Staying competitive: As the government cuts energy subsidies, businesses see an opportunity to diversify their offerings

Following a decline in global oil prices for more than a year and a half, in December 2015 the Saudi government announced domestic energy prices would rise overnight. On December 29, 2015 the price of petrol rose from SR0.60 ($0.16) per litre to SR0.90 ($0.24) for Octane 95, while 91-grade rose by more than 65%, from SR0.45 ($0.12) to SR0.75 ($0.20). Natural gas prices, meanwhile, increased by 60%, from $0.75 to $1.25 per million British thermal units (Btu), while ethane prices more than doubled, from $0.75 to $1.75 per million Btu.

Planned Subsidy Reductions

The Ministry of Finance confirmed that under plans laid out in Vision 2030 it would also trim subsidies for water, electricity, kerosene and diesel over the next five years, with the International Energy Agency predicting that prices for transport diesel, industrial diesel and kerosene would increase by 79%, 55% and 12%, respectively, as part of the Kingdom’s subsidy rationalisation plan.

While these price increases should help keep the national deficit from rising too rapidly at a time of lower energy earnings, there could be ramifications for the country’s industrial sector, which relies heavily on cheap gas for its feedstock. This comes as the Kingdom is trying to develop more downstream operations and manufacturing hubs.

Land Of Low-Priced Energy

Saudi Arabia has long enjoyed some of the lowest energy prices in the world, and the Kingdom is one of the world’s largest consumers of energy per capita as a result of the cheap and plentiful supply for residents and businesses. Overall, it is estimated that 38% of locally produced oil and gas currently goes towards domestic consumption.

Saudi Arabia spent an estimated $107bn – approximately 13.2% of GDP – on energy subsidies in 2014, according to some estimates. Yet as revenue dropped sharply in the face of falling oil prices – Brent crude declined from $115 per barrel in June 2014 to $28.50 per barrel in late January 2016 before recovering to just above $52 dollars as of early October 2016 – the Kingdom decided it was time to act. Saudi Arabia’s budget deficit reached an estimated SR367bn ($97.8bn) in 2015, equivalent to roughly 16% of GDP. “This is not just about energy, it is a commitment to seize the moment and take the right decisions to change our economy,” Adel Fakeih, minister of economy and planning, told the Financial Times in December 2015.

However, by cutting the existing energy subsidies, there is some concern that it could negatively affect state-owned and private companies currently operating in the Kingdom, or make some foreign companies reassess setting up facilities in one of the country’s expanding economic or industrial cities. Nevertheless, government officials and independent experts alike are of the opinion that the long-term benefits of subsidy cuts will substantially outweigh the short-term challenge for businesses. “Subsidy reform is essential if the economy is to be in turn more efficient and eventually more productive,” John Sfakianakis, director of economic research at the Gulf Research Centre, told the Financial Times. “Businesses have to become more efficient. They will have to become more competitive by using technology…”

Gauging The Impact

The price increases, especially for natural gas, are expected to raise operating costs by as much as 8% for some of Saudi Arabia’s largest industrial operators. As Majid Owaid Al Otaaib, CEO of Takwa, a spare parts distributor, told OBG, “The fuel subsidy reduction has driven up costs for the transport sector, so we have been working to absorb this.”

Saudi Arabian Mining Company (Ma’aden), the state-owned mining giant, said the changes in energy and gas feedstock prices would reduce its profit for 2016 by around SR120m ($32m), while Saudi Cement Company expects the price hikes to increase its production costs by SR68m ($18.1m). In a statement issued in late 2015, Saudi Basic Industries Corporation (SABIC), estimated its production costs would increase by 5% in 2016 due to the rise in energy costs, while Saudi Arabia Fertilisers expects an 8% jump and Yanbu National Petrochemical predicts a 6.5% rise.

Elsewhere, Petro Rabigh, a joint venture between Saudi Aramco and Japan’s Sumitomo Chemicals, foresees a financial impact of SR300m ($80m) from the price hikes, while National Industrialisation Company (Tasnee), a diversified industrial company with interests in petrochemicals, metals and chemicals, said a total of SR190m ($50.7m) could be trimmed off of its 2016 results.

“Industry will be negatively impacted by the government reduction of subsidies, which will translate into higher costs for the end user,” Bashar Abdulrahman, CEO of Almajal Alarabi, told OBG. “This will be difficult for certain regulated industries who can’t transfer costs, such as steel and taxis.” Almajal Alarabi is a holding company with 12 subsidiaries operating in the fields of IT, utilities, waste management, medical manufacturing, and operations and maintenance of hospitals.

Resilient Industries

Other industry leaders expect a lesser impact from the subsidy rationalisation. “People accepted the change in subsidies pretty well, because they understood the need for it. Energy prices didn’t see a major increase anyway; our costs have only increased by 3%,” Tameem Alshebel, CEO of Saudi Mechanical Industries, told OBG. He added that since the government did not substantially raise the price of electricity compared to petrol and gas, the impact of the subsidy reforms was minimal for the industrial sector.

According to Mohammed Al Namlah, managing director of Amnest Group, subsidy rationalisation has had less of an impact on certain industrial segments. “Subsidy reforms have had little effect on industries that are not energy intensive, such as light manufacturing,” he told OBG. In early January 2016 the chairman of Saudi Aramco and minister of energy, industry and mineral resources, Khalid Al Falih, said he was confident that local industries, including the Saudi petrochemicals sector, would be able to adjust to the rise in domestic energy prices and remain competitive globally.

Smarter Companies

The subsidy rollbacks are causing many companies to reassess their operations, while also forcing them to operate in a more efficient manner. Companies like Yanbu National Petrochemical Company have already said they are working on ways to reduce the impact of the subsidy cuts by increasing the efficiency of their plants. Yamama Cement has signed a deal with Germany’s ThyssenKrupp Industrial Solutions to build two new cement plants featuring low-power consumption technology that consumes less than 800 British thermal units per tonne of clinker and under 100 KWh per tonne of cement (see analysis). The question now is whether companies can carry on with the same prices for consumers simply by being more energy efficient, or if they will need to pass on any cost increases to the end users. Petrochemicals producers, who have been affected by sustained low oil prices, are said to be weighing the pros and cons of increasing consumer prices, given the risk of being priced out of certain deals.

Benefits Of Change

Businesses have had little incentive in the past to be energy efficient, and energy-saving technologies that are ubiquitous in other regions of the world have had minimum penetration in oil-rich Saudi Arabia until now. This could now change, as some stakeholders see the subsidy cuts as an opportunity rather than a problem. “As a businessman I don’t want the energy price to increase, but if you ask me as a Saudi, what is best for the country, it is very good. It impacts our margins, but people will start to think more about efficiency. We shouldn’t be wasting energy, even if it is cheap. This will make companies and business leaders think about saving power. It is good for the long term,” Ayman Al Hazmi, general manager of Wahaj (Saudi Specialised Products Company), an affiliate of Sipchem, told OBG.

Long term, the impact is likely to be positive. The International Energy Agency (IEA) predicts that the decision to cut subsidies will force Saudi industrial players to become leaner and more competitive. “The net long-term impact for Saudi Arabia is likely to be positive, as government balances improve and resource allocations become less distorted,” the IEA said in a January 2016 report.

Ongoing Competitiveness

The fact that Saudi residents and businesses are still paying a lot less for energy than most of their Gulf neighbours is also likely to help the Kingdom’s industry stay competitive in the region. Moreover, other GCC countries have announced their own energy subsidy reductions, with Oman, Bahrain, the UAE and Kuwait all beginning to enact subsidy cuts.

As impactful as the subsidy cuts could be to some firms – especially those already coping with the low oil prices and government spending cuts – in the long run they are likely to be a positive for the Kingdom as a whole. With growing awareness of energy usage and costs, companies will likely implement energy-saving practices and invest more in greener technologies. This will decrease domestic energy consumption and ultimately free up more crude oil and other fuels for sale on the international market energy products.

As the five-year energy subsidy reform programme moves ahead, industry insiders will be watching with great interest how and where the cuts in subsidies occur, and how much of the subsidies will be left at the end of the period.