Saudi Arabia, 2040

Saudi Arabia will be interesting to watch over the next couple decades.

Oil prices have been crazy lately, between the whole Saudi-Russia dispute and COVID-19 demand destruction. Zooming out and looking past all that, I think the long view of oil market dynamics has interesting implications for the future of Saudi Arabia. Similar historical cases suggest a number of ways this could go.

In a competitive world with short oil project life-cycles, the cheapest sources of oil would be exploited first, and oil prices would tend to equilibrate out at a level where producing the most expensive barrel had a small economic return. Oil prices could move significantly as the most expensive barrel changed. But eventually, at any given level of OPEC/Saudi production, there will be an equilibrium price where supply and demand balance at that level of production.

It seems like $55 oil has been about right the last couple years. It keeps the major multinational oil companies doing frontier development, it keeps fracking going, it allows oil sands operations to turn a profit, and so forth. When more super-low-cost oil suddenly comes on line, whether because of geopolitics or geological surprises or whatever, prices and marginal fracking will decline to accommodate the cheap barrels. A drop in demand (COVID-19!) has a similar impact, shifting the world along the geological cost curve. But within a few years, natural decline of the world’s existing oilfields will tend to push the price upwards until typical projects, particularly fracking, can again offset natural decline.

It feels like there is a lot of supply elasticity around these prices, meaning that a relatively small increase in price will eventually result in a pretty large increase in output. If the market was in equilibrium and Saudi then decided to produce +2MMBPD vs. status quo forever, there would initially be a price bloodbath, resulting in reduced investment in projects across the globe, but after 5 years the marginal barrel might well end up being a fracked barrel at $53/BBL (vs. $55 if Saudi had done nothing). If the market was balanced and Saudi suddenly reduced 2MMBPD, there would tend to be a spike in prices, with correspondingly frantic activity in the Permian. But at the end of 5 years, marginal barrel would still be a fracked barrel, maybe at $57/BBL. Obviously these are cartoon numbers, but it is striking how many oil companies quote budget price sets or breakevens in the $50-$60/BBL range, and how much fracking output has been able to expand with prices in that ballpark.

With genius-level subtlety and planning, Saudi could potentially exploit the dynamics of the situation and yo-yo the market back and forth, in such a way that the price spikes filled their coffers whilst the dips keep fracking at bay, and mid-term average prices work out above a fracked barrel equilibrium. However, short fracking project cycles and American firms’ ability to hedge output make this harder. Long-run, Saudi is only likely to get $50-60/BBL, no matter what they do, and to the extent they act optimally they will probably tend to end up at or close to maximum production.

If the elasticity of supply was much lower, or supply slower to adjust, might be a different story. Around 2010 (pre-shale), the marginal barrel might have been an oil-sands or deepwater mega-project that took 7 years to come online. But that world is gone. (Or at least that is my impression, and my lazy Googling did not find credible recent estimates of long-run oil supply elasticity, so impressions are all I’ve got.)

So what does Saudi look like 20 years from now at $50-60/BBL?

Their budget needs $80/BBL to break even, so they will never again have a balanced budget without significantly higher taxes or lower spending. There doesn’t seem to be much to tax aside from the oil. They can go on a long time running up their debt to some high percentage of GDP, but sooner or later the money will stop, and they will have to cut back and start acting more like a normal country. To the extent the social contract is based on distributing oil money, that will be hard to do.

The situation reminds me of Argentina, where natural resources (under-exploited ranching land) generated great wealth for a period of time in the early 20th century. It was in the top 10 richest countries for a time. But ranch land eventually stopped being such a jackpot. Meanwhile cultural and institutional factors had remained sort of typical for the region, so the post-resource-wealth economy dropped down the global league tables until it also reached a near-typical level for the region.

So what does “typical for the region” look like for Saudi, neglecting the oil jackpot? Consider its neighbor Yemen, which had a 2018 GDP of $895 per capita. That would be a long way to fall. But of course Saudi is trying to diversify, and rightly so. Historically successful diversification has not been the typical experience in commodity-rich countries, or in Saudi specifically, but hopefully they break the mold. I would love to buy some cheap Saudi manufactured goods to go with my cheap Saudi oil.

However, assume for a moment that Saudi keeps struggling to diversify, and continues under fiscal (and thus political) stress.

Could Saudi go the way of Venezuela? In this case, shrinking oil wealth upsets a high-spending social contract, political repression results, the oil company gets bled dry under management of steadily deteriorating quality, and production declines through the years until a former powerhouse fades into irrelevance.

How about Libya? There, internal strife has resulted in on-again, off-again production as conflicting groups seek to control key infrastructure. This is harder to imagine; Saudi production (unlike Libya’s) might be “too big to fail,” and the U. S. tends to take an interest in it. But if production drops, Saudi could eventually become like Iran; a country that produces a lot, but remains dispensable.

On the other hand, maybe MbS can orchestrate an economic miracle and turn Saudi into Singapore-in-the-desert, a country that leverages a few initial advantages to achieve world-beating economic success. This looks like quite a challenge. It’s hard to imagine putting much non-oil-linked manufacturing in Saudi; wages are too high. Megaproject-based economic development is one of the knobs MbS really can turn, but there’s no straighforward path from megaprojects to an organic, vibrant economy. But MbS does seem to acknowledge the challenge he’s facing and has his “Vision 2030” plan to meet it, so let’s hope he can make it work.

Perhaps the best hope is that Saudi can just muddle through. Many of these same points could have been made in the 1980s, when Saudi was also running huge budget deficits, yet here we are, so maybe things just keep on going in a comparable vein. Maybe oil prices do get back to $80+ in the long run. Maybe MbS can gracefully trim spending. Maybe diversification goes better than we might expect from history. As at least some of these issues shake out the right way and things go on being OK, compound growth goes onwards, and the country prospers.

Cultural change is also a wild-card, although a fair degree of continuity is a good bet. Elsewhere on the spectrum of conceivable results, maybe a growing group of American-educated Saudi royals eventually brings the American Way to a populace that has decided, after decades of marinating in global internet culture, that they are just about OK with that. Fukuyama’s End of History finally arrives in earnest, and in 2040 we all sit around watching Marvel’s attempt to do for Arabia what “Black Panther” did for Africa. Maybe the trend of secularization slowly deepens and Wahhabism ends up sort of like the Church of England.

All of this is to say that I don’t know what will happen, but the potential variance in outcomes seems pretty large. (Much more so than for, say, Sweden—official 2040 slogan, “still a pretty good place!”) It’ll be interesting to watch.

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