Saudi option: cut output up to 40%

June 11, 1981

The most recent financial data indicate that the Saudis are today even better placed than at the time of the 1973 Arab oil embargo to make sharp production cutbacks.

The big question has become not whether they can do so, but whether they will do so. and the answer will be crucial to both the economic and political dramas currently unfolding in the Middle East.

Up to now it has been largely Saudi willingness to maintain its present high output of 10.3 million barrels per day that has capped and even depressed oil prices -- saving mostly Western consumers upward of $100 million per day.

But there are a growing number of factors -- not least the latest Arab-Israeli tensions over both Lebanon and the bombing of Iraq's nuclear reactor -- which could tend to push the Saudi leaders toward a cutback.

Indeed, broad sectors of the Saudi populace would warmly endorse such cutbacks -- from students and technocrats to younger, US-trained ministers. The current policy of high production is widely resented here, although criticized only quietly. And discussion about the possibility of another oil embargo in retaliation for what are seen by most Arabs as aggressive Israeli actions in the region in increasingly eclipsing the issue of oil prices.

Saudi Arabia now has a set of fallback positions which would permit it to make virtually painless cutbacks down to 6 million barrels per day, or even fewer. All by itself, therefore, it can absorb the entire cutback in any likely embargo scenario.

Any such cutbacks would be taken step by step, each one involving greater technical, economic, or political costs.

The easiest step would be to cut production to the point where no further financial surpluses would be generated. the next step would be to cut oil output still further and begin substituting overseas portfolio income for lost oil income. Further cutbacks would mean drawing upon overseas assets. And finally, as a last resort, domestic spending could be reduced to compensate for oil revenues -- as both Iran and Iraq found recently under duress.

The first step is that of simply paring production levels and eliminating the current financial surpluses. Given last year's oil price rise and the present high production level, oil revenues exceed projected Saudi financial needs by $ 35-40 billion per year. Thus, Saudi Arabia could cut production down to 7 million barrels per day without even touching its financial muscle.

This easy cutback exceeds current US imports of all Arab oil. Hence, Saudi Arabia on its own could absorb completely a total Arab embargo of the US. Other Arab states, like Libya and Algeria, which need revenue, hence could redirect oil to markets sacrificed by Saudi Arabia without any revenue loss whatsoever.

This step would even be partly self-financing. Oil prices would jump precipitously, as Israeli, South African, and US traders would be forced to scurry for marginal supplies, as in 1973 and again in 1979.

The second cushion available to the Saudi government, in order to cut production still further -- either to penalize US support for Israel or to bolster oil prices -- is its rapidly growing dividend income. This is now estimated at over $10 billion yearly.

Much of this income is added directly to overseas capital accounts, so published figures often seriously understate Saudi financial surpluses. This dividend income could permit further cuts down to 6 million barrels per day.

Technical factors do not seriously constrain sharp cutbacks in oil output. Saudi Arabia's Eastern Province relies upon natural gas, produced collaterally with the oil, for generating electricity and desalinating water. But over half the gas is still flared unproductively for want of market, so by concentrating cutbacks in those fields the Saudis would enjoy wide latitude. Moreover, many electricity and water plants are dual-or tri- fueled, offering still further downside flexibility.

Although the entire probable embargo volume could be accommodated at zero cost, the Saudis have still more room to cut output if, for example, Iran and Iraq were to increase output and needed revenue.

The third cushion involves drawing down the surpluses of more than $100 billion invested abroad. In that way oil output could even be cut to zero for an entire year -- an extreme hypothetical case -- and still use only half the assets.

Limiting this option is the fact that some financial reserves are "hostage assets," located within us legal reach inside the US or in US-owned institutions in Europe. The saudis, with other OPEC states, since 1979 have steadily been shifting assets beyond US territorial or extraterritorial reach precisely to forestall possible seizure, and perhaps one- half are now safely accessible.

Lastly, the Saudis can retrench at home, cutting expenditures to match oil production cuts. No such contingency plan is known, but obvious candidates are the "big ticket" items, like heavy industry or major military procurement. domestic repercussions from focusing cuts on such outlays are minimal, because foreign labor or imported goods dominate these programs.

Iran, prior to the outbreak of the Gulf war, illustrated dramatically how spending can be cut, provided only there is some political consensus. In Saudi Arabia such projects could also be terminated or spending deferred with little domestic opposition except from the affected commission agents.

It is still unknown whether Saudi Arabia might again invoke the oil weapon or whether it might adjust production to permit prices to rise once more. the trigger for any retaliatory cutback might be an Israeli crossing of the Lebanon's Litani River, or it might be collapse of the AWACS/F-15 military package, or it might not exist at all.

But the consequences to the West of any miscalculation are ominous. and it is clear that Saudi ability to curb oil output for political purposes is not effectively constrained by any t echnical or financial needs.