Justin Dargin is an Energy and Middle Eastern Scholar at the University of Oxford. He was a former Research Fellow with The Dubai Initiative at Harvard University. He is also a Fulbright Scholar of the Middle East and North Africa. Previously, he worked for Owens Corning and OPEC. He is fluent in Spanish, Arabic, and English.
The Arabian Gulf region has the most prodigious energy reserves in the world. However, the region’s massive industrialization and expanding demography are also increasing energy consumption at unsustainable rates, leading to natural gas deficits across the region.
This article argues that the pressures of economic development and industrial diversification are steadily eroding the comparative advantage that the Gulf countries enjoyed for much of the late twentieth and early twenty-first century that allowed them to support domestic industries with extremely low-cost associated natural gas. As a result, the investment logic that guided energy-intensive industries to the region will have to concomitantly evolve.
Due to the region’s natural gas shortages, the Gulf governments will begin to reconfigure the dominant pricing framework. Furthermore, the region will begin to transition away from dependence on the current ethane-based petrochemical expansion strategy to one that leverages other feedstocks. Increasing competition from other natural gas production centers (such as China, the United States, and Australia) will also decrease the competitiveness of the Gulf petrochemical industry. Nonetheless, despite the pressures of the foregoing, this article illustrates that the regional response to such challenges will be the creation of a much more sustainable regional energy and petrochemical section for the long term.
The Arabian Gulf region1 has the most prodigious energy reserves in the world. As of 2012, it contained 486.8 billion barrels of proven oil reserves, approximately 37.5 percent of global supply, with the Kingdom of Saudi Arabia holding the lion’s share, at 20 percent of the global total (BP 2012). The latest figures for 2012 indicate that the region collectively produced 17.3 million barrels per day (b/d) (Institute of International Finance 2012). With the advantage of enormous oil reserves and small, albeit growing, populations, the region exports the majority of its oil production (BP 2012, 6-18). The region holds approximately 42 trillion cubic meters (TCM) of natural gas, about 23 percent of global natural gas reserves, but it only produces about 8 percent of the total global production. It is estimated that at current production rates, the current proven oil reserves will last another seventy years and natural gas reserves another 118 years (Arab News 2012).
However, as will be discussed below, there are several structural forces that could blunt the region’s immense energy reserves and thereby degrade its ability to foster economic growth. This article argues that the pressures of economic development and diversification are steadily eroding the comparative advantage that the Gulf countries have enjoyed since the 1970s that allowed them to expand domestic industries with extremely low-priced associated natural gas.2 Rapid industrial expansion, fueled by low-priced associated natural gas, caused high rates of natural gas consumption and energy intensity that strained the Gulf countries’ ability to adequately supply their local markets with natural gas.
As a result of this demand pressure, the investment logic that caused energy-intensive industries to relocate to the region will have to concomitantly evolve. This is of extreme importance when considering that due to the stresses of the Arab Spring, demographic growth, economic diversification, and pan-Gulf cooperation and integration, the Gulf countries will have to guarantee a sustainable economic model for their citizens.
In order to understand the contours of industrialization in the region and its connection with energy exports, the concept of absorptive capacity is essential to how energy-rich countries are able to domestically utilize revenue gained from oil and gas exports (Amuzegar 1983, 21). The absorptive capacity of a state concerns bottlenecks of supply in the face of expanding demand. It also concerns the lack of profitable domestic investment opportunities for countries that have high governmental revenue from the export of energy resources (principally oil). There are two types of Middle East and North Africa (MENA) energy-rich countries: the high absorbers and the low absorbers. Understanding this distinction will assist in understanding the policy choices available to the Gulf nations as they become more economically diversified.
The high absorbers are Algeria, Iran, Egypt, and Iraq—countries with relatively large populations and relatively small per capita oil reserves (Amuzegar 1983, 21). Additionally, these countries have a large manufacturing base, arable agricultural land, and overall, a much more diversified economic base (Luciani 1984, 107). The low absorbing countries, in contrast, are principally composed of the Arabian Gulf oil exporting countries and Libya, which have smaller populations and large per capita oil reserves and gross domestic product (GDP). However, they also lack a diversified economy, have a dearth of skilled manpower, and have few complementary resources (Amuzegar 1983, 21).
The concept of absorptive capacity is important because it impacts a country’s economic growth trajectory, its domestic development strategy, and oftentimes, its political stability. Therefore, the countries that have the lowest absorptive capacity tend to export more energy to the global market (again, principally as primary products) as there are fewer profitable uses at home. As I discuss in the next section, this dynamic of low absorptive capacity in the Gulf is evolving and placing enormous pressure on the ability of the Gulf countries, particularly Saudi Arabia, Oman, the UAE, and Kuwait, to continue their economic diversification plans while keeping a low administrative pricing framework (i.e., pricing set by policy as opposed to market forces).
This article proposes that Gulf policy makers implement natural gas pricing reconfiguration in order to moderate the region’s high energy intensity rates and consumption, as well as to increase natural gas production. The Gulf governments need to increase natural gas prices to at least the cost of production for new gas reserves to be brought online and ensure profitable development of these fields. These new gas fields are, for the most part, non-associated fields, which means that in contrast to associated natural gas fields, they are standalone fields. And, in the context of the Gulf region, they are often complex as they contain ultra-sour (UAE), ultra-tight (Oman), shale (Saudi Arabia), or ultra-deep (Kuwait) natural gas.
The varieties of Gulf non-associated gas are expensive to produce, with the cost of production several times higher (approximately $5-$8 per million British thermal units [MMBTU]) than the current associated gas production (approximately $.80-$1.30 per MMBTU). The current natural gas pricing regime does not enable profitable production for non-associated gas fields and thereby creates disincentives for expanding natural gas production. Furthermore, increasing natural gas prices will lower natural gas demand, which is currently at unsustainable levels.
Incorporation of these strategies will boost the region’s gas production, while relieving the stress of year-on-year power and gas demand growth. While other initiatives are important, the most important step is the creation of an attractive pricing framework to spur development. From pricing reform, energy intensity would consequently be reduced as the industrial and residential sectors begin to reduce their energy consumption and as large industrial concerns begin to invest in energy-efficient machinery. Of course, the above is not meant to be a comprehensive policy toolbox, as that is outside of the scope of this article. However, through the implementation of the basic elements of structural reform as indicated above, the energy-rich MENA countries would be able to definitively lower their rising energy demand and energy intensity while expanding the supply of available natural gas to continue on the path to economic diversification.
The next section of this article analyzes the economic impact of expanding industrialization in the region and its impact on natural gas supply. As the majority of Gulf-based industries depend in some manner on natural gas provision, an expanding industrial base places significant demand pressure on the Gulf countries’ ability to provide it. The article then offers an overview of the regional petrochemical sector and discusses the challenges facing the Gulf countries as they expand their petrochemical production, which is one of the primary industries used to diversify the regional economy. Lastly, the article concludes with the recommendation that the Gulf countries reconfigure their gas pricing regime. At least initially, Gulf natural gas price reconfiguration should not be comprehensive, rather it should be gradually liberalized in order to minimize any difficulties in managing the structural adjustment process. Furthermore, if gas price liberalization is not pursued, Gulf economic competitiveness will be severely hampered in the long term.
Gulf Economic Transformation
When the Gulf countries began to economically develop in the 1970s, policy makers viewed natural gas as the best means to develop a domestic industrial base. For several decades since the 1970s, the Gulf countries poured investments into large industrial projects in a bid to reduce their dependence on hydrocarbon exports. Yet, since the beginning of the 2000s, several significant economic forces morphed the contours of the global energy sector, consequently impacting Gulf economic growth. The “second oil price revolution,” a period of increased oil prices from 2000 to 2008, reflected a slow but steady increase in oil prices to the triple digits that enriched the Gulf countries.4 During this time period, the Gulf Cooperation Council (GCC) economies tripled in size to $1.1 trillion (Gulf Base 2009).
However, it was the global financial crisis that undercut what had seemed like an inexorable upward trend in Gulf economic growth. When fear of the global financial crisis climaxed in December 2008, oil prices dropped precipitously to approximately $30 per barrel. Combined with capital flight and constrained capital markets, the GCC countries were hit hard by the crisis, but relief was in sight as international oil prices began to steadily increase until reaching the current level (at the time of this writing in early March 2013) of $109.94 per barrel.
Despite the economic setbacks of the global financial crisis, the second oil price revolution heralded a period of unparalleled industrial expansion in the Gulf region. The Gulf countries initiated enormous value-added (petrochemicals, fertilizers), energy-intensive (cement, aluminum smelting), and power-expansion projects in the region. Additionally, during the same time period, the regional population increased from 28 million in 1998 to 39 million in 2010 (Gulf Investment Corporation 2012). The majority of the demographic bulge was composed of youth (under twenty-five), which spurred the Gulf countries to focus on job creation as a tool to alleviate socioeconomic discontent.
For the majority of the Gulf countries, the gas molecule has been at the center of plans for industrial expansion and economic diversification. This model of development did not pose any risks for the GCC countries until the expansionary pressure became too great by the mid- to late 2000s and the region’s associated natural gas could not keep up with the growth in demand. By 2007, the widening supply-demand imbalance fissures became apparent.
The rapidly increasing regional demand for gas is driven by administrative pricing. These prices tend to be much lower than international prices of natural gas, and they are below the production cost of new gas fields. The Gulf States’ internal pricing policies are causing allocation disruptions and exacerbating budgetary pressures because they cannot simultaneously supply low-price natural gas to their national industries while keeping their industrialization and diversification strategies on schedule.
When the majority of the natural gas produced was inexpensive and easily accessible (i.e., associated natural gas), this framework of providing low-priced natural gas to domestic industry was viable. However, with regional gas demand increasing alongside rising upstream production costs in non-associated and difficult to produce (i.e., ultra-sour, tight, shale) natural gas fields, the current natural gas pricing framework is unsustainable.
Nonetheless, the major challenges are not just limited to the natural gas sector—regional oil demand is also increasing. This is due to two interrelated factors. Firstly, as natural gas shortfalls cascade through the regional economies, Gulf countries, such as Saudi Arabia, the northern Emirates, and Kuwait, are using more fuel oil for power generation. When oil is consumed domestically at below-market prices instead of exported at international market rates, a significant opportunity cost results.
This contradiction is illustrated most clearly in Saudi Arabia. According to Khalid Al-Falih, CEO of Aramco, rising domestic energy consumption in the Kingdom could result in the loss of 3 million barrels per day of crude oil exports by the end of the decade it a business as usual scenario persists (U.S. Energy Information Administration 2013). As Saudi Arabia consumes more of its oil domestically, it loses a significant amount of foreign revenue. Moreover, in 2012, Saudi Arabia established enormous infrastructure and social spending programs, which will only increase domestic oil consumption. Rising oil demand is threatening Saudi Arabia’s ability to serve as the global oil production hub, the loss of which could make global oil prices much more volatile.
Gulf countries also face growing economic pressures due to the massive expansion of government expenditures in the wake of the Arab Spring. A report by Bank of America Merrill Lynch estimated the combined social spending by Gulf countries to stave off social discontent to be approximately $150 billion (Broomhall 2011). The ramping up of government spending programs has increased what is known as the “break-even oil price,” or the price of a barrel of oil required for an oil-producing country to remain solvent. For example, the break-even oil price for a barrel of oil in much of the region was approximately $30 in 2003. Nearly a decade later, the regional break-even oil price increased to approximately $77 per barrel (Abed 2011, Ijtehadi 2011).
The increase in the break-even oil prices across the region indicates that the Gulf countries are becoming more fiscally vulnerable. Therefore, the countries informally known as the “price doves” of OPEC will be forced by necessity to defend higher prices and thereby become “price hawks” (Schaeffer 2005, 259). It is clear that due to these pressures, a bifurcated strategy is emerging within many Gulf countries, especially Saudi Arabia. As the Gulf countries attempt to rely upon their comparative advantage and expand their industrial base so as not to rely solely upon oil exports, their industries “need” access to low-priced natural gas and oil to facilitate the process. However, simultaneously, as their economies expand and governmental expenditures increase through infrastructure development and subsidization of various economic sectors, there is a greater incentive to expand oil exports to capture the lost opportunity cost. Therefore, the Gulf countries, which were formally price doves, will likely become price hawks in the mid-term in order to support their massive budgetary outlays.
If coherent and clear-sighted energy policies are not developed, then the industrialization and economic diversification strategies of the Gulf countries will be at risk in the mid- to long term. While inconceivable a mere decade ago, the region could face energy security problems if it is not able to expedite production of its own natural gas reserves. A lack of non-associated gas development would force the region to rely upon the global market for natural gas import, as Kuwait and the UAE do at the moment. And, although unlikely to continue in a business-as-usual pattern, if Saudi Arabia’s current oil consumption trends continue, it could potentially become an oil-importing country by 2030 (Daya and El Baltaji 2012).
Additionally, the petrochemical sector, which is the basis of Gulf economic diversification, is also at risk due to the lack of energy price reformation. The Gulf countries are attempting to transition away from hydrocarbon dependence and develop a diversified and sustainable modern economy. But the low-cost pricing structure of natural gas is straining their ability to meet these strategic goals.
Threats to Diversification: A Focus on the Gulf Petrochemical Industry
The Gulf petrochemical industry is at a precarious point in its development. Its rapid expansion over the past two decades that was built upon low-priced natural gas enabled it to enjoy a substantial cost advantage over its global competitors. The Gulf countries staked their economic diversification plans on the continued availability of low-cost and low-priced associated natural gas. These countries considered associated natural gas the most cost-effective method to increase their non–oil related GDP (through downstream economic diversification) and create highly skilled jobs for their youth, of which a large proportion is under the age of twenty-five.
However, several issues obstruct the region’s plans to expand capacity as petrochemical companies battle to preserve their profit margins in the face of ethane (a crucial component for petrochemical production) shortages, which are further compounded by critical operational problems. The GCC’s diversification drive to absorb rising population growth now includes energy-intensive sectors such as steel and aluminum smelting, as well as upgrading and expanding the capacity of power and desalination sectors. All of these initiatives have placed extreme pressure on the GCC countries to effectively allocate natural gas among the various economic and industrial sectors. Because of this, ethane supply is not expected to increase over the coming decade, and most of the expected supply is already committed for allocation to existing projects.
Regional petrochemical companies have been adapting to the shortages of natural gas feedstock by utilizing liquid feedstocks (gas liquid and refined petroleum products such as naphtha and propane). Saudi Arabia, for example, ceased allocating significant amounts of ethane to the petrochemical sector in the middle of the last decade.
However, the ethane shortfalls, which are present in nearly every Gulf country (except for Qatar), will make strategic expansion challenging. Liquid feedstock is now the feedstock of choice (or necessity) for the Gulf countries.7 For instance, Saudi Basic Industries Corp. (SABIC), the world’s largest petrochemical producer, made the strategic decision to switch to propane and naphtha. The issue of where to source future natural gas feedstock allocations became even more important in the Kingdom considering the approximately $20 billion in current petrochemical expansion projects (Serrai 2011).
Another driver of the petrochemical boom has been the push to move deeper into the downstream value chain. By 2015, it is expected that at least nine new crackers will be operational across the region as the GCC countries attempt to take advantage of robust Asian demand, especially for highly engineered plastics.8 As discussed above, this downstream diversification is part of the strategic goal to transition away from oil and natural gas export to the production of bulk petrochemical products, such as polymers for compounding plastics, and higher-value specialty chemicals for use in the textile, electronic, construction, and pharmaceutical industries. Furthermore, the diversity of downstream production will enable the Gulf countries to meet their long-term goals of economic diversification, job creation, promotion of technology transfer of advanced machinery and industrial production techniques, stabilization of foreign revenue, and the creation of more “value addition” to petrochemical production.
The limited ethane feedstock, which has forced a number of Gulf countries to transition to more costly liquid and refined feedstocks, has eroded the comparative advantage of the petrochemical industry (most pronounced in Saudi Arabia). Furthermore, the pressure on the administrative pricing structure for natural gas will cause the Gulf countries to revise the natural gas pricing framework over the next several years. This will further degrade the Gulf’s comparative advantage and profit margins.
In terms of global competition, while the Gulf countries still have a comparative advantage even with the switchover to liquid and refined feedstock (which is often provided at heavily discounted prices to domestic firms), the liquid and refined feedstock price is still several times higher than the price at which natural gas feedstock is supplied. Despite this, the Gulf’s price of liquid and refined feedstock is still less expensive than the price in the international market. Moreover, the current elevated price of oil (averaging over $100 per barrel) benefits the profit margins of Gulf petrochemical producers vis-à-vis their Asian competitors.
Asian petrochemical producers utilize, for the most part, crude-based naphtha, and will be obligated to have higher prices in order to preserve their profit margins. As a result of upward price pressure on Asian petrochemical producers, Gulf petrochemical companies will be able to raise their prices while still undercutting their Asian counterparts. Nonetheless, higher petrochemical prices will depress global demand, impacting all petrochemical producers.
Conclusion: Implementation of Natural Gas Pricing Reform
The resolution of the challenges of rising consumption and promotion of non-associated gas production lies in natural gas price reformation. Indeed, natural gas price reformation, if conducted with the utmost care so as not to unnecessarily disrupt economic growth, will have a stimulating effect and create true Gulf energy sector sustainability. The main motivation to reassess the current pricing regime in much of the region is to alleviate the impact of growing energy and power consumption and, as a consequence, significant energy deficits throughout the regional economies. The current energy pricing regimes exposed some energy-rich Gulf countries to the conundrum of being energy exporters to the world market while at the same time obliging them to import energy either through pipeline, liquified natural gas (LNG), or refined petroleum products to supply rising domestic demand.
Regulated energy prices have also been an important means for some MENA states to attract large-scale Western energy-intensive and petrochemical companies to relocate to their jurisdictions and thereby assist in building up local capacity and technology transfer. Yet, price support mechanisms are not the most efficacious methods to promote allocative efficiency in times of energy shortages. In addition, energy price support mechanisms in the Gulf region constitute a significant portion of GDP and budget expenditures, even before the global financial crisis of 2008.9 Additionally, while low energy prices encourage consumption, they do not stimulate the requisite investment in needed energy infrastructure. Because the public utility sector often operates at a loss in the MENA region, the private sector is often hesitant to become involved and invest, and public utilities often do not make needed investments in energy efficiencies, upgrading, and expansion of services.
That is why, in terms of energy pricing, there should be a dual-track pricing structure that aspires to gradual liberalization. It should be created so that the most economically productive sectors, such as petrochemicals, benefit from prices of at least the average cost of production for the non-associated gas reserves in that particular country. This pricing structure would, at a minimum, economically support extraction of the most difficult non-associated gas fields and encourage international oil companies to invest their capital, time, expertise, and technology in its production.
When considering the power sector, market regulators should allow for power tariffs to meet the power generation cost. This would ensure that the electricity service is uninterrupted. In the residential sector, the price framework should be set at cost-plus (the cost of production plus a predetermined amount over the basic production cost) to guarantee a return on investment for the power sector, which would create incentives for energy efficiency upgrades and capacity expansion to promote energy access. However, for citizens that meet a certain poverty level, regional governments should create a cash disbursement mechanism to mitigate the social cost associated with structural adjustment, as well as the financial burden on the impoverished.
Reform has already taken hold in Oman. Oman is a country that faces considerable internal contradictions in its energy sector, yet its far-reaching energy pricing reformation (see the sidebar “Case Study: Price Reform in Oman”) has gone the furthest when compared to its Gulf peers. It has increasing domestic demand from the power and petrochemical sectors, as well as demographic growth, all of which are compounded by demand from water desalination and fertilizer projects. Oman, as a result of the growing demand, imports natural gas from Qatar’s North field through the Dolphin pipeline project of 5.66 million cubic meters per day (MCM/d). Oman also exports LNG to the global market, principally to South Korea, as well as to other markets. In addition, it diverts a significant amount of natural gas to its oil field re-injection program to sustain production. Due to the above-mentioned trends, Oman aggressively attempted to produce non-associated natural gas (mostly tight gas).
As part of its gas expansion strategy, Oman and BP are developing an approximately $24 billion tight gas project in Block 61 (including the Khazzan and Makarem fields, in north central Oman) (Elston 2012). If production begins as planned, Block 61 will be the largest gas project ever undertaken in the sultanate. The successful completion of the development of the Khazzan and Makarem fields would grant Oman between 566 and 849 billion cubic meters (BCM) in reserves with the first phase of the project producing approximately 30 MCM of gas per day by 2019 (Energy-pedia 2012). The second phase of the project plans to bring another 30 MCM of gas per day online.
Implementing natural gas price reform is essential in the Gulf region if the countries wish to be able to supply enough natural gas to their petrochemical sectors in the mid- to long term. Additionally, there is significant competition on the horizon, such as the massive increase in shale gas production in the United States, known as the “shale gas revolution,” the coal-to-olefin initiatives in China, and the new gas fields coming online in other parts of the world, such as Iraq, all which pose additional challenges for Gulf petrochemical dominance.
U.S. shale gas production has lowered natural gas prices, and American and international chemical companies are attempting to transform this into petrochemical dominance. Shell is currently exploring building a world-scale petrochemical complex in the Appalachian region of the United States near sites of gas production in the Marcellus shale formation. This development may augur a return of major American petrochemical producers from the Gulf to the United States. Several international energy and petrochemical companies such as Westlake Chemical, Braskem, Dow Chemical, and Nova Chemicals have either expressed interest or begun the initial process of developing sites in the United States to take advantage of the low-cost natural gas feedstock.
China has similarly developed plans to produce between 60 and 100 BCM of shale gas by 2020, which will directly threaten the Gulf petrochemical sector. Another potential threat may come in the form of a World Trade Organization (WTO) suit against the Gulf countries for supplying natural gas and liquid/refined feedstocks below international market prices to their petrochemical producers. In 2009, China and India imposed punitive anti-dumping tariffs against Gulf petrochemicals, and the European Union (EU) followed suit in 2010 with a schedule of tariffs on producers of polyethylene terephthalate in the UAE.
The United States and Western European countries also threatened to bring a suit in the WTO under the Agreement on Subsidies and Countervailing Measures (ASCM) for alleged subsidies granted to the Gulf petrochemical industries by their governments. Pressure from the WTO is also causing the Gulf countries to seriously consider revising their natural gas prices upward and allowing them to fluctuate based on market forces. But in terms of the broader Gulf diversification plans, with price reform, in the mid-term, the petrochemical ventures in the Gulf region will be forced to become leaner enterprises. They will be focused on preserving profit margins and increasing operational efficiency, while at the same time integrating a higher production cost structure for their feedstocks. These steps, while slightly painful in the beginning due to the structural adjustment costs, will assist in creating Gulf economic sustainability for the long term.
The author would like to acknowledge the diligent efforts of his research assistant, Arthur DeLong.
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From pricing reform, energy intensity would consequently be reduced as the industrial and residential sectors begin to reduce their energy consumption and as large industrial concerns begin to invest in energy-efficient machinery.
The increase in the break-even oil prices across the region indicates that the Gulf countries are becoming more fiscally vulnerable.
If coherent and clear-sighted energy policies are not developed, then the industrialization and economic diversification strategies of the Gulf countries will be at risk in the mid- to long term.
Implementing natural gas price reform is essential in the Gulf region if the countries wish to be able to supply enough natural gas to their petrochemical sectors in the mid- to long term.