Mr. McGuire: I want to say one word to you [about your future]. Just one word.
Benjamin: Yes, sir.
Mr. McGuire: Are you listening?
Benjamin: Yes, I am.
Mr. McGuire: Plastics.
     — from the movie The Graduate

In a recent personal communication sent to ASPO-USA, former Saudi Arabian exploration and production head Sadad Al-Husseini made the following statement.

There has been a paradigm shift in the energy world whereby oil producers are no longer inclined to rapidly exhaust their resource for the sake of accelerating the misuse of a precious and finite commodity. This sentiment prevails inside and outside of OPEC countries but has yet to be appreciated among the major energy consuming countries of the world. 

Saudi Arabia's production declined 8% in 2006. This is a fact which requires interpretation, and there are two opposed views: they can't or they won't raise exports. Matt Simmons has doubts about current Saudi capacity, most prominently raised in his book Twilight in the Desert. At The Oil Drum, Stuart Staniford's analysis appears to buttress Simmons' position, but is hampered by a lack of current production data from Ghawar, which the Kingdom will not reveal. The "won't" position has gotten scant attention in the peak oil community. Al-Husseini's statement points to a fundamental reorganization of the world's future oil supply. Downstream investments in the Persian Gulf states lends support to his view that these producers will exert greater and greater control over their fossil fuel resources in the future.

The paradigm shift reflects the historical trend toward resource nationalism. IHS Energy's Pete Stark summarizes the change.

Considering that governments and NOCs control more than 80% of the world’s remaining oil reserves, are expanding and upgrading refineries and infrastructure, and are developing gas resources, the effect [of the shift] is considerable. But that has not always been the case. In the past, when oil prices were low, investments in exploration dropped, and governments were eager to create incentives to attract investments—including reducing tax rates and state participation, or providing royalty relief.

All that changed in 2003 when oil prices began to soar....

The core issue for the large consumer nations is how quickly¹ resource holders will produce oil & gas to meet their burgeoning demand. The IEA and other OEDC representatives constantly call on OPEC — with ever greater acrimony and desperation —  to increase production (graphic below, left). The key question, as energy economist Ferdinand Banks notes at EnergyPulse, is why should they?

On this topic I think it best to pay attention to something that Matthew Simmons of Simmons & Company – a Houston-based investment firm specializing in oil – once said: "Too many people are looking at OPEC through the rear-view mirror. There’s a resolve in their eyes never to go back to the days of cheap oil." Not just in OPEC’s eyes but in their investment policies, which make it clear that they feel that it is in their best interests to refrain from bringing too much additional oil to market. This is a good place to ask one of my favorite questions: would you if you were in their place? Accordingly, the optimal  development strategy for a country like Saudi Arabia is to pay more attention to the refining of oil, and the production of petrochemicals.

A paradigm shift means that OPEC nations are determined to never see the low prices of the late 1990's ever again. The Call on OPEC? (published here, May 2, 2007) calls attention to the obvious fact that the OPEC nations will always act in their best economic interests. This conclusion would seem self-evident, except that the IEA apparently has not absorbed the lesson, as Al-Husseini says. Further to the point, there is no OPEC desired price band at the moment. It was also argued, based on some reasonable assumptions, that at the current OPEC Basket Price — $67.90 on June 18th — Kuwait, Saudi Arabia and other OPEC states are making as much money leaving some of their oil in the ground as they would if they were producing it, which would only lower the price.

This conclusion runs counter to James Hamilton's reasonable assertion, made in June, 2006, that Saudi production did not fit "the classic story of a monopolist cutting back production in order to raise the price." However, Hamilton also says "while I believe the Saudis are quite capable of letting output drift down in order to try to defend a price floor, wherever such a floor might be, it's not $70 a barrel." A year later, on June 15, 2007, the Brent price is $71.84, and has hovered around the $70/barrel mark for the past month, rising from low $50s since the beginning of the year. There is little evidence that current price level has stifled world oil demand, although that demand has been redistributed from the poor to the wealthy. (See Africa and Central America.) The desired price today is whatever OPEC thinks the market will bear, not the fair price of $60/barrel back in 2006. This is a dangerous game because the downward demand pressures on consumer economies created by even higher prices (about $80/barrel) could be severe.

Oil consumers expect Middle Eastern nations to invest heavily in upstream activities to keep the oil flowing. In fact, major investments are being made, in the downstream refining and petrochemical sectors. The numbers are staggering, as compared with upstream investments, according to Ali Al-Naimi.

Based on the outlook of growing demand for their oil and gas, by 2011 the countries of the Middle East will invest some $94 billion in their oil and gas upstream sectors, more than half of which will go to expand oil production capacity. This is in addition to more than $240 billion of investment in the mid and downstream oil and gas chains and petrochemicals...

Of the $70 billion Saudi Arabia is investing by 2012, only $18 billion is for upstream expansions. Nancy Yamaguchi's Middle East petroleum sector: growing in all directions (Petromin, March 2007) provides an overview of refinery expansions in the Middle East (graphic, left).  Saudi Arabia has ambitious plans to create more refining capacity, including the Jubail and Yanpu export facilities.

The Middle East push into petrochemicals rivals the refining investments. Saudi Aramco has a joint venture with  Japan’s Sumitomo Chemical to build a complex at Rabigh. The  Gulf Cooperation Council (GCC) nations spent almost $70 billion in 2006, with Saudi Arabia leading the way at $44 billion (Gulf News).

The Persian Gulf states are expanding downstream capacity to meet rising internal consumption of refined products (see Yamaguchi), but that's only a small part of the story. Due to their substantial comparative advantage, refining and petrochemicals is where the money is. Oil and condensate can be provided for refining at below market costs. Saudi Arabia can refine its own heavy, sour (sulfur-laden) crude. Cheaply produced naphtha or natural gas or gas liquids can be used as a petrochemical feedstock for olefins (e.g. ethylene). From the Gulf News (link above) --

Investment in petrochemical facilities is driven by availability of cheap feedstock and the region's proximity to large markets of Asia such as China and India.

More than 30 million tonnes per year of ethylene capacity will be added in the Middle East by 2012-13, according to London-based Chemical Week.

The new capacity is also likely to put pressure on global petrochemical markets. Steam crackers coming onstream from 2008 in Kuwait, Qatar and Saudi Arabia will cause an imbalance in worldwide supply and demand, lowering petrochemical plant operating rates and leading to a softening in prices, it quoted industry analysts as saying....

General Electric has already capitulated, selling its petrochemicals division to Saudi Basic Industries for $11.6 billion. The Kingdom's future is plastics.

Saudi Arabia is expanding their refining nameplate capacity to 3.6 million barrels per day. It is hard to reconcile such large capital expenditures in a context where the Saudis have diminished expectations about their future oil production. They will not want that expensive capacity sitting idle, nor the petrochemical industry upon which it depends. The Persian Gulf countries are planning for a future where global oil spare capacity stays tight and refining margins remain high. They will increasingly export gasoline and ethylene, not crude oil.

Ferdinand Banks argues² that "OPEC is in the driver's seat." The paradigm shift strategy optimizes production rates over time, protecting the longevity of the resources while keeping prices high. Banks believes OPEC's best position is one in which non-OPEC supply price elasticities are falling just as OPEC controls a greater and greater market share. This seems to be what is happening. Angola, one of most successful non-OPEC producers, joined the cartel this year, a move which raised their market share about 2.5% all at once. Meanwhile, non-OPEC production is struggling to rise above declines. Lower downstream product costs allow sales at global market prices, a market in which OPEC can expect to exert more and more control over those prices. It looks like a license to print money. Those assets will be used to diversify the economies of the Persian Gulf oil producers.

If non-OPEC oil is on the verge of peaking, and OPEC output is going to be limited for macroeconomic reasons (Saudi Arabia, Kuwait), political reasons (Venezuela), lack of investment (Iran, Venezuela) or disruption (Iraq, Nigeria), then the near term peak of world production is all but assured. If Saudi Arabia can't manage natural declines at Ghawar at this time, and must wait a few years for additional capacity, declines there will merely speed up a liquids peak that appears inevitable in any case. Many in the peak oil community have not paid enough attention to so-called "aboveground" factors. The "paradigm shift" Al-Husseini speaks of is likely to forever change the world oil supply balance.

1. The U.S. Congress provides an amusing sideshow to the argument. They saw fit to pass a bill making it illegal for OPEC to withhold "our" oil & natural gas from the world market (NOPEC). A well-informed colleague voiced his eminently reasonable opinion that Congress is currently living in La La Land. This is not good news.

2. Bank's paper Economic Theory and OPEC is unpublished. Contact the author to arrange to see a copy.

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