Why Saudi Arabia Won't Cut Its Oil Production

Anyone who wonders why Saudi Arabia has refused to reduce its oil production to drive the price back up can find an answer in the global climate change accord agreed to by 195 nations in Paris last month.

The parties committed themselves to reducing the consumption of hydrocarbon fuels in the second half of this century to the point where their use produces no more carbon dioxide than can be absorbed by the world's trees. Each step they take toward reaching that goal diminishes the value of Saudi Arabia's vast crude oil reserves -- the economic lifeblood of the kingdom. The Saudis apparently figure that they might as well sell as much as they can now for whatever they can get, rather than leave it in the ground and see its value wither.

As one American analysis of the climate pact noted, it "sends a clear message to the fossil-fuel industry that much of the world's remaining reserves of coal, oil, and gas must stay in the ground and cannot be burned."

Saudi Arabia is dependent on oil exports for 85% of its revenue. The Saudis saw this coming. For years, as their country remained dependent on oil exports for 85% or more of its revenue, they have feared not that they will some day run out of oil but that they will run out of customers for it. They anticipate that electric vehicles, industrial efficiencies, bio-fuels and climate-change concerns will turn consumers away from oil. A return to $100 oil would accelerate that evolution, even if in the short term it encouraged new high-cost producers to enter the market.

As long ago as the 1970s, Saudi Arabia broke with other members of the Organization of Petroleum Exporting Countries (OPEC) to slow the acceleration of price, fearing that continued increases would spur consumers to seek other sources of energy. In the United States, the Synthetic Fuels Corp, created during the Jimmy Carter administration to promote the development of alternatives to oil, is remembered with ridicule (if it is remembered at all).

But the Saudis haven't forgotten the message: If the price of oil rises past some unknown point, or if alternatives become feasible, consumers will find new sources of energy.

"The stone age didn't end because the world ran out of stone." Saudi Arabia's oil minister of that era, Ahmed Zaki Yamani, observed that "the stone age didn't end because the world ran out of stone." He was saying that there will still be oil in the ground when the oil age ends. The climate agreement is likely to accelerate the arrival of that day.

It won't be in 2016 -- or any time in the next 20 years. According to the International Energy Agency, even under new policies due to be implemented in many countries, oil consumption will grow, "with global demand reaching 103.5 mb/d in 2040, up nearly 13 mb/d on 2014 levels."

But the Saudis take the long view.

"We have no doubt that one day there will be alternatives," Abdul Aziz al-Khayyal, a senior vice president of Saudi Aramco, told an interviewer a few years ago. "It's going to happen one day." When it does, he said, "We want to be able to have our BTUs compete with other BTUs." The Saudis have demonstrated that their energy can compete with other sources of energy on price, but the Paris accord makes it doubtful that they can compete on the basis of environmental considerations. If international alarm over greenhouse gas emissions means that energy consumers are will to pay more for energy from non-emitting sources, the eventual turn away from oil will become irresistible.

Oil that is profitable to produce at $100 per barrel may not be profitable at $50.

In the short term, the sharp decline in the global price of oil from more than $100 to less than $40 in less than a year has forced the Saudis to draw down their considerable reserves and to borrow money, but from their perspective it has also had benefits. It has imposed economic hardships on Iran and Russia, and has discouraged new production of oil from other, more expensive sources, such as shale in the United States and Canada's tar sands. Oil that is profitable to produce at $100 per barrel may not be profitable at $50. If these new sources languish while Saudi Arabia's share of the world's market increases, that's fine with Riyadh. The Saudis know that eventually, as shale and tar sands fuel leave the market because they are too expensive to produce, the diminished supply will drive the price back up and bring those sources back on line.

According to the IEA,

There is evidence the Saudi-led strategy is starting to work. Lower prices are clearly taking a toll on non-OPEC supply, with annual growth shrinking below 0.3 mb/d in November from 2.2 mb/d at the start of the year. A 0.6 mb/d decline is expected in 2016, as US light tight oil -- the driver of non-OPEC growth -- shifts into contraction. As companies make further spending cuts in reaction to sub-$50/bbl oil, the impact on supplies -- both from non-OPEC and OPEC -- will be even more pronounced in the longer term.

Of course, Saudi Arabia would like to be receiving a higher price for its oil. Three years ago its veteran oil minister, Ali al-Naimi, said $100 per barrel would be the "ideal price": It would give producing nations enough revenue for their needs; it would keep the product affordable for consumers; and it would incentivize the development of new oil fields and new drilling technologies that would stabilize the global supply-demand balance, ensuring that consumers would keep buying.

The Saudis are more concerned about the 30 years down the road.

There is little chance that the price will return to $100 any time soon. Two respected financial institutions in Riyadh forecast only a modest price upturn in 2016, followed by slightly faster increases in the few years after that as high-cost shale disappears from the market.

With their deep pockets, the Saudis are less concerned about these short-term developments than about the 30-year horizon. They are realistic about what the Paris climate agreement portends. Like many other countries, the Kingdom submitted its compliance plan even before the Paris conference. "The Kingdom of Saudi Arabia," it says, "has ambitious plans to diversify its economy away from heavy reliance on income generated from a single resource. Therefore, contribution to the climate ambition will be integrated in the future policy to promote this plan."

Saudi Arabia has pursued this goal of economic diversification for 40 years, with limited success. Now the question is whether it can accelerate that process.

This article was originally published on Forbes.com