Saudi Arabia, the world’s biggest oil exporting country, appears to have determined this is the right time to bring forward plans to raise production capacity by 1 million barrels per day. The government has directed Saudi Aramco to raise its production capacity by 1 mb/d to 13 mb/d. Saudi Aramco CEO Amin Nasser said in an earnings call with analysts on March 15 that the company, which is still majority owned by the Saudi state, would proceed with the expansion on an accelerated time frame even as it announced it would reduce its capital expenditure for 2020 and review 2021 spending plans.

Global oil prices may be at their lowest in nearly two decades. Saudi Aramco has an advantage in that its operating costs are lower than the global average and that gives it an edge over the multinational oil companies. Indeed, oil services companies and rig operators whose businesses will take a hit from a slowdown in capital spending as a result of the coronavirus pandemic will likely offer their services at a far lower cost than they would in a healthy economy.

While the international oil companies are slashing their upstream expenditures and reviewing their global exposure, Saudi Aramco is betting on continued growth for hydrocarbons. In recent weeks, it has taken full-page advertisements in leading newspapers and magazines to deliver its message. “The journey to the future is one that will be fueled by hydrocarbons,” it said in one advertisement that appeared shortly before the company announced its 2019 earnings.

Its first earnings call as a publicly listed company on March 15 came as oil prices tumbled below $30 per barrel. This was partly in response to the demand shock caused by the coronavirus pandemic, but mostly because of the oil price war launched by Saudi Arabia earlier in the month after Russia refused to join OPEC in cutting production. Moscow, as leader of the non-OPEC alliance of producers, abandoned the agreement with OPEC that had been in place since 2016 to stabilize markets. Russia, which says it can sustain its economy at an oil price of $30/bbl for years, wants to penalize the higher-cost U.S. shale oil producers it believes benefited from previous output curbs by the OPEC+ group. Russian oil company Rosneft, which is 100% owned by the state and is the largest oil producer in Russia, said through a spokesman on March 8 that cutting production was not in Russia’s interest as the United States had replaced lost volumes on the global market. Moscow plans to increase its production by 500,000 b/d, effectively reversing the output curbs to which it had agreed but never fully complied under the Declaration of Cooperation between OPEC and non-OPEC.

Saudi Aramco responded immediately by slashing the official selling prices of its crude grades, offering the steepest discounts in areas in which it competes directly with Russia. It also announced it would supply the market with 12.3 mb/d, some 300,000 b/d beyond its maximum sustained capacity, and 2.6 mb/d above February supply. Some of the oil will be drawn from storage, while much of the incremental supply due to hit the market in April will have to go into storage tanks already brimming with crude because of the demand destruction caused by the coronavirus outbreak. This is likely to put further pressure on oil prices even if demand picks up later in the year.  On March 11, the Saudi Energy Ministry directed Aramco to increase its maximum sustainable production capacity to 13 mb/d, signaling it was hunkering down for the long haul.

Benchmark Brent crude oil prices have since weakened further, at one point trading below $25/bbl, a level that is far below the pain threshold of a number of oil producers, including Saudi Arabia.

Nasser told analysts during a conference call, after presenting the company’s full-year results, that he was confident the company’s low operating costs would allow it to grow its business despite the current uncertainty. Upstream lifting costs in 2019 were only $2.8 per barrel of oil equivalent, the lowest in the industry, he noted. The low cost of production and the company’s flexibility would allow it to sustain a low break-even price, he added.

Aramco can maintain production at 12 mb/d for a year without additional capital spending, Nasser told the analysts.

Such high levels of oil production have not yet been tested over a prolonged period.  They would erode the spare capacity cushion that Saudi Arabia maintains as a tool to impose discipline and balance markets in the event of supply disruptions. Saudi Arabia’s oil production topped 11 mb/d briefly in November 2018, when it anticipated a supply shortage from Iran due to U.S. sanctions. The kingdom’s policy is to have 1.5-2 mb/d of spare production capacity at all times. To honor that commitment, it will need to bring on net new capacity even as oil prices have tanked. Aramco is now bringing forward the timeline for the development of fields that will beef up its production capacity by tapping into its reserves, which were certified for the first time and estimated at 258.6 billion barrels of oil equivalent, higher than previous estimates. This, says Nasser, translates into more than five decades of reserve life.

Saudi Oil Production July 2014 to January 2020

Aramco has responded to prevailing market conditions by reviewing its capital expenditure plans for 2020 and 2021. At the time of its IPO in December 2019, the company had indicated it expected its capital expenditure to be in the range of $35-40 billion in 2020. It has now revised that down to $25-$30 billion as its earnings declined by 21% year-on-year. The capital spending budget for 2021 and beyond are also under review, Chief Financial Officer Khalid al-Dabbagh said during the earnings call.

However, the spending cuts are not expected to derail its capacity expansion plans, since Aramco had already earmarked the budget for the increments before the downturn. It awarded contracts worth $18 billion in July 2019 to expand the capacity of the offshore Marjan and Berri fields by 550,000 b/d of crude oil and an additional 2.5 billion cubic feet per day of gas processing capacity.

Originally scheduled for completion in 2024, Aramco is now expected to bring the date forward to ensure that it does not overstrain reservoirs from existing fields. The kingdom expects production of 500,000 b/d to resume from the Neutral Zone it shares with Kuwait imminently after the two neighbors resolved a dispute that had halted production.

This will allow Kuwait to ramp up output in line with its Gulf Arab allies in OPEC. The UAE is planning to boost its production in April to 4 mb/d from 3.03 mb/d. Neutral Zone production does not count toward Aramco’s capacity since it is operated by the U.S. company Chevron.

The increments from Berri and Marjan will contribute largely to the planned mb/d capacity boost, while the ongoing expansion of two mega fields – the offshore Manifa Field and onshore Shaybah – will also lift capacity. Aramco has been in the process of expanding capacity at existing oil fields. It brought an additional 75,000 b/d of capacity from the Harmaliyah structure in the Ghawar Field, the world’s largest oil field. Other structures within the massive field are being advanced and will yield an additional 175,000 b/d of capacity. Aramco plans to bring on 75,000 b/d from the Dammam oil field by 2026, though that timeline too may be brought forward. Ghawar previously accounted for roughly half of the kingdom’s total production but has been in decline, and Aramco has had to deploy enhanced recovery techniques to maintain reservoir pressure and extend the life of one of its oldest producing fields.

Aramco maintains a strict reservoir management policy that allows it to relax production from older fields by tapping into new reservoirs. The Berri and Marjan additions were initially meant to replace natural declines, and it is not yet clear just how much net new capacity will be available once the projects are completed.

Nevertheless, Aramco does have a reputation for completing megaprojects on time and within budget, so a timeline of 2023 is not unrealistic. The additional gas produced as oil output is expanded will allow Saudi Arabia to use more of its natural gas for water desalination, power generation, and petrochemicals production, thereby freeing up more crude oil to export.

However, should demand crater and reach a plateau sooner rather than later, Saudi Aramco may find itself sitting on costly idle capacity that weighs on prices and ends up becoming a stranded asset. Yet it is precisely that spare capacity buffer that allows Riyadh to dictate policy unilaterally by acting as the central bank of the oil market. It has retained that power even as OPEC has seen its market share erode and its powers diminished because of the dramatic rise in U.S. shale oil production in the last decade. The Oxford Institute for Energy Studies said in a February report on the medium-term supply outlooks in the Middle East and North Africa that by using its spare capacity, Saudi Aramco had generated an estimated $35.5 billion of additional revenue from 2013 to 2018. This is mainly because Saudi Arabia taps into its spare capacity in response to supply disruptions elsewhere when oil prices tend to be high, the report says.

Even before the coronavirus epidemic wreaked havoc on oil markets and prices, the oil industry was facing a backlash from investors because of climate change concerns. By some estimates, the extraction of oil and gas accounts for roughly 15% of global energy sector greenhouse gas emissions. Aramco, however, prides itself on having very low carbon emissions and intends to cut these emissions by capturing, reusing, or storing carbon dioxide, a technology known as Carbon Capture Sequestration and Utilization.

There is additional demand uncertainty caused by the transition away from hydrocarbons in favor of renewable and clean energy sources. With peak demand for oil seen occurring some time during the current decade, raising production capacity from conventional resources with long lead times poses a risk, but is one that Saudi Arabia appears willing to take.

There had been speculation that Saudi Arabia might reconsider its position since it holds the current presidency of the G-20 Group, a forum for international economic cooperation among the world’s leading economies. U.S. President Donald J. Trump initially welcomed the fall in gasoline prices as good for U.S. consumers but as the economic fallout from the oil price collapse intensified, the U.S. administration appealed to the Saudis to reverse course. U.S. Secretary of State Mike Pompeo spoke to Saudi Crown Prince Mohammed bin Salman, the kingdom’s de facto ruler, on March 24 and urged him to “rise to the occasion” and work to stabilize the market.

However, a meeting of G-20 leaders held via teleconference on March 25 to discuss a collective response by the industrialized countries to the coronavirus pandemic ended with a communique that made no mention of the oil market or the price collapse.

The official Saudi news agency carried a March 27 statement by a Ministry of Energy official that there were no negotiations with Russia to try to reach agreement on balancing markets.

Russia may be a low-cost producer, but it does not have excess oil production capacity to match that of Saudi Arabia. It does, however, have the advantage of a more diversified economy and a lower break-even oil price, as well as its superpower status.

The two oil giants are now engaged in a battle on several fronts. They are simultaneously at war with each other while they are taking on the U.S. shale oil producers, who may end up the biggest losers as finances dry up.  In any event, the collateral damage will inflict pain on the parties involved and the smaller producers caught in the middle.