Saudi Arabia sets out strategy to reform subsidies and reduce domestic energy usage

In December 2015 Saudi Arabia launched a five-year energy subsidy reform plan aimed at reducing government expenditure and making the Kingdom more energy efficient at a time when revenues have been hit by low oil prices. With the Kingdom relying on oil for an estimated 73% of government revenues, maintaining the existing subsidy framework became harder to justify as prices fell throughout 2014 and 2015. “It is a commitment to seize the moment and take the right decisions to change our economy,” Adel Fakeih, the Minister of Economy and Planning, told The Financial Times in December 2015.

Belt Tightening 

On December 28, 2015 the Saudi government announced that the price of domestic energy would rise overnight. Petrol jumped from SR0.60 ($0.16) to SR0.90 ($0.24) per litre for high-grade Octane 95, and from SR0.45 ($0.12) to SR0.75 ($0.20) for Octane 91.

Natural gas prices increased from $0.75 to $1.25 per million British thermal units (Btu), while ethane prices more than doubled, from $0.75 to $1.75 per million Btu. Furthermore, the Ministry of Finance said that over the next five years it would significantly cut the subsidies available for water, electricity, kerosene and diesel. The International Energy Agency (IEA) has forecast 79%, 55% and 12% increases in transport diesel, industrial diesel and kerosene prices, respectively, over the next five years as part of the Kingdom’s subsidy rationalisation programme (see Economy chapter).

Despite the price increases, Fakeih told the media that residents would continue to pay considerably less than those elsewhere in the region, and that residents in the neighbouring UAE were paying 60% more for their petrol. Even so, the subsidy cuts and subsequent rise in prices will likely have an impact on Saudi Arabia’s residents and businesses operating in the Kingdom, though there is also hope that it could spur many to consider energy-saving options.

Subsidy Cost

For decades, cheap energy has been a major pillar of Saudi development. By keeping energy costs low, the Kingdom is able to target strategic growth areas and promote certain sectors of the economy, as well as pursue key social and political objectives. Yet, this has come at a financial cost. According to a report by Jadwa Investment, energy subsidies cost the Saudi government around $61bn in 2015, or 9.3% of GDP, although the opportunity cost of such subsidies decreased by 39% in 2015, as crude and crude-related product prices dropped steadily. The firm’s analysts estimate that the subsidy for diesel alone cost the Saudi government $23bn, or 3.5% of GDP, for the year. Whereas subsidies on petrol – which was available at the pump for the equivalent of $0.16 per litre until December 2015 – cost around $9.5bn, equivalent to 1.4% of GDP, when compared to prevailing international prices of petrol. Moreover, with domestic users paying the equivalent of $0.03 per KWh for electricity, which is 60% less than international prices, the government spent $23bn on electricity subsidies in 2015. Overall, Jadwa Investment estimates that the increase in prices by the government will raise approximately $7bn per year.

According to a January 2016 report by Arab Petroleum Investments Corporation, the decisions to raise prices in Saudi Arabia and in the neighbouring UAE was driven by the need to generate revenue amid these more challenging economic times for oil-dependent nations. “This is not ideal. Experience suggests that reforms are better implemented in good times, when the economy is in a better shape,” the report said. “However, a period of weaker oil prices makes it easier for countries to adjust their domestic prices to international levels, hence presenting a unique opportunity to align the two.”

Concerns

There are concerns that subsidy cuts and the subsequent higher energy prices could put off foreign businesses and investors looking to invest in manufacturing, refining and other energy-intensive industries in the Kingdom. However, there has not yet been a case of a major project being cancelled due to increased energy costs.

The energy subsidy reforms are also expected to have a significant impact on revenues of state-run companies and private businesses already operating in the Kingdom (see Industry chapter). The Saudi Arabian Mining Company (known as Ma’aden) expects its profits will go down by SR120m ($32m) in 2016. Meanwhile, Saudi Arabia Basic Industries Corporation (SABIC), a manufacturer of chemicals, industrial polymers, fertilisers, and metals, estimates that its production costs will grow by 5% over the year due to the changes in energy and gas feedstock prices. Likewise, Yanbu National Petrochemical, an affiliate of SABIC engaged in the manufacturing of petrochemical products, predicts a 6.5% rise, while the Saudi Arabian Fertiliser Company will see an 8% jump in its production costs.

“People accepted the change in subsidies pretty well, because they understood the need for it. Energy prices did not see a major increase anyway; our costs have only risen by 3%,” Tameem Alshebel, CEO of Saudi Mechanical Industries, told OBG.

Energy Efficiency

Beyond the economic advantages for the Kingdom, the subsidy reduction plan is part of a broader attempt to create a more efficient economy and entice companies to be more energy and operationally efficient.

In the past, with energy being so cheap, Saudi businesses have had little incentive to be energy efficient. In part as a result of this, the Kingdom ranks as the largest oil-consuming nation in the Middle East, with roughly 38% of its oil and gas output going towards domestic consumption. Given higher energy prices, companies operating in Saudi Arabia will now be forced to evaluate their own operations and look for ways to cut down on their energy usage. In January 2016 Khalid Al Falih, chairman of the board of directors at Saudi Aramco and current minister of energy, industry and mineral resources, said he believed that local industries, including the petrochemicals industry, would be able to adjust to the higher domestic energy prices and maintain their competitive edge globally.

Citizens

Although residents rushed out upon hearing of the price rises to fill their petrol tanks, it is unlikely that the increase in the price of high-grade Octane 95, for example, will have a major impact in the short term, unless prices rise more significantly throughout the five-year subsidy reform period. While fuel and electricity prices almost doubled overnight, they are still among the cheapest in the world. For private citizens of the Kingdom, the energy price increases may have more of a psychological impact than an economic one.

Looking Ahead

The subsidy reform plan and the decision to cut subsidies is likely to have a long-term positive impact on the Kingdom and its overall energy usage levels, obliging Saudi businesses and industrial operations to become more aware of their energy footprint. “The net long-term impact for Saudi Arabia is likely to be positive, as government balances improve and resource allocations become less distorted,” the IEA said in a January 2016 report.

The impact of the subsidy reforms is also being felt outside the Kingdom. Following the announcement of the cuts in Saudi Arabia and the UAE, other GCC nations, including Kuwait, Oman and Bahrain, outlined plans to increase their own energy prices.

For Saudi Arabia, the goal seems to be to eliminate subsidies all together, while directing funds at those most in need. Although it does not specify a goal for oil subsidies, the National Transformation Programme, approved in June 2016, aims to decrease non-oil subsidies by 20% over the next five years.