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Saudi Arabia’s US$50bn First Step Towards Sustainable Energy

The Saudi royal family has been vocal about its plans to diversify the country’s economy for years. As internal energy demand rises sharply, the multibillion tender for a series of solar and wind projects marks one of the first concrete steps taken by the Kingdom towards sustainability.

Feb 24, 2017 // 1:56PM

Saudi Arabia is looking for bidders for fresh initiatives that will see 700 megawatt wind and solar power plants built, part of a US$50bn push to generate 10 gigawatts of renewable energy by 2023. The announcement was made by the country’s Energy Minister Khalid Al-Falih in mid-February, and is part of a much wider 2030 Vision laid out by the country’s rulers.

Despite some success of the Saudi-driven cross-OPEC oil production cuts, which lifted deflated oil prices towards the $60 per barrel mark, the country’s balance remains in the negative. The deficit shrank to SAR297bn (US$79bn) in 2016, from a record SAR367bn gap in 2015, a drop from 15% to 12% of the GDP, according to Trading Economics. That was below the government's initial 2016 budget projections, which forecast a deficit of SAR326bn. The new target is to balance the budget by 2020.

In the meantime, rapid population growth is driving domestic energy consumption ever higher. About 38% of the Kingdom's oil and gas is consumed domestically, with some estimating the consumption rate could double by 2030.

“The key here is that energy consumption in Saudi Arabia has been rising quite sharply over the past few years and that has eaten into the country’s oil exports,” commented Middle East economist for Capital Economics Jason Tuvey. “Notwithstanding changes in prices, that has impacted the Kingdom’s revenue stream, which is less than 50% of what it was three years ago.”

As a result, Saudi leaders are increasingly inclined to move towards reducing domestic energy consumption to leave more oil for export, as well as powering through with diversification from fossil fuels by carrying out reforms in the public sector, reducing oil tax benefits, and developing alternative sources of energy and income.

“This [project] marks the starting point of a long and sustained programme of renewable energy deployment in Saudi Arabia that will not only diversify our power mix but also catalyse economic development,” Al-Falih said in the statement.

While similar initiatives have been launched – and fizzled out – in the past, experts now appear to be more convinced by the Saudi leadership’s commitment to the cause, irrespective of the near-term oil price dynamic.

“I think that it is a longer-term strategy,” Tuvey noted. “So, if oil prices drop again, they may have to reassess the size of these commitments and find other sources of funding – for example, the debt markets – but are likely to continue down this path.”

OPEC production cuts

This drive towards sustainability is spurred on by medium and long-term concerns about commodity prices. On the one hand, the OPEC production cuts have been more successful than many anticipated. OPEC in January delivered record compliance of over 90% with its output curbs, according to estimates from the International Energy Agency.

But adherence to the deal has been mixed among OPEC members, with BMI Research, reporting a compliance rate of just 40% in Iraq, OPEC's second-biggest producer, and insufficient cuts by the UAE and Venezuela. Producers outside OPEC have been even less cooperative, with reduction levels initially as low as 40%, although that was later revised to over 60%.

Some countries are finding other ways of circumventing the agreement. Russia has been implementing cuts gradually, meaning a drop of only around 50% of initial expectations, and, by hiking oil exports (which is technically not prohibited by the agreement), has actually managed to overtake Saudi Arabia as world’s largest crude producer.

The return of US shale producers to the market has stalled the rally in recent months, despite continued downward pressure on the supply side. Since October, the baseline month for most OPEC cuts, US producers have hiked output by almost 500,000 barrels per day, Energy Information Administration data show.

All these factors combined have prompted some analysts to question the longevity of recent positive shifts in the market.

“In the coming months, these tensions will increase and we may see more countries try to cheat on the agreement – Russia, for example, historically doesn’t have a great track record, having reneged on numerous similar agreements before,” Tuvey suggested.

And if non-OPEC countries fail to comply as OPEC does, the Saudis are unlikely to extend the deal, in which case, prices could drop back into low 30s, according to some estimates.

“Saudi Arabia is still one of the biggest exporters in the world and wields a lot of power, but in the past few years we’ve seen shale become just as responsive to swings in oil markets. So, it is a case of Saudi’s role slowly fading – with the recent recovery US producers have been able to carve out a bigger stake in the market, and the Kingdom is well aware of it,” Tuvey concluded.

With uncertainties hanging over the oil market and over Saudi Arabia’s willingness to budge and, potentially, even become a “swing producer” – a label the Saudi leadership loathes – it is still too early to tell what shape the Saudi economic transition will take. But one can speculate.

Alternative sources of income

As the long-time leader and still the most powerful player in the oil market, Riyadh will seek to squeeze every drop from the fruit that sustained its prosperity for decades. Even as it seeks to diversify away from oil, the commodity – and revenues from it – will provide the basis for this process.

Developing the credit and equity capital markets further is central to its long-term aspirations, and the eagerly anticipated IPO of the state oil giant Saudi Aramco could be the two-trillion dollar boost (a highly optimistic figure, some analysts suspect) that is needed to launch Saudi Arabia further into international markets than it has ever been before.

The terms are still far from clear: Will it be a partial flotation or a closed transaction? How will the infamously secretive company be valued as it opens up? What factors will dictate the timing of the transaction? As time delivers clearer answers to these questions, there is no doubt the privatisation is bound to provide a safety cushion for the sovereign to carry out the reforms that it needs, and help encourage more institutions to become more outward facing – potentially a huge boon to international banks operating in the Kingdom.

Unloading the public sector’s dominance in people’s lives (and purses) will be key, a monumental and challenging shift.

“They have a lot of hurdles to overcome to make this diversification successful, for sure," Tuvey admitted. “They need massive education system reforms, to encourage domestically-focussed firms to shift towards exporting and expanding globally. The public sector is still very heavy, so more privatisation is needed.”

The economist points to two main thrusts that can help achieve this: incentivising firms to move away from relying on government contracts, as well as expanding globally whilst maintaining high wages for workers – perhaps, as the IMF suggested, through wage subsidies. That, however, requires equipping and re-skilling Saudi workers, who for many years have been able to get high-wage jobs in the public sector with relatively relaxed working conditions, which is no easy feat.

Some progress is already being made. Over the past year, the government froze major building projects, cut cabinet ministers’ salaries, and imposed a wage freeze on civil servants to cope with soaring budget deficit.

But that will not be enough. The Kingdom will need to attract foreign investment and develop its financial sector. In January, the Cabinet approved an IMF-backed value-added tax to be imposed across the Gulf states (which enjoyed a heavily subsidised partnership in the past). It is expected to help broaden the country’s investor base and make its debt more appealing to investors.

Last year’s record breaking US$17.5bn sovereign bond was extremely successful and could open up a pipeline for further sovereign (and corporate) issuances. In late February, the Saudi government sent a request for proposals to banks for a planned US dollar Sukuk. Few would be surprised if this issuance also breaks records – this time, for Sharia-compliant instruments.

“If the Saudis want to, they will return to the debt markets with ease – their bond sale last year was considered a big success by the government and investors, the yields were quite low. They could keep those yields sufficiently low in potential new issuances because the government made considerable progress with fiscal consolidation and the balance sheet is still very strong. And we think that concerns about devaluation have now faded as well, so that premium is no longer an issue,” Tuvey said.

If these efforts eventually lead to a rebalancing of the budget and provide ample reserves, the government will have the financial cushion necessary to complete its reforms, develop solar and wind infrastructure, and successfully pivot to alternative energy resources – part of a much wider, crucial shift in the Kingdom.

In that context, the US$50bn cash injection certainly lays solid groundwork for further funding streams into renewables and economic diversification. But the much wider path to reform is riddled with challenges. The 2030 Vision is an admirable target, but the Saudi policymakers will need 20/20 vision to hit it.

Middle East Energy Islamic Finance Policy & Government

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