16 May When Saudi Arabia Abandons Oil. Now what?
Saudi Arabia has embarked on the impossible and intends to wean itself off its addiction to oil. What effect could this have on global LNG markets? Read on.
We’re not out of stones yet
Western business people would see nothing unusual about the Kingdom’s pivot on oil. All products have a life cycle, some are just longer than others. Our best-known products have experienced rapid take up, become a key part of the landscape, and then succumb to changing tastes, cheaper better alternatives, or technology obsolescence. As I see it, the Saudis think that it’s simply oil’s turn.
Imagine Saudi Arabia as super big company with 18m employees, 10 million contractors and one product. Here’s a few of the strategic questions that likely inform Saudi thinking on the future state of energy.
COP21 confirmed an international resolve to tackle climate change, and that resolve includes all the big economies. But modelling of global energy mix and climate change commitments say that post 2050 we need to reduce current hydrocarbon consumption by 40-70%, and strand the rest. What is your strategic response if you own the biggest pile of the cheapest hydrocarbons? Do you continue your old strategy to maintain high prices? Will that work?
Rapid decline of peer products
Other nations have taken note that to make a big move on carbon emissions, the fastest and easiest way is to eliminate coal. The US did this using the only viable fuel at the time (natural gas from shale). Other nations will follow, and if not using shale, they will certainly attempt the switch using renewables, pressured along the way by the green movement. But it won’t stop there – transportation fuels followed by natural gas are the next biggest emissions sources after coal (one of the reasons why Chevron resisted the call to join the carbon tax movement – once the tax is applied to one carbon source, why not apply to all, including gas and oil?). What is your strategic response when the most important and technologically advanced market successfully shifts off a key related hydrocarbon in a shockingly quick timetable? Could that happen to your product?
Product substitutes gaining traction
It’s helpful to consider who is the customer for crude oil and who is the consumer. The customer for crude oil is an oil refinery. No one else buys this stuff. Consumers buy the bulk of refined petroleum products, but only because we have personal petroleum powered transportation. What if consumers turn their backs on cars and SUVs of the petroleum variety? Car makers, ship makers and truck makers are all much closer to the real consumer, and they seem to all be championing their latest innovations, electric transport, which may not consume petroleum to the same degree.
We have learned to be wary of these small beginnings and where they ultimately go (consider personal computers and mainframes, email and postal services, home phones and mobile). What is your strategic response when your ultimate consumer starts flirting with alternatives that make your key product obsolete?
The supply of crude oil has also changed, from the dominance of conventional deposits (the Saudi supply), to the ubiquity of unconventional shales. Shale technologies that have enabled the US to crack open its shale gas resources will have the same eventual effect on oil, both in the US and in other nations. In addition, those same technologies can be applied to old and abandoned oil fields. Some researchers estimate that this could unlock many more millions of barrels of crude oil a day. Technology moves between countries and companies at light speed. What is your strategic response when your sole product, which was, until recently, kept scarce by your market actions, and therefore high priced, is now suddenly in super abundance and low price?
Poor strategic alternatives
The Saudis have gazed into the future when the price of their key product fell. One telling interview suggests the Saudis did not like what they saw – a rapidly draining treasury, continued wasteful behavior in the country, a lack of urgency in the population to embrace change. A quick check with their OPEC compadres would be revealing. Venezuela? Rapid inflation, food shortages, riots. Russia? Currency collapse, neighborly belligerence, economic stagnation. What is your strategic response in light of the lack of preparation and failed responses in these other key oil exporting nations? Are those viable strategies to emulate?
It’s a curious thing that these low oil prices have not actually triggered very much fresh demand growth. Economies around the world are flat. Governments heartily tax the refined product keeping its retail price high. The trusted formula, lower prices stimulates demand causing shortages, which begets higher prices, might be broken. What is your strategic response when your tried and true playbook for addressing lower prices (just wait it out) is no longer having the desired effect?
So. Governments around the world now reject products like yours because of their negative side effects and your product is next in line. Your sole product is at risk of being rejected by your ultimate consumers. Your channel customer (transportation makers) is trying to shift to new technology that renders your product obsolete. Your ability to keep prices high has failed because the product is suddenly abundant and will be for the foreseeable future. Your stand pat strategy is not working. What do you do?
Same old same old is not going to cut it. A new game calls for a new play. Here’s how the Saudi strategy is going to play out.
- As the lowest cost supplier in a shrinking market, go for market dominance and squeeze out as many competitors as possible. Exploit your lowest cost position by getting your most accessible reserves out now. Pull capital back from your high cost frontier projects in favor of your low cost supplies.
- Produce all out. There is no reason to carefully manage supply if the game is to move away from oil. Keep drilling when others are unable to. Invest in keeping production at maximum. Produce as much of the lightest crudes possible since customers will want less carbon-intense heavy crudes.
- Make up for any price-driven revenue loss by selling volume. Try to lock in customers to maintain their addiction. Invest in their economies. Use lower prices to increase switching costs, and prolong the transition to alternative technologies.
- Seize market share – as the others retreat move quickly to fill their void with your volume. Make investments in your customers (refineries) to tie them to your product – forward integration into the supply chain.
- Direct your future investments into new energies (leave one product lifecycle and move onto another).
- Just like any corporation, move in a new management team to execute what is a different strategy.
And out goes the Minister for Oil.
There are several geopolitical threads to this story, but save that for another time.
Implications for LNG
Natural gas is not oil, but I would take some lessons from this pivot.
Gas will come under the same pressure as coal and oil to reduce its carbon footprint. Sure, its contribution to global warming is a lot less, but the models suggest we need to keep gas in the ground too. The Green movement believes this, and will come after gas next. Note the green blockades in the US and Canada on LNG projects, gas pipelines and exports, and all around the OECD on oil and gas techniques like hydraulic stimulation. I would expect new LNG and gas project approvals to get harder to achieve for climate reasons.
Gas is suddenly super abundant too, because of shale (and not just in the US but in many other countries). Its on-going pricing should reflect that abundance. Short term and spot pricing will stay low. This will make it difficult to sanction LNG projects on purely economic grounds, and for existing projects to be economically successful.
The overall competitiveness of gas is at risk because the collapse in coal and renewables costs make switching to gas less economic. The switch from coal, when it happens, will first be to renewables to help deal with climate commitments.
The Asian LNG pricing model (where LNG prices are set with reference to an oil price) will now be structurally lower as the price of oil is lower. Future projects will find it harder to attract financing, but demand for LNG should strengthen.
Some nations are addicted to their gas exports, such as Qatar. There is no gas OPEC, but is it conceivable that Qatar could flood global markets with cheap gas so as to prolong the switch to renewables? In a sense, copying the Saudis strategy with oil? What is the appropriate response by companies participating in the LNG economy? Increasing LNG market liquidity makes alternative strategies viable.
In my view this move by the Saudis is a decisive acknowledgement by the hydrocarbon market leader that we are clearly in new times. Oil companies are on notice that their business models are quickly expiring. The legacy LNG business model and a specialty of Australia (we build costly LNG facilities to access high cost gas to supply rich markets) cannot avoid the fall out and will need to react.