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Wed 27 Apr 2016 05:08 PM

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Why Saudi Arabia will struggle to kick its addiction to oil

Transforming the economy is an enormously ambitious undertaking fraught with considerable risks, says Reuters analyst John Kemp

Why Saudi Arabia will struggle to kick its addiction to oil

"King Abdulaziz and the men who worked with him for the establishment of the state did not depend on oil and they established the kingdom without oil, and they ran this state without oil, and they lived in this state without oil," Saudi Deputy Crown Prince Mohammed bin Salman said in an televised interview on Monday.

The deputy crown prince criticised the kingdom's subsequent "addiction" to oil which has "disrupted the development of many sectors in the past years" implying this was a relatively recent problem.

The prince claimed his national transformation programme would enable the kingdom to "live without oil" as early as 2020 ("Transcript of Prince Mohammed bin Salman's Interview", Al Arabiya, April 25).

But if modern Saudi Arabia was founded by conquest and the skilful statesmanship of Abdulaziz, it has been held together by the revenue from oil, even more than conservative religion.

Distribution of oil revenue to client groups has formed the foundation of the state from its earliest years and shaped the contours of the economy and society.

Sharing oil wealth in exchange for popular submission to absolute monarchical rule has always been central to the social contract between the ruling Al Saud and the kingdom's population.

Transforming that contract so that it does not centre on oil is an enormously ambitious undertaking fraught with considerable risks and with an uncertain chance of success.

Before the discovery of oil, Saudi Arabia was a desperately poor country, with a largely subsistence economy and depending on the annual pilgrimage to Mecca and Medina.

The modern state was assembled through a series of conquests between 1902 and 1926 and proclaimed as the unified Kingdom of Saudi Arabia in 1932.

At the time, the only government revenue came from customs duties, pilgrimage taxes and tithes. From the start, the state was short of money and desperately looking for additional sources of income.

One reason the kingdom granted a concession in 1933 to prospect for oil to the U.S. company Socal rather than Britain's Iraq Petroleum Company was that Socal was prepared to offer more cash up front and loans to be repaid from future production ("A king and a concession", Aramco, 1984).

In 1938, the government's revenue amounted to just $7 million, according to Arthur Young, the U.S. financial expert sent out after World War Two to help set up the Saudi Arabian Monetary Agency.

The first commercial oil discovery was made the same year and the kingdom received $340,000 in oil royalties ("Saudi Arabia: the making of a financial giant", Young, 1983).

Hopes of an immediate bonanza were delayed by the world war, which led to the postponement of exploration and development work. But once the war ended, production and oil revenue began to ramp up.

The kingdom's annual oil revenue surged from $340,000 in 1938 to $10 million in 1946, $57 million in 1950, $334 in 1960, $1.2 billion in 1970 and $84 billion in 1980.

Even before oil, gift-giving was an important element of the compact between the ruler and his subjects, and the need to demonstrate generosity frequently strained royal finances ("Two kings in Arabia", Bullard, 1993).

Once the gusher of oil revenue arrived, it provided the scope to co-opt almost all social groups and make them clients of the state.

Tribal groups were granted generous state subsidies and recruited into the national guard. Hundreds of thousands of other citizens have been put on the payrolls of the armed forces and various ministries.

Money could also be used to settle tensions within the royal family by allowing each senior prince to be given their own vast and essentially autonomous bureaucratic fiefdom.

Oil wealth enabled the state to avoid levying income and other taxes and to subsidise the provision of basic services including water, electricity and gasoline.

Oil wealth enables Saudi Arabia to maintain more than 250,000 men under arms and run the world's third-largest defence budget ("Princes, brokers and bureaucrats: oil and the state in Saudi Arabia", Hertog, 2010).

More or less everything in modern Saudi Arabia depends directly or indirectly on oil.

From the very beginning, however, expenditure tended to run ahead of receipts. "When oil production and spending grew after the war, spending grew even faster", according to Young.

"Governments, like individuals, have the urge to spend more whenever income suddenly increases."

In 1949, despite oil revenue amounting to $39 million, the government was struggling to pay its bills, the first of several budget crises in the subsequent decades.

The kingdom's history from the 1950s to the 2010s has been a series of oil-fuelled booms followed by painful adjustments when oil prices fell and revenue shrank.

Periodic crashes in the oil price and state revenue have brought periodic calls to adjust the social compact between the state and its citizens.

Prince Mohammed, effectively the kingdom's top economic policymaker, is not the first ruler to complain about the country's addiction to oil ("Saudi reform efforts wax and wane with oil prices," Reuters, February 2016).

"The GCC governments and peoples should realise that the boom period is over. We must all get used to a certain type of lifestyle that does not rely entirely on the state," then-Crown Prince Abdullah warned back in 1998.

"The upcoming period needs the private sector to assume part of the responsibility which has up until now been carried by the state."

Abdullah was speaking at the GCC summit in Abu Dhabi in December 1998, just as oil prices were hitting rock bottom at the end of a long period of stagnation through the late 1980s and 1990s.

But the impetus to reform was lost as oil prices and revenue soared again in the 2000s.

The problem is that when oil prices are low the revenue needed to accomplish the transition are scarce and the difficulties can appear daunting. When oil prices rise, it has been easier to postpone difficult decisions.

Prince Mohammed's "SaudiVision2030", adopted by the cabinet and published on Monday, is essentially a diversification strategy which aims to move the kingdom away from dependence on oil revenue (April 2016).

It is closely modelled on an earlier and even more comprehensive study by the McKinsey Global Institute entitled "Saudi Arabia beyond oil: the investment and productivity transformation" (December 2015).

The aim is to shift the economy away from an almost exclusive reliance on oil (and the spending of oil revenue) to develop other sectors such as mining, manufacturing, retail, tourism, pilgrimage, and healthcare.

The strategy also envisages developing the country as a logistics hub for East-West trade, becoming a financial services centre, localising defence manufacturing, and development more small and medium-sized enterprises.

The prince has stressed that much of the transformation can be achieved through improvements in government efficiency and restructuring (termed "qawam" in the vision document).

There is no doubt Saudi Arabia needs to undertake these changes, and a younger generation of policymakers has brought an increased sense of urgency to tackling the problems.

But describing the kingdom's problem as an "addiction" to oil, as if it was incidental, rather than a fundamental part of the political, social and economic structure, risks understating the challenge involved.

External commentators have focused on the valuation likely to be realised from a part-privatisation of state-oil company Saudi Aramco but that is the least of the problems.

True diversification requires developing industries which have nothing to do with the extraction of oil and spending of oil-related revenue.

Pilgrimage is a natural choice but the business environment for other sectors such as finance, logistics and manufacturing remains forbiddingly tough.

Saudi Arabia's rulers must construct an attractive place to do business when companies currently have much simpler alternatives such as the United Arab Emirates.

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Sal P 3 years ago

All of these ambitious plan could be only partially achieved if a big cultural change is adopted by Saudi society.

Eco FutureLab 3 years ago

All this money and tunnel vision on industry and technology.
Industry and technology backbone of any nation, why import when you can produce.

If you want to sell in Saudi, you can produce it in Saudi

Heinrich Klier 3 years ago

A view over the border would certainly help. The UAE shows the way. Saudi Arabia has to promote a cultural change first (like mentioned by SalP/see above). However, it won't be easy due to all the mutual debendencies causing turmoil when suddenly interrupted. It's a delicate and dangerous operation. Good luck!

Telcoguy 3 years ago

Actually not, UAE is still very dependent on oil. Real estate and tourism sectors have a strong GCC component that is going to suffer (not to mention Russia)
Plus UAE is a small country in terms of population while KSA is substantially larger. This brings different opportunities and different challenges.
Regarding the cultural changes, well... you find a much more substantial participation of locals in the labor force in KSA than in UAE, it is not such a clear one way street as you seem to think.

UAE, specially Dubai played to its strengths but all GCC countries are dangerously dependent on a single product.
It is going to be a rough ride for sure.

WHJ 3 years ago

I agree with Heinrich. The UAE is a model to be emulated in the region. It enjoys a diversified economy and has managed to "sidestep the worst of the collapse in oil prices". Its economy grew by 3.1% in 2015 and is expected to grow by 2.5% in 2016.
Furthermore, if you look at Dubai on a stand-alone basis, a recent report published on AB stated that it's economy grew by 4.1% in 2015 and " if Dubai continues to push forward.....it seems as if the [real estate] market is ripe for a rebound".
Hardly the doom and gloom many on this forum had been professing.

Simon 3 years ago

It wasn't so long ago WHJ that you claimed that Dubai would not be hurt by the decline in Oil and that the Russian effect, would have no effect.

Personally, I do not buy into the Dubai insulated new-economic model. Debt levels continue to increase and Dubai relies too heavily on new international money to make every facet of its new-economic model work.

When the rest of the world slips, which is plain to see it is doing, that new money will dry up and Dubai will be hit just like before...and that is where the real issues lie...not in Dubai.

I concur with Telcoguy, the worst is yet to come.

Telcoguy 3 years ago

@Simon, my point is more related to the fact that the solution that may work well for UAE simply do not work for a country that has roughly 22 times the population, it seems that the scale factor does not matter in WHJ's alternate reality and I will not push the point further

UAE is in a great position to benefit from the opening of Iran economy, I have some difficulties imagining KSA doing that, but again I am not lucky enough to inhabit that alternative reality

Leaving aside its dependency on other oil countries, UAE non-oil economy is built around real estate and tourism and as such is labor intensive in low-added value jobs, again how would this work in KSA?

There are a number of steps that both economies should take, but I am sceptical they will take as they would involve some serious cultural changes, but thinking that the UAE path is the KSA path could only come from someone who rather takes a real estate broker report over World Bank's GCC 2016 economic outlook

WHJ 3 years ago

@Simon. The economic figures are there for everyone to see. Dubai's GDP grew by 4.1% in 2015, and according to the IMF, the IMF mind you, Dubai "is poised to record 3.7 per cent......- far exceeding the average GCC growth forecast at 1.8 per cent for 2016."
It may be true that Dubai's debt level is high but, to put things in perspective, so is the UK's (90.6% debt to GDP) and Spain's (101% debt to GDP), which is not necessarily a bad thing as long as debt is used to promote economic growth and expansion. From a macroeconomic perspective, "government debt can be thought of as future spending brought forth into present time".

WHJ 3 years ago

Telcoboy. The tunnel vision you so admirably apply to your argument is not surprising...maybe it is to james though.
UAE's economic diversification, which is the model that should be emulated in KSA, is not restricted to real estate and tourism. It is also trade, transportation, finance, construction, investments... "Saudi officials have been visiting the Abu Dhabi Investment Authority – which has more than $700bn invested in developed and emerging-market equities, fixed income, private equity, real estate and infrastructure – to see how it works".
I hate to break it to you hombre but there's a lot you need to learn about economic diversification beyond what you've learnt from reading el economista.