How Cheap Oil Will Hurt the Saudi Arabian Economy

The Middle East has long been a huge supplier of oil. For the past half a century, countries in this region have been extracting the substance from the Earth and selling it around the world. Because the Middle East has essentially controlled the world’s oil supply for decades, the region has experienced enormous economic growth – to the point where countries such as Saudi Arabia are among the richest in the world.

Even though oil has gone through rough periods in the past, the Saudi economy has been able to recover. But will it be able to sustain its growth with oil hovering around $40 per barrel? While things for the Saudis don’t look quite as bad as they have for Greece, there may be some troubling times ahead for Saudi Arabia. (For more, see How Petro Economies Are Coping with $40 Oil.)

The Saudi Economic Situation

From pictures of Saudi cities, it is clear that there is no shortage of money in Saudi Arabia. There are buildings that are marvels of human innovation, technology that would rival that in the Microsoft Corp. (MSFT) headquarters and an overall feeling of excess. That is not to say there are no poor people in Saudi Arabia; it is just that the nation is an area of wealth and prosperity.

Saudi Arabia’s wealth is in large part due to sizable government subsidies and the lack of a personal income tax for Saudi nationals. Since oil plays a big role in the Saudi economy, the government makes sure to give the best gasoline deals to its residents. The end result is that gasoline costs a mere $.16 per liter, or roughly 60 cents per gallon.

But the economy isn’t purely centered around oil. Saudi Arabia has a number of social programs that are designed around Islamic principles to help those who have been dealt a bad hand. These programs include many similar to those found in the U.S., such as disability, health care, housing and more. The idea is that every citizen in Saudi Arabia should have a decent standard of living.

The problems arise with the high costs associated with implementing these programs. Just the fuel subsidies alone are estimated to cost the government around $52 billion this year, which accounts for approximately 8% of Saudi Arabia’s GDP. Despite the lack of personal income tax revenue from Saudi nations – foreigners doing business in the country are still taxed – the government does have means of income. These means largely include the revenue generated from a whopping 85% tax rate on companies that produce oil or hydrocarbons.

What is Needed to Balance the Budget?

Oil and gas are such a huge part of the Saudi economy that when their prices drop, the country is in jeopardy of experiencing a huge economic downturn. Consider this: suppose a company can produce a barrel of oil at a cost of $25 per barrel. The companies sells that barrel for $100, bringing in $75 of profit. At a tax rate of 85%, the government takes $63.75 from that barrel. Now if the price of oil is cut in half, the company will sell the barrel for $25 profit, and the government will only see $21.25. Ultimately, oil costs half, but tax revenue falls by two-thirds. Obviously this is an overly simplified tax scenario.

In the U.S. and many other countries, the answer to a budget shortfall is to look at spending and taxation across the board. Income taxes may increase, social programs are cut, property taxes go up and, in the end, everyone pays more and gets less. Saudi Arabia, however, refuses to consider this approach. Instead of cutting social programs, something the government feels is necessary, taxes will likely be raised on wealthy landowners. There are no plans to initiate a personal income tax on Saudi nationals, and there are also no plans for the Organization of Petroleum Exporting Countries (OPEC) to manipulate the market. (For more, see Is OPEC The World's Oil Central Bank?)

OPEC’s Control of the Oil Supply

In the past, OPEC has manipulated the oil supply in order to control prices. Since higher prices means more income for the Saudi government, it was in its best interest to control the supply side to keep prices up. However, there are some flaws in this method.

As shale oil production, also known as hydraulic fracturing or fracking, has taken off in the U.S., Saudi Arabia has seen more competition for its precious resource. A larger supply on the market has not only taken away customers who previously purchased oil from the Middle East, it has also contributed to the drop in prices. Historically, OPEC’s reaction to dropping prices was to slash production, consequently lowering the supply and forcing prices to rise. That tactic wasn’t as much of an option this time. (For more, see Oil Price Analysis: The Impact Of Supply & Demand.)

Slashing production would mean less income for oil-exporting nations such as Saudi Arabia. It would also mean that prices increase, causing more companies to get into the market on the U.S. side. This would increase production in the U.S., bringing prices back down and creating even more competition. Thus far, OPEC has decided not to cut supply, perhaps in hopes that U.S. companies will go out of business due to lower oil values. (For more, see How Saudi Arabia Benefits From Low Oil Prices.)

Can a Crisis Be Averted?

The Saudi economy relies on oil. Without it, the nation will be at a huge loss in terms of government revenue. Still, there are some options.

First, the country should look into more sources of revenue. Even with a heavy economic dependence on oil, the country can explore alternative energy. Since the vast majority of Saudi Arabia is a desert and the sun shines most of the year, it could easily develop solar power. This is precisely what the government is doing. During the oil crisis in the 1970s, Saudi Arabia began to research solar power. After the crisis, however, the research was largely put on hold, only to be picked up less than a decade ago.

In 2010, King Abdullah established a brand new city called the King Abdullah City for Atomic and Renewable Energy (K.A. Care or Ka-Care). This city revolves entirely around the research and development of energy sources independent of oil. Recently, the city announced that Saudi Arabia would generate 41 gigawatts of energy from the sun annually by the year 2032. This is an impressive goal considering the nation's solar power output currently accounts for just .003 gigawatts. Other renewable and alternative methods would bring total production up to 120 gigawatts annually.

Nevertheless, in the short term, the Saudi reliance on oil means that the price of oil needs to increase. As long as the decline continues, more economies in addition to Saudi Arabia will suffer – this can be seen in the layoffs and hiring freezes of areas like the Bakken Basin in North Dakota. For Saudi Arabia alone, it is estimated that oil needs to sell for about $100 per barrel to stave off any cuts in social programs or tax increases. Increasing the price of oil, however, is largely outside of the control of the Saudi government.

The Bottom Line

Many investors have been pulling their money out of Saudi Arabia after the markets performed a death cross. This cross occurs when the long-term moving average for a commodity is valued higher than the short-term moving average, which generally signals a bear market, and investors react accordingly.

This isn’t the first time that Saudi Arabia has faced this sort of crisis, and as long as oil is a highly prized commodity – a guarantee until the world runs out – it won’t be the last time.

In the past, luck has been on Saudi Arabia’s side, and the price of oil changed course before anything major happened. It appears the country may not be so lucky this downturn.