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Economics: The Saudi Oil Floor
New York: September 19, 2005
By John R. Stephenson

Today, oil and Saudi Arabia are synonymous. With 25 percent of the world's proven oil reserves and the ability to increase supply, seemingly at will, Saudi Arabia is the fulcrum that the global economy teeters on. The country produces more oil annually than any other nation on earth and boasts the largest known oil field - the Gharwar field which accounts for 55 percent of Saudi output. The country produces about 9.5 million barrels a day of crude oil, more than any other single country and the high quality and prodigious supply has ensured Saudi Arabia a place at the world table.

Saudi Arabia has tremendous influence in world not only because of its own treasure chest of reserves, but also because it and it alone functions as the market regulator for the global petroleum industry. Not to mention that the country has the money, influence and political will to pursue control of the Arab Peninsula and Central Asia - a region that collectively controls more than sixty percent of the world's proven oil reserves. Like it or not, the economies and the fates of the western world, particularly America, are deeply entwined with the fortunes of Saudi Arabia.

But it wasn't always so. For centuries the harsh climate and sheer size of Saudi Arabia coupled with its sparse and nomadic population made it a difficult place to inhabit and even harder to unify. For centuries the vast interior of the Arabian peninsula existed in total isolation from the rest of the world - characterized by extreme poverty, a desert mentality and strongly held religious views. From 1750 to the early 1900s, control of the Arabian Peninsula jostled between the Al Saud family, the Ottoman Empire, Egypt and other competing Arabian families. This all ended in 1902 when Ibn Saud restored the family dynasty by seizing Ridyah. Over the decades that followed, he reconquered and reunified the rest of the peninsula and in 1932 the territory was named the Kingdom of Saudi Arabia after the Al Saud family.

With the discovery of oil in 1938, everything changed. Almost overnight Saudi Arabia was transformed from a country of extreme poverty to one of immense wealth. As oil prices surged in the 1980's, Saudi Arabia became the richest country in the world. For most of the 22,000 members of the extended Saudi royal family this extraordinary wealth has come without responsibility. With little to do and money to burn, the descendents of Ibn Saud are known throughout the casinos of Monte Carlo and the beaches of the Mediterranean as playboy princes for their self-indulgent and lavish lifestyles.

It isn't just the members of the Saudi royal family that have been living high off the hog, the average Saudi is eligible for free healthcare not to mention interest-free home and business loans. College educations are free and gasoline, electricity and telephone service are heavily subsidized. But this paradise is not all its cracked up to be - instead of providing tremendous opportunities for its citizens this ultimate welfare society has left many of its citizens including the best educated and brightest unwilling to work. Foreign laborers fill Seventy percent of all jobs in Saudi Arabia -and almost ninety percent of all private-sector jobs - because Saudis are either unwilling or unable to work.

Further complicating the problem is the familiar story of demographics. Outside of Africa, Saudi Arabia has one of the highest birth rates in the world - approximately 37.25 births for every thousand citizens. The result? Half of the Saudi population is under eighteen and fully ninety-seven percent are sixty-four or younger. With free education - much of which is religious based, there are far too many young people chasing too few opportunities.

With surging ranks of young people looking for work and young royals pushing up from below, chafing against a leadership that was slipping into its seventies and eighties, Saudi Arabia has begun to show signs of strain. But it isn't just a generational clash that is causing strain within Saudi society; it is the run-away spending that poses the most immediate threat. Spending on maintaining the welfare state and huge expenditures on arms. In fact, Saudi Arabia probably spends more per capita (13 percent of GDP) than any other country on arms, while most of their external security needs are looked after by the United States. France, which maintains a combat ready mobile army spends only 2.57 percent of GDP on its military.

With the Kingdom spending boatloads of money on arms, construction services and drilling rigs supplied by the U.S. in return for ready access to oil a fuse has been lit that threatens the very survival of the Saudi Arabia. The first warning came after the first Gulf War when prodigious spending on the war at up Saudi Arabia's entire budget surplus and sent them begging for money and living off of credit.

According to Randy Ollenberger an analyst with BMO Nesbitt Burns in Calgary, "the oil price required for the Saudi's to run a balanced budget is estimated at around US $30/bbl. This number include the actual lifting costs, which are quite low (approximately US $3/bbl) and the remainder is what we think of elsewhere as royalties, which is basically everything else above the lifting cost up to the point at which the country can run a balanced budget. For OPEC countries such as Saudi Arabia we should also consider these additional expenditures (over and above the lifting cost) as a cost since oil is their main source of revenue for funding social infrastructure."

With a floor of $30 per barrel for the Saudis to entertain further development of the their oil fields while keeping their budgets in balance, suddenly the cost structure inherent in the oil sands projects of western Canada begin to look more reasonable. With cash costs for the oil sands projects averaging $30 to $35 per barrel, suddenly the worlds second largest oil reserves are starting to look competitive with the historic benchmark for cheap, reliable and plentiful crude.

Investors, who are concerned about the surging demand for oil coupled with tight supply, should consider building a portion of their portfolios around the oil sands producers. With a massive government surplus, plentiful supply and cash costs that are now on par with the most prodigious region in the world, oil sands investments are starting to look more reasonable all the time.

StephensonFiles is a division of Stephenson & Company Inc. an investment research and asset management firm which publishes research reports and commentary from time to time on securities and trends in the marketplace. The opinions and information contained herein are based upon sources which we believe to be reliable, but Stephenson & Company makes no representation as to their timeliness, accuracy or completeness. Mr. Stephenson writes a regular commentary on the markets and individual securities and the opinions expressed in this commentary are his own. This report is not an offer to sell or a solicitation of an offer to buy any security. Nothing in this article constitutes individual investment, legal or tax advice. Investments involve risk and an investor may incur profits and losses. We, our affiliates, and any officer, director or stockholder or any member of their families may have a position in and may from time to time purchase or sell any securities discussed in our articles. At the time of writing this article, Mr. Stephenson may or may not have had an investment position in the securities mentioned in this article
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