Steps Saudi Arabia must take to stretch its resources further

"If something cannot go on forever, it will stop," as the noted economist Herbert Stein said. This epigram applies very well to Saudi Arabia's fiscal situation.

"If something cannot go on forever, it will stop," as the noted economist Herbert Stein said. This epigram applies very well to Saudi Arabia's perilous long-term fiscal situation, analysed in a recent report from the investment bank Jadwa.

Jadwa identifies three converging, unsustainable trends. Government spending, essentially flat from the late 1970s to the early 2000s, is now soaring at 10 per cent or more a year, and was further boosted by King Abdullah's recent US$130 billion (Dh477.45bn) package. The large part of the budget devoted to government salaries is hard to cut without triggering discontent.

As well as domestic spending, Saudi Arabia is also absorbing the lion's share of GCC aid to various neighbours following the Arab Spring: 3 million barrels of oil to Yemen (worth some $300 million); $10bn promised to each of Bahrain and Oman; $4bn to Egypt; and $400m to Jordan.

Second, Saudi oil production capacity, about 10 million barrels per day (bpd) for the past 30 years, is unlikely to rise significantly. This may be pessimistic, given the giant reserves base, but Saudi Aramco has few near-term projects once the giant Manifa heavy oilfield is developed.

Opec faces growing competition from Brazilian deepwater fields, unconventional sources such as Canadian oil sands and US shales, and cheap, abundant natural gas. Demand in developed countries is shrinking; vehicles becoming more efficient. The producers' organisation will probably maintain its share of the global market but not increase it much.

Growing expenditures have led Saudi Arabia to favour a higher price than the $70 to $80 per barrel its oil minister described as "fair" as recently as June last year.

Yet the Saudis will have to balance their Opec quota against a resurgent Iraq, and perhaps a returning Libya and post-Chavez Venezuela. They could burn off some competition only by stepping up their own production substantially and lowering prices.

Third, domestic oil consumption is soaring because of low, government-fixed prices: less than $3 per barrel for power generation, and $0.16 per litre of petrol, compared with the UAE's (also subsidised) $0.47. Up to 1 million bpd is burnt for electricity and water desalination during the summer because of gas shortages.

With dramatically improved energy efficiency elsewhere, it takes Saudi Arabia 10 times more oil than the rest of the world to generate $1 of output. The result is that oil export revenues, some 90 per cent of the budget, will increase only modestly.

There is no immediate danger. Oil prices remain high, and the kingdom has virtually no debt and $562bn of foreign assets. But Jadwa forecasts the budget will be in deficit by 2014; by 2024, foreign assets would be essentially depleted and government spending would need to be financed with debt.

The obvious conclusion is that an oil-dependent economy is not sustainable: not because reserves run out, but because relying on petroleum alone raises a population's aspirations while generating only anaemic long-term growth.

What can the Saudi government do?

Costs for new gasfields are above current US prices. This implies that Saudi petrochemical plants, a key pillar of the government's economic diversification strategy, would not be competitive without subsidised inputs.

The same is true of electricity. Despite negligible progress to date, the King Abdullah City for Atomic and Renewable Energy plans ambitiously for solar and nuclear power to be the vast majority of the kingdom's energy supply by 2050.

But even if it delivers, Saudi Arabia has no competitive advantage over other countries in alternative energy. Solar, in particular, is much more expensive than gas-fired generation. And replacing most oil for transport implies that most vehicles would be electric - so who will be buying Saudi oil exports?

The missing piece of the puzzle is energy efficiency. Raising prices gradually to world levels would tame the explosive growth in consumption, reduce the strain on the budget, and lead Saudi industries to rely on technology and capabilities rather than government largesse.

Money saved in subsidies can be redistributed in targeted payments to low-income groups, or to all Saudi citizens; Brazil and Alaska have examples of such schemes.

Or rather than making government more bloated and expensive, private-sector employment of Saudis can receive incentives. Combined with a far-reaching reform of the education system, the country might start the slow march to an economy not dependent on petroleum, or its close relatives such as chemicals.

Yet the prospects for such visionary moves seem dim. The crisis is still too far off; the lure of easy oil spending too strong; the required changes too radical, demanding deft execution untypical of the Saudi state.

Although the current system cannot last forever, Machiavelli cautioned that: "There is nothing more difficult to take in hand, more perilous to conduct, or more uncertain in its success, than to take the lead in the introduction of a new order of things."

Robin Mills is an energy economist based in Dubai, and the author of The Myth of the Oil Crisis and Capturing Carbon