The political and economic structures of the Arab Gulf countries have been surprisingly resistant to change. The resilience of the “old political deal” between royal families and traditional elites — the ‘ulama’, tribal leaders, urban merchants and technocrats — can be attributed to three main factors. First, the institutional, tribal and commercial prominence of the traditional elites meant that they have been able to “deliver” popular support to the ruling families. Second, the Gulf monarchies have been able to shift from dependence on domestic groups for military protection to a dependence on foreign states. Treaties and military cooperation with the US and Britain have protected them against land or resource grabs by their larger and more populous neighbors. Third, oil revenues — the means to finance patronage — have held the system together.
In order to ensure the efficient distribution of these oil revenues, the ruling families have created state institutions. Government expenditures as patronage have flowed one way, while loyalty to the royal family has flowed in the opposite direction. The size and nature of the oil revenues have had other important consequences. They have given the ruling families of the Gulf much greater economic power than taxes could ever have produced. Massive state spending has made Gulf populations dependent on government-financed social programs. Moreover, because oil revenues are external to the system, they have made the ruling families less dependent on other social forces in each country than they had been before the development of the oil sectors. Finally, new state institutions have strengthened internal security, while oil revenues have given the Gulf states the means to buy external protection.
The “old deal” is being undermined on several fronts. The traditional elite is losing its effectiveness as urbanization and the emergence of large welfare states have diminished their authority. [1] More importantly, the financial resources which hold the patronage system together have dwindled as revenues have been stagnant over the past several years.
There is a widespread recognition in the Gulf that the status quo is unsustainable. Piecemeal attempts to shore up the political and economic system through selective reforms will prevent radical changes. They will not, however, prevent a gradual weakening of the economic power of the state and with it the ruling families. Moreover, the reforms will gradually increase the influence of the private sector, particularly if it is successful in securing strategic footholds in areas where the state has so far reigned supreme.
To prevent this shift in relative economic, and ultimately political, power in the Gulf, the ruling families will have to increase oil revenues substantially in a short period. This is unlikely to happen because world oil markets have become a hostile environment for Arab Gulf producers. Oil prices have never recovered from the 1985-1986 crash and Arab Gulf oil producers have lost the “market share battle.” In the short run, even small supply increases from non-OPEC and OPEC countries will force Arab Gulf exports to remain at current levels. Over the long run, huge increases from Iraq and the Central Asian states may rob Arab Gulf producers of the increments in increased global demand they thought would accrue to them.
The smaller Arab Gulf countries, notably the UAE, Qatar and Oman, have reacted to stagnating oil exports by investing in gas production and exports. The larger producers, however, have lagged behind in gas development either because of a lack of gas reserves (Kuwait) or available financial resources (Saudi Arabia). The development of Saudi Arabia’s gas resources is inevitable given its enormous appetite for electric power, desalinated water and petrochemical feedstocks, all of which require gas inputs. To do so, however, it will have to allow private firms (Saudi and foreign) to enter this strategic sector of the economy.
Developing gas is fundamentally different from oil and has important domestic political implications. Private sector involvement is needed, whether foreign or domestic, to meet capital costs, to provide technological expertise and to help secure markets. With this involvement comes exposure to international standards of financial accountability, forcing a curtailment of wasteful government expenditures. Moreover, because the payback period for gas projects is longer than for oil projects, global investors will continue to scrutinize this sector well into the future.
Global Oil Markets
When oil prices crashed in the mid-1980s, producers with a longer-term outlook argued that demand would rebound in the industrialized West and grow rapidly in the industrializing East. Moreover, they believed that high-cost oil producers that had flooded the market in the early 1980s, undermining international prices, could not sustain their output at lower prices and eventually would have to cut production. The large Arab producers hoped that these developments would provide them with an ever-increasing share of global demand.
In 1988, the collapse of the Soviet economy led to nearly a 5 million barrel per day (bpd) decline in its crude oil production. In 1990, the international embargo on Iraq after it invaded Kuwait led to a decline of nearly 3 million bpd in crude oil on world markets. But, even these two market-rocking developments did not help large Arab Gulf producers preserve their market share. Saudi Arabia was able to make up for part of the reserve loss by raising its output by 3 million bpd. Kuwaiti output, also knocked out by the UN embargo and later by Iraqi sabotage, rebounded to 2 million bpd in the early 1990s, nearly 700,000 bpd higher than pre-invasion levels. Adding small increases by the UAE, Qatar and Oman, the Gulf has hiked its output by 4.8 million bpd since 1988. The region, therefore, only took one third of the incremental demand increases of 12.1 million bpd between 1988 and 1996.
The remaining demand was met by two major sources: non-OPEC producers, particularly the North Sea, and other OPEC producers, namely, Venezuela and Algeria. A combination of technology and better terms offered by the UK and Norway have kept North Sea crude oil output rates rising. [2] Developments within OPEC are more interesting. In response to domestic financial constraints and given the prospect of falling oil production and revenues, some of the poorer OPEC countries invited foreign multinationals back to assist in raising domestic production capacity. More than the intra-OPEC rivalries over production quotas and prices, this was the most serious threat to an organization created to provide a united front against the major international oil companies. By the early 1990s, it was clear that the non-Gulf OPEC members saw their future outside the organization, particularly since Gulf producers dominate OPEC and often block OPEC-mandated market share hikes for the smaller, more financially constrained producers.
Algeria was one of the first OPEC member states to change its foreign investment law. Despite the worsening political situation, the large unexploited oil and gas resources in the south lured a large number of foreign companies to invest in Algeria. An even more threatening move was made by Venezuela. With little fanfare, Petroleos de Venezuela pushed through a phased domestic restructuring program allowing for the reentry of foreign oil companies. With new capital flowing in for the first time since the nationalizations of the 1970s, the company was able to invest in refining capacity in overseas markets. By 1997, Petroleos had become the largest refiner in the US through its ownership of Citgo. it made similar moves into the market of other South and Central American countries.
World Market Shares
Even though they are linked through information networks that communicate jitters, world oil markets are quite segmented by region. Countries in the Atlantic Basin (including the Mediterranean) and the Asia/Pacific regions are all net importers of crude oil. The Gulf is the major exporting region in volume and until recently had been able to “swing” between Asia and the Atlantic/Mediterranean. In the late 1980s, Arab Gulf countries expected that steadily rising energy needs in both regions would increase demand for Gulf oil. Increased demand in the Atlantic Basin however was met by suppliers in the North Sea, Venezuela and Colombia. In North America, Petroleos’ purchases of refineries created “dedicated buyers” of Venezualan crude and effectively shut out crude originating in the Arab Gulf.
This left the Arab Gulf producers to concentrate on expanding their share of the Asia/Pacific market. Rapid economic growth and policy changes in Asian countries — particularly India and China — led to an enormous increase in petroleum product consumption, much of it met by Middle East supplies. Fine-tuning supply according to specific domestic needs, however, requires that refineries be closer to the consumer than the producer. Asian policymakers, therefore, have determined that Asia will need to add nearly 5 million bpd of new refining capacity to meet rising demand.
Arab Gulf producers view these new Asian refining needs with great interest. Buying into or building stable and protected markets from scratch could secure for them a situation similar to that of the Venezuelans in North America and minimize competition for markets from Iraq (when the UN embargo is lifted) and the Central Asian states (once export pipelines are built).
Kuwait had been eyeing Asian refineries after having developed an extensive network of refineries and gas stations in Western Europe under the brand name Q8. After the Iraqi invasion, however, the Kuwait Petroleum Company was forced to divert funds earmarked for Asian investments to rebuild the domestic oil sector. In the early 1990s, with Kuwait and Iraq temporarily out of the crude market, Saudi Arabia rapidly picked up several pieces of Asian refining capacity, namely a portion of the South Korean refiner Ssangyong and outright ownership of the Petron refinery in the Philippines. Saudi Arabia’s attempts, however, to secure parts of the Japanese refining industry — the real prize — failed, mainly for political reasons. Likewise, it was unable to gain a foothold in China because Sinochem, the government refining company, demanded that Saudi Aramco pay for substantial social benefits for workers currently supported by the Chinese company. In other Asian countries such as India, subsidized domestic prices which render refining projects unprofitable, have discouraged the Saudis and Kuwaitis from investing. As of mid-1997, despite many announcements of Saudi, Kuwaiti and Omani joint ventures or investments in the Asian refining sector, no solid deals were in the offing.
The pressure to secure market share for the Gulf Cooperation Council (GCC) producers will mount in the next several years. Their greatest competitor in the long term is Iraq. On the eve of the invasion of Kuwait, Iraq was pumping just over 3 million bpd. After the Gulf war, its output fell to around 600,000 bpd, sufficient to meet domestic consumption and a trickle of exports to Jordan and Turkey. Since December 1996, Iraq increased its exports under UN Security Council Resolution 986, which makes provisions for Iraq to sell $2 billion worth of oil to pay for food and medicine imports after deducting reparations and other payments.
This “humanitarian oil” was relatively easily absorbed into the Mediterranean market early in 1997. In what may be a dress rehearsal for the “bigger” return of Iraqi crude to the market, international oil prices fell some $4 to $5 per barrel when Iraqi supplies returned to the market. Moreover, Arab Gulf countries were once again restricted to producing at levels they agreed to nearly three and a half years ago at the March 1994 OPEC meeting. Once sanctions are removed from Iraq, it is not inconceivable that that country will be able to produce around 3 million bpd almost immediately and export nearly 2.5 million bpd once port facilities at Umm Qasr are upgraded or rebuilt. Most of that crude will flow into the Asia/Pacific region and encroach upon Arab Gulf market share.
Competition for the Arab Gulf countries will also come from the large oil producers of Central Asia and the Caucasus, once they develop export routes to world markets. This is unlikely to happen very soon. Russia has actively blocked exit routes from Azerbaijan and Kazakhstan (the two largest potential oil producers of the region) through its own territory and through Armenia and Georgia to Turkey. The US has effectively banned US oil companies from investing in Iran and threatened non-US oil companies with sanctions if they build oil or gas pipelines through Iran, the most logical exit route to the Asia/Pacific region.
Beyond the next five years, however, it is quite conceivable that Central Asian and Iraqi oil will reach Asian markets, which could force the Arab Gulf producers to limit their own production. Saudi Arabia in particular could attempt to increase its market share by raising output, thereby abandoning its role in global oil markets as “swing producer.” This could be dangerous for the kingdom because it could mean having to live with lower oil prices. Although the actual production costs for the Gulf producers may be extremely low by international standards, if the socioeconomic costs of maintaining an economy so dependent on oil revenues are factored in, these countries become very “high-cost” producers. Fears that an economic meltdown would result from a rapid fall of oil prices have restrained Arab Gulf countries from aggressively pursuing higher market shares.
In the medium to long term, since Gulf economies are unlikely to reduce their dependence on oil revenues, cautious economic policies will most likely restrain them from raising oil output. This means stagnant oil revenues in nominal terms, falling oil revenues in real terms and therefore a continued slide in oil expenditures per capita. The reduced direct contribution of the Arab Gulf states to the incomes of their citizens will decrease the ability of the ruling families to maintain political loyalty.
Gas Development
Given the dim prospects for raising oil revenues in the medium term, several Arab Gulf countries have embarked on ambitious gas development projects to diversify their export earnings. The UAE was the first to invite foreign gas companies to build its Liquid Natural Gas (LNG) facilities in the 1970s and was followed in the 1990s by Qatar, whose LNG shipments to Japan started in 1997. Shell is building Oman’s LNG facilities, while Total is setting up Yemen’s LNG export program.
The economics of gas development are different from oil development. Gas development requires substantial capital outlays mainly because of the need to develop distribution and export facilities (liquefaction units and/or pipelines). Given these capital costs, the period before projects begin to generate net revenues can be long. Once they begin, however, the income is steady — like a long-term annuity — unlike oil revenues which peak rapidly and then decline as production falls. Because of the high capital costs and long gestation period, such projects require substantial gas reserves and creditworthy customers who can pay for the gas over the long haul. [3] The capital costs associated with gas development have proven prohibitive for some of the relatively poorer Gulf governments (namely Qatar and Oman). As a result they have had to open up channels for multinational investment.
Investment in gas development may produce unanticipated sociopolitical consequences. Large foreign investments have exposed these countries, for the first time, to international credit assessments. In order to “live within their means” governments must cut expenditures, which strikes at the heart of domestic politics. Just as important, especially in Saudi Arabia, gas projects have opened up the hydrocarbon sector to the prospect of domestic private investment. Large Gulf companies with substantial capital resources are angling for a stake in a sector that has traditionally been out of bounds to them. Although not likely to affect significantly the smaller Gulf countries, it will become a major factor in Saudi Arabia.
In strictly economic terms it might be easier for the Saudi government to invite foreign companies in, as Shell, Agip and other multinationals are suggesting. Three factors, however, are likely to lead to Saudi private sector predominance. First, inviting foreign firms back into the kingdom without the participation of the domestic private sector could constitute a major political embarrassment for the government. Second, the private sector has not enjoyed significant lucrative opportunities since the boom years of the early 1980s. Projects of this sort will be a major bonanza for a key constituency of the ruling family. Moreover, from an economic point of view, the repatriation of private capital it will produce will boost the balance of payments and the overall economy. Third, there are a number of new Saudi oil and gas companies that are joint ventures between merchant families and members of the royal family. These companies have invested in hydrocarbons in Yemen, the Central Asian republics and elsewhere. They view the opening of the domestic gas sector as an excellent opportunity to tum political connections into commercial success. Nimr and Delta, two such companies, are lobbying for the opening of the gas sector, while other major companies are gearing up to participate in the bonanza.
The idea of the “upstream” gas sector being opened up to private capital is still considered radical in the Gulf, especially in Saudi Arabia. Recent developments in the power sector, however, do point in that direction. The Saudi industry and electricity minister recently reclassified power generation as an industrial activity, [4] thereby opening up enormous investment opportunities for private sector firms.
It is logical that the next step in this process of denationalization will begin “downstream” — power generation in the gas value chain — proceeding to “midstream” pipelines and gas distribution and finally all the way “upstream” extracting resources from the ground. The latter is the most lucrative part of the gas chain and the most coveted by the private sector.
Changes in the international oil and gas industry do not portend radical shifts in political power in the Arab Gulf states. A gradual transfer of economic power, however, from financially constrained states to their private sectors, which will gain control of key economic sectors, will ultimately mean a broadening of the political system. In the short run, this does not translate into popular politics. It does, however, point to oligarchical rule rather than the monopoly the ruling families of the region enjoyed after the rise in oil prices during the early 1970s.
Endnotes
[1] See Fareed Mohamedi, “State and Bourgeoisie in the Persian Gulf,” Middle East Report 179 and Fareed Mohamedi, “Saudi Arabia’s Crunch,” Middle East Report 185.
[2] North Sea output rose from 3.5 million bpd in 1988 to 5.9 million bpd in 1996. Norway’s oil production rose from 1.1 million bpd to 2.8 million bpd, propelling it to the number two spot in the world in crude oil exporting.
[3] If commercial banks and export credit agencies are financing these projects, they require gas purchasing guarantees from the consumer to ensure that the loan payments will be met.
[4] Middle East Economic Digest, September 12, 1997.
