Saudi Arabia: the operative word is austerity
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Is the Saudi local market oil demand winding down? Since 2015 it has slowed down culminating in the large 2016 recession and the motives are both cyclical and structural

While most of the analysis on Saudi Arabia tends to focus on its output policy, the Kingdom has been an important source of crude and petroleum products demand growth. Between 2003 and 2015, Saudi Arabia’s oil demand (including crude burn) grew in every year, with annual demand growth reaching a record level in 2014 of 208 thousand b/d. All oil products registered a positive growth, particularly diesel and gasoline, and increasingly fuel oil, mainly used in the power sector.

A progressive decline

Since 2015 however Saudi oil demand growth started to slow and in 2016 it took a big hit. Overall Saudi energy demand growth in 2016 was 0.5% compared to an annual average of 4.5% during the previous five years. For the first time in recent history, peak demand for electricity did not increase, while Saudi oil demand growth turned negative in 2016. The reasons for this slowdown are multiple, some of which are cyclical while others are structural. In face of lower revenues, the Kingdom has been forced to implement some severe austerity measures, which have had their adverse impact on the economy. Some key sectors have been hit particularly hard, such as construction, which contracted by 3% in 2016 as a result of reduced activity and delayed payments by the government, which put some of the biggest construction companies under severe financial pressure. The government has also slashed its capital spending which led to the cancelation of many big infrastructure projects. The impact of the slowdown in the economy has been felt mostly on diesel, which contracted year-on-year in almost every month of 2016 with an average yearly decline of 78 thousand b/d in 2016 compared to a growth of 26 thousand b/d in 2015. The substitution away from diesel in the power sector contributed to this decline, so did the fuel consumption by the transport sector, given that diesel meets more than one third of transport demand, mainly used by trucks for transportation of goods. Transport demand contracted by 3% in 2016 compared to an annual average of 6.5% in the last five years. One key element in recent reforms has been the adjustment in fuel prices. In December 2015, Saudi Arabia increased fuel and electricity prices, though from a very low base. It is difficult to disentangle the impacts of higher energy prices from slower economic growth on overall demand. This is even more complicated as Saudi Arabia has been implementing an aggressive energy efficiency programme. But gasoline demand dynamics can provide some clues. Given that gasoline prices in the Kingdom are still some of the cheapest in the world and given that gasoline demand is highly inelastic in the short term, especially in the absence of alternative modes of transport other than private cars, the change in gasoline demand in response to the price increase is expected to be minimal. But gasoline demand growth did slow down markedly in 2016, with 5 months registering year-on-year declines. This indicates that while price increases may have had an impact, most of the recent declines can be explained by slower economic growth and the squeeze in households’ incomes. Most telling is the decline in car import activity. Imports of new cars declined from 964 thousand units in 2015 to 725 thousand units in 2016 (i.e. a decline of around 25%) while imports of used cars declined from 67.7 thousand units in 2015 to 37.5 thousand units in 2016 (a decline of around 45%). The slowdown in economic activity and higher electricity prices had also been felt on electricity demand, which almost flattened in 2016. In addition to slower growth in electricity demand, liquid fuels consumption was also impacted by the increase in new gas supplies from the newly commissioned gas fields Hasbah (1.3 bncfd) and Alarabiyah (1.2 bncfd), which displaced crude burn in existing power plants. Saudi direct crude burn in the power sector averaged less than 0.5 mb/d in 2016, which represents a decline of 75 thousand b/d from 2015. The swing in crude burn during the summer of 2016 (from March to August) was less sharp at 342 thousand b/d compared to a swing of 0.5 mb/d in 2015. The increase in the relative price of diesel following the energy prices increases in December 2015, especially when compared to fuel oil and crude oil incentivized plant operators to reduce the use of diesel to the minimum possible.

Consolidation will come in 2020

Looking ahead up to 2020, some of the trends seen in 2016 will consolidate. In December in 2016, the Saudi government announced that it would continue with its austerity measures in an attempt to balance its budget by 2020. An important component of these adjustment measures is to increase energy prices, with some of these increases to be implemented in the second half of 2017. The impact of the planned price increases on energy demand between now and 2020 is potentially large. Unlike the first round of price increases back in December 2015, which were from a very low base, the expected new price levels will be high, constituting a larger share of households’ incomes and hence we expect to see a strong demand response. The rise in energy prices will adversely impact households’ incomes both directly, as energy is part of the consumer’s basket and indirectly as prices of other commodities that use energy for production and transportation will also increase. The compensation scheme designed by the government will not compensate fully for these declines in incomes. There is also a high risk of second-round inflation effects. Loss of purchasing power due to first and second round effects plus all the other austerity measures being implemented alongside such as introducing VAT and increasing administrative fees will lower economic growth and squeeze household incomes.  This would have adverse impact on the consumption of all fuels including fuel oil and crude burn, which do not enter directly into the consumer basket, but indirectly through the impact of higher electricity prices on electricity demand, which is expected to flatten for yet another year. So for 2017 and 2018, overall Saudi oil demand is expected to decline or stay flat oil, unless the economy picks up strongly, which is unlikely given the austerity measures in place although oil price recovery will help give a modest boost to the economy. The impact will be mostly felt on diesel (and on gasoline to some extent), allowing Saudi Arabia to put additional volumes of diesel on the international markets.

Investments in the electric sector are important

While the picture in the short term looks gloomy for Saudi diesel and gasoline demand, the impact of the expected increase in electricity prices and efficiency measures will not dent the long-term trend of rising power demand and the need to invest in expanding power generation capacity as population pressures persist and when economic activity picks up. The Ministry of Electricity and Water estimates that Saudi Arabia would need to invest in electricity projects over the next ten years to cope with rising power demand with the peak electricity to hit 90,000 megawatts (MW) in 2022 compared to the current installed capacity of around 70,000 MW. While the ramping up of the Wasit gas plant has reduced crude burn in the power sector, there are some doubts as to whether incremental gas volumes from Wasit can meet the additional gas-fired capacity coming online in both the power and petrochemical sectors. The next large non-associated gas project to come online, the 1.5 bcf/d Fadhili processing plant, has an expected start-up of late-2019, so will not provide additional gas volumes for some time. Given the pressures on gas supplies, natural gas is not expected to make a big dent in the share of liquid fuels in the power fuel mix for the next few years and if there is a rise in electricity demand, the level of liquid burning in the Kingdom between 2017 and 2019 will increase to satisfy that demand, before Fadhili can provide some respite. Any potential fall in liquids consumption will be mainly driven by the decline in electricity demand rather than by gas substitution, as lower electricity demand means that oil-fired plants will not need to run at maximum capacity with the government prioritizing gas fired plants. Gas imports could relieve the pressure on gas supplies and the Saudi Energy Minister Khlaid Al-Falih did not exclude the option of Saudi Arabia importing gas to boost the role of the fuel in the energy mix. But even if Saudi Arabia decides to go ahead with such a plan, this would take time, as the necessary infrastructure needs to be put in place and the Kingdom has to iron some issues regarding its WTO commitments as importing gas at a higher price and selling it domestically at a cheaper price could result in antidumping cases against Saudi Arabia. Saudi Arabia has also ambitious plans to increase the share of renewables in the energy mix, with the energy minister Khalid Al-Falih recently unveiling an ambitious plan to add 10 GW of new capacity. But bringing these projects online will take time especially that there is still no adequate regulatory framework in place to integrate renewables into the power system and to compensate the renewables IPPs.       

Growth, but at a slower pace

So in the short to medium term, liquids fuel consumption in the power sector will continue to grow, but at a much lower pace, as electricity demand slows down. What is more difficult to predict is how the shares of liquid fuels in the power mix will evolve between now and 2020. In the long term though, the demand for liquids in the power sector will continue to be squeezed from multiple sources: higher fuel prices, more aggressive efficiency programmes, new infrastructure and pipeline projects, new domestic gas supplies, potential gas imports, and plans to increase the share of gas and renewables in the power mix. This does not mean that liquid fuels will play no role in future of the Saudi power sector, but the high growth rates of oil consumption and crude burn that we have seen in the past decades are certainly behind us.