lesser on the other are over-stated, they are worthy of closer examination by decision makers.

It was once commonly believed that a crisis in the Gulf would most severely affect oil importers while leaving the oil-producing countries relatively unscathed. Well, that turned out not to be the case, as the experience of the past two decades has repeatedly shown. In fact, Gulf oil exporters turned out to be the primary losers from war and unrest in their region. The Iran-Iraq and Kuwait wars both imposed enormous losses on the Persian Gulf itself - without creating significant oil shortages or hardships for importers. The bombing of Iranian oil installations, the embargo of Iraqi oil and for a while Kuwait oil, the setting of hundreds of wells on fire—all these led to an unexpected reduction in oil prices. This suggests that those who should be most worried about Gulf security are the Gulf countries, not Western oil importers.

Sarah Yizraeli, author of The Remaking of Saudi Arabia (Dayan Center of Tel Aviv University, 1997), writes commentaries on the Middle East for Israeli newspapers and has been a visiting fellow at the Washington Institute for Near East Policy.