The kingdom's adherence to the state-control policy of its energy sector came into question in September 1998 when Crown Prince 'Abd Allah ibn 'Abd al-'Aziz met in Washington with senior executives from seven American oil companies.¹ He said the Saudi government wanted to join them in a new, strategic energy partnership. To understand this change in Riyadh's energy policy, the following questions will be addressed: What were the Saudi motives for inviting international oil companies (IOCs) back into their energy sector? What were the main characteristics of the Saudi Gas Initiative (SGI)? And, what was the outcome of this development?

To be sure, most crude oil producers have switched away from an exclusively state-controlled energy sector to a gradual opening to foreign investment. So, the Saudi move should be seen as part of a larger trend in the oil and gas industry. Major producers such as Algeria, Indonesia, Iran, and Venezuela have already invited IOCs back to their oil and gas industry. Theoretically, there are several reasons why governments are reopening the door to foreign investment: shortages of capital, modern and sophisticated technology and human resources.

First, the need for capital stems from many factors, the most significant of which is the period of low and stable oil prices from 1987 to 1997, followed by a dramatic decline until early 1999. As a result, many producing governments have found themselves without the necessary financial resources to maintain their current levels of production, let alone increase their capacity.

Second, technological advances have drastically changed the oil and gas industry. Most notably, successful explorations have increased, and the costs of production and development of oilfields have fallen. Technological advances have made it cheaper and easier to find and develop hydrocarbon resources. Multinational oil companies have more access to state-of-the-art technology in the industry than most national oil companies.

Third, human resources include not only management personnel, geologists and engineers but also professionals with expertise in applying new technologies and new market techniques, such as e-commerce. Some oil producing countries simply do not have a large enough pool of these necessary experts.

With regard to Saudi Arabia, these theoretical incentives apply only partially. Saudi Aramco, like other national and international oil companies, had few financial resources to expand its production capacity when oil prices were low. But since 1999, prices have recovered and stabilized at a higher level than in the 1990s. This means that Saudi Aramco is under less restraint to finance its exploration and development operations. Also, the Saudi takeover of Aramco was friendlier and less confrontational than was the case in most other oil producing countries. Furthermore, the kingdom has never been subjected to international economic sanctions. As a result, Saudi Aramco has always had access to advanced Western technology and expertise. No wonder, then, that a leading energy expert has described Saudi Aramco as "a very large and competent entity which is producing some 8mn b/d of oil and refined products. It maintains huge surplus capacity, and has undertaken significant investment projects."²

In short, Saudi Arabia has few incentives to invite foreign investment back to its upstream oil sector. Thus, despite some expectations, and hope and desire expressed by top executives of IOCs, there has been no change in the kingdom's policy. Rather, the door has been opened for foreign investment in the exploration and development of natural gas.

Exploration And Development of Natural Gas

Saudi Arabia is one of the world's richest countries in hydrocarbon resources. Most of the attention, however, has been focused on developing the massive oil reserves, with little attention to natural gas. Indeed, until the early 1980s, gas was flared. In the last few decades, this policy of minimal utilization of the country's gas resources has substantially changed. The creation of the Master Gas System (MGS) in the early 1980s signaled growing official interest in utilizing this largely untapped hydrocarbon potential. Several characteristics can be identified in the Saudi gas sector.

First, Saudi proven gas reserves are roughly 60% associated gas and 40% non-associated.³ The former occurs in crude oil reservoirs and the latter is not in contact with significant quantities of crude oil in the reservoir.⁴ Non-associated gas development is desirable in particular because it guarantees the utilization of gas independently of the fluctuation of oil output and prices.

Second, during the last two decades Saudi Aramco's efforts in gas exploration and development operations have been successful. The kingdom's proven reserves of natural gas have almost doubled. At the end of 1983, these were estimated at 3.54 trillion cu ms and 20 years later (2003) they had risen to 6.68 trillion cu ms.⁵ This expanding capacity was matched by rapid domestic gas consumption. During the same period (1983-2003), Saudi Arabia's gas consumption rose at a remarkable rate of 7.2% annually and is projected to grow on average by 3.7% per year during 2004-25 according to Saudi Aramco officials.⁶ Natural gas is largely used in power generation, water desalination and to satisfy an impressive growth in the petrochemical industry.⁷

This collapse of SGI, however, has not put an end to the kingdom's strategy of inviting foreign investment back to its gas sector. Saudi officials held a meeting in London in July 2003 with representatives of about 40 energy companies. Mr Naimi confirmed his country's commitment to create an environment that was attractive to private investment.¹² In line with this determination, Saudi Arabia reached a tentative agreement, which was officially signed in November 2003, with Royal Dutch/Shell, the Anglo-Dutch energy group, and Total of France, to invest approximately $2bn to develop non-associated gas in the Empty Quarter region. Shell, with a 40% stake in the venture, is the operator, while the remaining 60% is divided equally between Total and Saudi Aramco.¹³

This agreement with Shell and Total was followed in early 2004 with another with Russia's Lukoil, China's International Petroleum Exploration and Production Corp, or Sinopec, and a consortium of Italy's Eni and Spain's Repsol YPF. According to the award, the companies would explore for non-associated natural gas in the Empty Quarter. Each contract recipient would also form an exploration-and-production-company jointly with Saudi Aramco, with the latter holding a 20% share of each.¹⁴

Two important conclusions can be drawn from the signing of these agreements. First, the Saudi award of contracts to European, Russian, and Chinese companies signals Riyadh's strategy to strengthen relations with these countries. Commercial interests cannot be separated from strategic considerations. Examining Riyadh's relations with these countries is beyond the scope of this essay. Still, the growing significance of these relations should be highlighted. Saudi Arabia has close strategic, political and commercial ties with most European countries.¹⁵ The EU is Riyadh's main trade partner. Geographically, Europe is closer to the Middle East and has had extensive historical ties with most states there than any other global power. In addition, there is a large and growing Muslim minority in several European countries. Indeed, Islam is the fastest growing religion in Europe.¹⁶ Finally, the European stand on many political issues, such as the Arab-Israeli conflict, is closer to the Arab position than that of the United States.

In early September 2003, Saudi Crown 'Abd Allah led a large delegation on an official visit to Russia. The visit was the first top-level contact between the two countries since 1932. This summit meeting between the crown prince and President Putin opened a new chapter in relations between the two nations.¹⁷ There are several areas of potential conflict or cooperation between them. Riyadh is the world's largest oil producer and exporter, and Moscow is number two. Meanwhile, Russia is the world's largest producer and exporter of natural gas. Furthermore, Russia is interested in improving relations with the Islamic world, given its large Muslim minority (more than 20mn). Finally, China's impressive level of economic growth for more than a decade has substantially increased its demand for energy. In 2003, China surpassed Japan and became the world's second largest oil consumer (after the United States). China is very dependent on oil supplies from the Middle East, particularly from Saudi Arabia. Riyadh and Beijing established full diplomatic relations in 1990 and Chinese President Jiang Zemin visited the kingdom in 1999, announcing the creation of a "strategic oil partnership" between the two nations.

The second conclusion to be drawn from the signing of agreements between Saudi Arabia and IOCs to explore and develop the kingdom's gas resources is the absence of U.S. companies from all these awards. This probably reflects Saudi frustration at the repeated accusations by some members in the U.S. Congress, media outlets, and think-tanks that Saudi Arabia is not doing enough to combat terrorism. They claim that the kingdom is not a reliable partner in the war on terrorism and that the United States should reduce its oil dependence on Saudi Arabia. Some have gone even further and advocated a "regime change" in Riyadh. This rhetoric aside, it is important to point out that official relations between Riyadh and Washington remain strong, and the kingdom has maintained its status as a key oil supplier to the United States (along with Canada, Venezuela, and Mexico).

Future Prospects

The decision to invest in the Saudi Arabia's energy sector is made by both the Saudis and the IOCs for different reasons. The Saudis are interested in stimulating their economy, generating jobs, expanding their petrochemical industry, satisfying a growing domestic demand, and freeing additional oil for export. IOCs on the other hand, are interested in maximizing their profit and establishing a base in Saudi Arabia with the expectation that one day the door will be opened for investment in the country's lucrative oil sector. In addition to these commercial interests, strategic and political considerations play a role. The course of foreign investment in the Saudi energy sector in the foreseeable future is likely to be determined by a combination of domestic, regional and international developments.

First, inviting foreign investment to the Saudi energy sector should be seen as a part of broader strategy of economic reform. The high level of economic growth since the early 2000s is due mainly to high oil prices. The Saudi economy is heavily dependent on oil and suffers from structural imbalance. Saudi leaders have acknowledged the need for economic reform and since the late 1990s have repeatedly re-affirmed their contention that privatization is a "strategic choice." In line with this contention, the Saudi government has moved cautiously and slowly toward subsidy cuts and tax increases. In 1999, a Supreme Economic Council was created and charged with boosting investment and promoting privatization. In January 2004, the Saudi cabinet approved a reduction in taxes on foreign investment to 20% in most sectors and 30% in the natural gas sector.¹⁸ These efforts were endorsed by the International Monetary Fund, which commended the Saudi government for speeding up the implementation of structural and institutional reforms needed for a sustained increase in private investment, including foreign direct investment.¹⁹

An important incentive to reform the economic system is the kingdom's desire to join the World Trade Organization (WTO). Saudi Arabia is the only GCC state that is not a member. Negotiations to join began in 1993 but were stalled for several years. Since the early 2000s, the Saudis have expressed a growing willingness to reform their economic system and trade policy to accommodate the WTO. In August 2003, Saudi Arabia signed a trade agreement with the EU that would ease the kingdom's WTO entry and increase the flow of trade and investment between the two sides. Under this deal, Riyadh agreed to reduce import tariffs for industrial goods and agricultural products and committed itself to improving access to its markets for financial services, telecommunications, construction, transport and other services.²⁰ Riyadh also agreed to end its practice of selling gas at cheaper rates to domestic businesses than to the world market.²¹ The underpinning reason is that WTO membership is seen as crucial to attract foreign investment.

Second, since the early 2000s, there have been rising terrorist attacks against Saudi and Western targets inside the kingdom. In 2004, these have focused on oil installations, offices and residences of foreign oil companies. In early May, militants attacked an office of foreign petroleum industry contractors in Yanbu', on the Red Sea in the western part of Saudi Arabia. Later in the month, militants attacked a complex housing oil employees in al-Khobar in the east. Several people, Saudis and foreigners, were killed or injured. As the Saudi ambassador to the United States has acknowledged, the terrorists' goal is "to disrupt the Saudi economy and destabilize the kingdom."²² The attacks were orchestrated with the aim of demonstrating that the royal family cannot maintain security in the heart of its own oil industry in the east and west of the kingdom.

The attacks have not succeeded in disrupting Saudi oil production and exports; but, they have created a "psychological factor," which will be taken into consideration by foreign companies if their frequency and intensity increase. The security of energy installations and foreign workers will be crucial in shaping the future of foreign investment in Saudi Arabia. So far, there has not been any significant movement to relocate foreign workers outside the kingdom. For their part, Saudi officials have sought to reassure global markets about the security and stability of their country.

Third, developments in next-door neighbor Iraq will have an important impact on foreign investment in Saudi Arabia and the rest of the region. Some analysts suggest that Saudi Arabia has vigorously negotiated with IOCs out of concern that these companies will focus on investing in Iraq and lose interest in the kingdom. As one reporter put it, "cognizant that post-Saddam Iraq could potentially absorb billions from the oil major's capital expenditure budgets, once its security problems are sorted out, the Saudis may be ready to ditch their traditionally glacial approach to striking deals."²³ This argument, however, is flawed for two reasons: The negotiations between Saudi Arabia and the IOCs started long before the 2003 war; and, more than a year after that war, the security environment remains very dangerous. Given the high level of uncertainty over political and security conditions in post-Saddam Iraq, it is hard to imagine any foreign company investing there in the foreseeable future.

Iraq is a major Arab country and a founding member of OPEC. Uncertainty in Iraq may have a spillover impact on the entire region. The delicate balance and potential conflict between the Shi'as and Sunnis and between the Arabs and Kurds are not only Iraqi issues, they are also regional concerns. Indeed, Iraq can be seen as a powder keg that could destabilize the entire Gulf region. Containing this potential danger would ease the investment climate in Iraq and the rest of the Middle East. Understanding the ramifications of instability in Iraq, the GCC interior ministers signed a security agreement in May 2004 that called for the exchange of information in the field of intelligence and vowed to step up the battle against growing threats of terrorism in the region.²⁴ 

Fourth, Russia is the world's largest exporter of natural gas and the second largest oil exporter (after Saudi Arabia). Following the Soviet collapse in 1991, Russia's oil production fell sharply. With more stable economic and political environment and the gradual privatization of the oil industry, the country's production has rebounded. This rising Russian oil production, in conjunction with repeated calls in the West to reduce dependence on Middle East oil, has made Russia an attractive energy partner to both the EU and the United States. Both Brussels and Washington seek to invest billions of dollars in Russia's energy sector to reduce their dependence on the Middle East. More foreign investment in Russia would come at the expense of other regions and would mean fewer financial resources available to invest in other oil producing regions and countries, including Saudi Arabia.

It is important to underscore that the investment climate in Russia is rigid and poses serious challenges to IOCs. The conflict between the Russian government and Yukos and the arrest of the company's head, Mikhail Khodorkovsky, raise questions regarding the rule of law and the government's commitment to economic reform. Equally important, most of Russia's undeveloped oil and gas fields are located in remote areas and are geologically and environmentally challenging.²⁵

To sum up, the future of foreign investment in the Saudi energy sector will be largely shaped by the Saudi government's commitment, by political stability within the kingdom and the entire Gulf region and by competition with other oil and gas producers. In the foreseeable future, it is highly unlikely that IOCs will be allowed to invest in the Saudi oil sector. The kingdom has no incentives to change its policy, so the focus will remain on the gas sector.     

Notes:

1.    Those attending the meeting with Crown Prince 'Abd Allah included senior executives from the four American oil giants - Mobil, Exxon, Texaco, and Chevron - that established the Arabian American Oil Company, now known as Saudi Aramco, in the 1930s. Senior executives from Atlantic Richfield, Conoco, and Phillips Petroleum also attended.

2.    Robert Mabro, "Saudi Arabia's Natural Gas: A Glimpse at Complex Issues," Oxford Energy Comment, October 2002, available on-line at www.oxfordenergy.org.

3.   Energy Information Administration, Country Profile: Saudi Arabia, June 2004, available on-line at www.eia.doe.gov.

4. Energy Information Administration, Energy Glossary, July 2004, available on-line at www.eia.doe.gov/glossary/glossary_n.htm.

5.    British Petroleum, BP Statistical Review of World Energy, London, 2004, p20.

6.    Khalid A al-Falih, "Saudi Arabia's Gas Sector: Its Role and Growth Opportunities," Oil and Gas Journal, Vol102, No23, 21 June 2004, pp18-24, p19.

7.    In the early 2000s the kingdom's gas capacity was further expanding with the coming on stream of two huge gas processing plants, one in Hawiyah (2001) and the other in Haradh (2003).

8.    A general term for all liquid products separated from natural gas in gas processing or cycling plants.

9.   These eight companies are: ExxonMobil, Royal Dutch/Shell, BP, Conoco, TotalFinaElf, Phillips, Occidental, and Marathon.

10.  Maureen Lorenzetti, "US Companies: Saudi Gas Negotiations at Critical State," Oil and Gas Journal, Vol100, No38, 16 September 2002, pp26-28, p26.

11.  Robin Allen, "Saudi Talks with Oil Groups Close to Collapse," Financial Times, 25 July 2002, on-line at www.ft.com.

12.   British Broadcasting Corporation, "Saudi Woos Energy Firms," 23 July 2003, on-line at http://news.bbc.co.uk.

13.  James Gavin, "A New Live for Gas Opening," Petroleum Economist, Vol70, No12, December 2003, pp25-26, p25.

14.   Oil and Gas Journal, "Saudi Arabia," Vol102, No 5, 2 February 2004, p8.

15   For a thorough analysis of the Saudi-European relations see Gerd Nonneman, "Saudi-European Relations 1902-2001: A Pragmatic Quest for Relative Autonomy," International Affairs, Vol77, No3, July 2001, pp631-661.

16.  For a recent analysis of the role of Islam in European domestic and foreign policies see Timothy M Savage, "Europe and Islam: Crescent Waxing, Cultures Clashing," Washington Quarterly, Vol27, No3, Summer 2004, pp25-50.

17.  For a discussion of Saudi-Russian relations see Gawdat Bahgat, "Terrorism and Energy: Potential for a Strategic Realignment," World Affairs, forthcoming.

18.   Energy Information Administration, Country Profile: Saudi Arabia, June 2004, available on-line at www.eia.doe.gov.

19.  International Monetary Fund, IMF Concludes 2003 Article IV Consultations with Saudi Arabia, 5 December  2003, available on-line at www.imf.org.

20.  Frances Williams, "Saudi Arabia on Track to Join WTO," Financial Times, 25 October 2003, on-line at www.ft.com.

21.   Tobias Buck, "EU Deal Likely to Smooth Saudi WTO Entry," Financial Times, 31 August 2003, on-line at www.ft.com.

22.   Neil MacFarquhar, "Saudi Military Storms Complex to Free Hostages," New York Times, 31 May 2004, on-line at www.nytimes.com.

23.   James Gavin, "War Brings Feel-Good Factor," Petroleum Economist, Vol70, No9, September 2003, pp4-12, p4.

24.  'Abd al-Rahman 'Attiyah, GCC Secretary General, described the accord as the most important since the GCC was founded in 1981. For more details see Eric Watkins, "GCC Ministers Agree to Boost Security in Persian Gulf," Oil and Gas Journal, Vol102, No20, 24 May 2004, pp28-30, p29.

25.  For a detailed analysis see Gawdat Bahgat, "Russia's Oil Potential: Prospects and Implications," OPEC Review, Vol 28, No2, June 2004, pp133-147.   

Dr. Gawdat Bahgat is Director of the Center for Middle Eastern Studies, Department of Political Science, Indiana University of Pennsylvania, USA.

Editor's Note: Hyperlinks added to provide additional context.