The Fuse

Saudi Arabia Faces an Unprecedented Crisis

by Gregory Brew | May 14, 2020

The oil crisis spells big trouble for Saudi Arabia, the world’s largest petro-state.

For years, the nation’s leaders—particularly Crown Prince Mohammed bin Salman—have been preparing for an economic transition away from oil.

But the spectacular collapse in global demand and prices stemming from the coronavirus has brought a moment of reckoning for the Kingdom, one that will require unprecedented action to manage without prompting profound economic stress or internal political instability.

For decades, oil revenue has been the glue holding the Saudi economy together.

For decades, oil revenue has been the glue holding the Saudi economy together. It helped cement the kingdom’s internal stability, funding lavish welfare programs benefitting millions of Saudi citizens. Such programs have helped stave off political reforms, as the royal family continues to rule as it has since the kingdom’s founding in the 1920s, wielding absolute power unimpeded by democratic assemblies or popular suffrage.

But pressure from the years of low prices and fears of perpetual oil dependence prompted a reform program. When it was first announced in April 2016, “Vision 2030” was hailed in the media as sweeping plan for transforming the world’s largest oil economy. A sovereign wealth fund would pump $400 billion into diversification and private sector expansion. Crown Prince Mohammed bin Salman envisioned expanding tourism, petrochemical manufacturing, sports, and other sectors to diversify the Saudi economy and attract foreign investment. The idea was to ween Saudi Arabia off of oil and reduce the size of the public sector, which supplied half the Saudi population with income subsidies.

In another sense, embracing entertainment and tourism was meant to soften the kingdom’s public image, distracting from the unpopular war in Yemen, restrictions on women’s rights and democratic demonstrations, and the high-profile assassination of journalist Jamal Khashoggi in 2018.

Aspects of Vision 2030, such as the IPO of the state-owned oil company Saudi Aramco, have been somewhat successful. Lacking sufficient international investor interest, the Saudi government sold most Aramco shares to its own citizens. Foreign investment trickled in slower than expected, kept away by the state’s iron-fisted tactics, including a scheme from the Crown Prince to extort $107 billion from wealthy Saudis held hostage in the Riyadh Ritz-Carlton in 2017.

Then came COVID-19.

The pandemic worsened an already-bleak outlook on oil markets. In early March, the Crown Prince embarked upon a needless and ill-timed price war with Russia, sending prices plunging. Though the two sides were able to patch up their differences and agree to a new production cut agreement in April, by that time it was too late: the spread of coronavirus had stalled economic growth around the world. Oil demand projections dropped by 30 percent in the short term, and the IEA expects demand for the year to drop by 9.3 million barrels per day (Mbd), erasing a decade of growth.

The kingdom prepared for some belt-tightening. The Crown Prince’s plans for a $500 billion “dream city” in the desert have been put on hold, while hopes for the kingdom to grow into a regional tourism hot-spot have been suspended in light of the outbreak.

On May 11, the kingdom announced it would be cutting an additional 1 Mbd from its production voluntarily, bringing total cuts to 4.8 Mbd from the April production level, or 7.49 Mbd in total production. After the rout of March and April, which saw the West Texas Intermediate plunge into negative territory as producers had to pay buyers to offload oil, prices have edged slowly upward, encouraged by the production cuts and hopes of recovering demand later this year.

But the financial fallout from the crash in prices is already spreading. Despite the Crown Prince’s reform efforts, Saudi Arabia still depends on oil revenues to cover 80 percent of budget expenses, with a break-even price of at least $55 per barrel. Cratering prices caused a 25 percent drop in Aramco’s net profits in the first quarter, while production cuts will reduce the kingdom’s earnings as prices hover around $30 per barrel.

Faced with yawning budget deficits, the Saudi government is taking unprecedented measures.

Faced with yawning budget deficits, the Saudi government is taking unprecedented measures. It’s raiding its currency reserve and borrowing as much as $58 billion to meet its budget expenditures of 1 trillion riyals ($266 billion). Value added tax will be tripled while public spending, particularly civil servant salaries, will be cut. The two moves are likely to worsen a recession in the private sector, the engine which the Crown Prince had hoped would drive the kingdom’s economic transformation, and the increased VAT will make it harder to attract foreign investment.

Big changes are coming in Saudi foreign policy, driven in part by the budget crisis. After five years, Riyadh has signaled it will be exiting the war in Yemen. Saudi Arabia’s defense budget in 2018 was $76.7 billion, the fifth-largest in the world, according to the International Institute for Strategic Studies. Since then spending has been progressively cut, and the announced budget for 2020 will see spending drop to $48.5 billion.

But Saudi must pare this budget-trimming with efforts to keep the economy, which depends on public spending, afloat at a time of uncertainty. Stimulus actions to maintain consumer spending and prevent mass bankruptcies in the private sector form an important part of the Saudi strategy. The kingdom is turning to deficit spending and debt capital markets—typical measures deployed by governments to keep economies afloat during economic depressions.

And despite the struggles associated with the roll-out of Vision 2030, Saudi Arabia retains some amount of flexibility. It remains the world’s “swing producer,” a market advantage it demonstrated (for better or worse) during its March price war with Russia. The kingdom’s financial reserves, though draining, remain large and its ability to borrow on the international markets will allow it to cover budget needs for some time.

The kingdom’s vast financial reserves, built up during the oil boom of 2003-2014, will not be replenished any time soon.

Without question, this is a turning point. The kingdom’s vast financial reserves, built up during the oil boom of 2003-2014, will not be replenished any time soon. Its flirtation with regional dominance has come to a crashing halt in Yemen, and military cuts will not permit further adventurism for some time to come. Crown Prince Mohammed bin Salman, once hailed as a visionary reformer, stands atop a shaky power structure dependent on social welfare programs that will become difficult to sustain if oil prices do not recover. There is little room for error as the world’s largest petro-state navigates the current crisis.