Saudi Arabia’s Natural Gas: A Glimpse at Complex Issues

Natural gas is a very significant energy source. In 2001, world production reached 2,218 million tonnes of oil equivalent, slightly less than coal (2,248 mtoe) and about 62 per cent of the amount of oil production (3,585 mt). The share of gas in the primary energy balance stood at just below 25 per cent in 2001. In the past 10 years (1991-2001) natural gas production grew at an average compound annual rate of about 2 per cent, compared with oil at 1.3 per cent and coal at a negligible 0.15 per cent.

The main qualities of gas are well known. It is considered to be environmentally friendly but only relatively to coal and oil. It is a favoured fuel for power generation in combined cycle plants because of their greater thermal efficiency. At a price, gas can be transformed into sulphur free (or low sulphur) liquids. Non associated gas once discovered is often cheaper to extract than oil but its transport, be it by pipeline or in LNG form is much more expensive. The world holds more natural gas than oil reserves, but this feature is of greater relevance to the long- than the short-run.

In the final analysis, the significance of gas relates to the merits of diversification. A world where a commodity has substitutes that serve essentially the same purpose while displaying diverse properties is better than one where a commodity reigns unchallenged in its important uses.

Saudi Arabia cannot afford to ignore this significant energy source given the size of its proven gas reserves estimated at 219 Tcf at end of 2001. Although small compared to the Russian 1,680 Tcf and the Iranian 812 Tcf the fact remains that Saudi Arabia’s reserves rank fourth in size among gas countries (after Russia, Iran and Qatar).

Resources involve potential opportunities for exploitation. (If they did not, we should not refer to them as ‘resource’). There is no doubt in my mind that gas in Saudi Arabia has economic uses that need to be identified, and appraised with rigorous economic criteria. Gas resources should be developed where and when the economic calculus, qualified where necessary by some strategic considerations, reveals that expected benefits are greater than those that would accrue from alternative uses of investment funds. In other words, one always needs to take into consideration competing opportunities.

Three essential points must be kept in mind when analysing the role of gas or assessing the merits of its development.

First, gas is not oil. This means that it would be wrong to assume in any analysis that the economic characteristics of these two fuels are identical.

Second, although gas is not oil, these two fuels are related to one another by a number of significant links. Any analysis of gas issues that fail to take these links into account could turn out to be seriously misleading. The main relationships are as follows. (a) Gas and oil are substitutes in a range of energy uses. There is an asymmetry however. Oil can easily replace gas in virtually all the sectors where gas has an established market – power generation, space heating, raising heat under boilers. The main exception lies in the production of certain petrochemicals. But gas has greater difficulties in replacing oil in the transport sector where gasoline, automotive diesel and jet kerosine have their stronghold. (b) Gas is found in nature in two forms, associated with oil or non-associated. In Saudi Arabia, a very large amount of gas reserves are of the associated type. When studying upstream issues associated gas cannot be considered separately from oil. (c) Natural gas plays a major role through re-injection in the extraction of oil. This specific use distinguishes gas from oil while constituting an important relationship between the two fuels. (d) Natural gas may be either wet or dry. Wet gas is of great interest to foreign investors because the liquid element, which is essentially an extremely light oil, can be exported much more cheaply and easily than the gas itself. But the gas liquids represent in effect additional oil supplies. An eminent gas consultant once said, only half in jest, that gas is an input, that is a cost incurred, in the production of liquids.

In short, any thinking about gas development should not exclude the many relationships that gas has with oil. It is fundamentally wrong to think about gas in isolation from or as a separate issue from oil.

Third, despite all the accepted views about globalisation and the universality of sound economic principles, the fact remains that real conditions differ from country to country. There is no ‘fit all sizes’ policy formula or model of development. The development of natural gas in Saudi Arabia is bound to display a different pattern from, say, Qatar where gas dominates the country’s resource endowment; or from the USA where the multiplicity of production sources and an extensive pipeline network creates a competitive market, or from Europe where European supply sources (Netherlands, Norway etc.) have to compete with imports (Russia, Algeria etc.).

Saudi Arabia is a major oil producing and exporting country. It has large gas reserves most of which is of the associated type. Its national oil corporation is a very large and competent entity which is producing some 8 mb/d of oil, natural gas and refined products. It maintains some 3 mb/d of surplus capacity, and has undertaken significant investment projects of which the Shaybah oilfield is an impressive recent example. At the same time, the demand for the main utilities – water and power – is growing at a high rate, and the need to create jobs for large numbers of new entrants to the labour force every year has a particular urgency.

The purpose of the Gas Initiative is to induce a development of gas resources to fuel new power stations, water de-salination plants, petrochemical and other industries such as metal smelting, and the like. The developmental objectives are to meet growing requirements for utilities and to create employment. The recourse to foreign investors is meant to free some scarce capital in government hands for alternative uses. The essence of the scheme is in its integrated aspect. To develop natural gas in the absence of outlets (domestic or export markets) is meaningless, as would be investment in utilities and industries in a situation of gas shortages. Recourse to foreign investors is necessary in situations where the cost of capital to the host country is very high, its managerial resources are affected by paucity of skills or are otherwise over-stretched, when technology can only be acquired from direct investors, not through service companies or on-the-shelf purchases, or when access to markets is required.

As the Gas Initiative was launched at a time when oil revenues had been badly hit by the oil price collapse of 1998/early 1999, it is fair to say that the need for capital from outside was, at that time at least, a significant consideration. However, the financial situation has dramatically improved thanks to the higher oil prices that obtained since the second half of 1999 to date. The argument that foreign investment is a cheaper option because foreign firms can obtain capital on much more favourable terms than a developing country is not always true. All depends on two sets of factors. First, the size of the differentials between the rates and terms at which the country can borrow in the international capital market and the cost of capital to the foreign firm. For Saudi Arabia this differential is much smaller than for many developing countries. Secondly, the lower capital costs of the foreign investor are not passed through to the country. On the contrary, the foreign company will ask for a return on its investment that includes compensation for a wide range of risks. This compensation is likely to be greater than the above-mentioned differential in the Saudi case. The point that deserves stressing is that the risks faced by the investors for which they legitimately ask for a return, are not risks which the national oil corporation or any other national entity face.

The technology argument is unconvincing. There is no technology for upstream developments that Saudi Aramco either does not possess or is unable to acquire from sources other than the international oil companies. As regards downstream gas nobody would argue that the oil companies are specialists in power generation or water plants. Different foreign investors possess the appropriate technology for these projects.

The market argument is irrelevant at this stage in the case of Saudi gas because the development is sought for domestic uses.

The managerial argument, however, is the most compelling. To manage a huge integrated project that involves upstream development, a transmission infrastructure and plants of different types and industries as final user of the gas is probably not within the resources of Saudi Aramco or any other Saudi organization.

This begs a question however. Why conceive of the project as a vast fully integrated operation? The reason, probably, is that the alternative which was to break the scheme into constituent elements and go to different firms each specializing in power, water, petrochemicals, metals and transmission would still require both coordination and the management, one by one, of a large number of projects.

The decision to go for an integrated scheme and to invite major oil companies to implement it may be explained first, by the managerial argument, and secondly, by the view that major oil companies are big, reliable and experienced entities endowed with the skills and resources needed to manage mega-projects. There is a problem, however. The two parties of the relationship — Saudi Arabia and the foreign oil companies — have asymmetrical positions as regards their objectives and their desiderata. To put it simply, the major oil companies seek an involvement in the upstream of Saudi Arabia’s hydrocarbon sector. They are not really in the business of running utilities, building a gas pipeline network downstream desalination plants or power stations. On the other side of the relationship Saudi Arabia has no interest, really nothing much to gain, in opening up the upstream sector. It already holds a significant volume of surplus productive capacity in oil. And Saudi Aramco which has been managing and developing the country’s oil resources without much ado is perfectly capable of finding and developing new gas resources. Given the appropriate financial incentives they will do the job. As Winston Churchill once said: ‘give us the tools (in our case we should say the money) and we shall do the job’. What Saudi Arabia wants, and this was made perfectly clear by Crown Prince Abdullah when he met the heads of oil companies in Washington, is the downstream infrastructure and the plants in diverse utilities and industries that use gas and that will generate output and employment growth.

In short the oil companies want an involvement in a sector that Saudi Arabia does not really want to grant even if it agreed in the end to some concessions. And Saudi Arabia wants investments in sectors which are not of real interest to the oil companies even when they express a conditional willingness to do the job.

To be sure, in most relationships the parties involved have different objectives and views, but for the relationship to be fruitful there must be a fundamental commonality of interest. In our case, the discovery of a common ground on which to build a solid and sustainable long-term agreement is made very difficult by the very pronounced (and indeed very unusual) asymmetry of the respective positions.

The companies are prepared to surmount their reluctance to invest in the utility plants if they can obtain a risk free return on their capital equivalent to the expected returns from their projects elsewhere. This stance has the merit of being perfectly rational from the companies’ standpoint (given that their resources have profitable alternative uses), and the drawback of making the scheme far too expensive for Saudi Arabia.

Saudi Arabia surmounted its reluctance to opening the upstream sector by limiting the concession to natural gas. But gas for domestic use is not terribly attractive to the companies. Their interest in gas lies in exports (which are not part of the scheme) and in the liquid contents which can be indeed sold in international markets. In other words the interest in gas lies in oil.

This last point leads us to the heart of the matter. As stated earlier on, although gas is different from, and should not be confused with, oil these two fuels are related to each other in a variety of important ways. In countries endowed with both oil and gas resources, oil and gas policies and oil and gas development should be designed in the same framework because of the impacts that the gas policy may have on oil and vice versa.

Within a unified framework where all the links, reciprocal impacts and trade-offs can be taken into consideration the main hydrocarbon developmental issues can be raised and assessed. Looking at oil and gas separately as if oil or gas, each in turn, did not exist is bound to lead to inefficient outcomes.

Some of the important issues that can be raised in this context are as follows:

(1) Should gas be developed for export or for domestic use? At the moment domestic demand for gas is the priority. Once this demand becomes satisfied thanks to new gas investments, the export issue should be seriously considered. Arguments sometime put forward against developing gas for export are that unit revenues for the government are much greater for oil than gas and that increasing gas supplies in the international market is at the detriment to the share of oil. It would be worth examining the merits of a counter argument which states that gas exports from Saudi Arabia would compete with other gas supplies and not with Saudi oil. Another counter-argument is that Saudi Arabia should diversify its hydrocarbon portfolio and establish a position for the long run in the ever expanding international gas market. The answer to these questions requires research.

(2) Given that Saudi Arabia’s oil resources are immense should crude oil that is available at very low cost be used wherever possible to fuel utilities instead of investing expensively in gas? Again this question can only be answered with an assessment of (a) the benefits of diversification relative to the cost differentials between crude oil and gas use and (b) the opportunity costs of increased domestic oil consumption of oil that will reduce the oil export potential given that OPEC policy is in terms of production not export quotas.

(3) In export markets the closer competitor to oil is not dry gas but the liquids derived from a gas development. Although gas liquids are not included in OPEC quotas increased supplies have an impact on the market and therefore on prices. The question is at which point does this impact become significant?

Having argued that oil and gas developments, as well as all other oil and gas policies, should be designed and assessed within a single framework, I would like to go further and suggest that they should also be studied within the broader framework of Saudi Arabia’s economic development strategies.

Hydrocarbons are Saudi Arabia’s most important resource. Much depends for the economic well-being of the country in both the present and the future not only on the revenues derived from exporting oil, also on the judicious use of hydrocarbons within the domestic economy. Priority for the domestic use of gas should be given to sectors where gas has no good substitutes (certain petrochemicals) and only when this demand is satisfied should it be supplied to power and water plants where crude or fuel oil can be used. Gas and oil are no doubt important for a range of industries but Saudi Arabia’s comparative advantage is in supplying these abundant resources at favourable prices to the country’s infant industries. The key question, here, is whether foreign investors can supply these fuels at a lower cost to the country than its national corporations. Only rigorous calculus can shed light on this question.

But the most critical issue relates to Saudi Arabia’s leading role in the world petroleum market. Much depends for both Saudi Arabia and the world on the ability to perform this role efficiently. The oil companies benefit themselves from the role played by Saudi Arabia in defending the oil price. This is why all oil and gas policies, all strategies involving national corporations or foreign investors, must be rigorously tested against this fundamental criterion – their possible impact on Saudi Arabia’s role in the world petroleum market.

By: Robert Mabro