A reliable strategy for the Middle East’s hydrocarbon diversification

When we hear of diversification in Middle East economies, we may think of ambitious, futuristic initiatives: cities inhabited by robots, self-driving cars, hyperloops and space exploration.

Or it may be more prosaic businesses: financial services, construction, tourism, airports and airlines. But in the Arabian Gulf’s latest drive, it is going back to basics, wringing more value out of the hydrocarbon industry.

What is the point of diversification? Economies that grew up on the export of oil and gas are exposed to various problems as they mature. Prices are highly volatile, making it difficult to manage the government budget from year to year.

The industry employs few people, leading to a reliance on the state to create jobs for the rest of the population. The enormous inflow of wealth leads to over-appreciation of the currency and crowds out other businesses, except those dependent on the government’s favour.

For the Gulf states, with their enormous resource bases, there is also the concern for a time when oil may be progressively replaced by other energy sources, leaving them with untapped oil under the ground of little value.

These problems have been recognised since at least the 1970s. Some countries have escaped the trap, such as Malaysia, Norway and Chile (an exporter of copper), by investing in their people, and steadily moving up the technological ladder. Paradoxically, it helped Malaysia and Norway that their offshore fields were difficult and expensive to tap, and the reserves relatively limited, forcing them to use more advanced technologies.

Middle East countries have been through ambitious economic schemes and visions for reducing dependence on hydrocarbon exports. Some have been quite successful, while others remain works in progress or have been quietly shelved. Yet oil and gas exports still provide 15 per cent of GDP in the UAE and 45 per cent in Kuwait, compared with 6 per cent in Norway, and account for a large majority of budgets.

Much of the successful Gulf diversification from the 1980s onwards focused on energy-intensive heavy industry – aluminium, steel, petrochemicals – where the region had a natural competitive advantage. Now, after four years of relatively low oil prices, regional governments are again dusting off this blueprint.

The new plans for regional economic growth lean heavily on further expansion of the energy sector. The UAE’s Adnoc intends to spend $45 billion to become a leading global player in downstream – the business of refining oil and making petrochemicals, intended to add 1 per cent annually to national GDP. Saudi Aramco will invest $100bn on chemicals over the next decade, and $160bn in gas development. Saudi Arabia’s Ma’aden is mining for alumina, phosphates and gold, in the tradition of big, capital-intensive extractive projects.

Oman is developing a refining, petrochemical and oil storage hub at Duqm in its south-east, at a cost of $15bn. As gas production expands, Egypt wants to become a regional energy hub. Adnoc and Aramco also intend to boost their oil trading arms, as Oman has for several years.

Some would challenge whether such investments are really diversification, as they still depend on hydrocarbons.

They provide a stream of export revenues that are less correlated to oil prices. Refining margins – the increased value of the mix of oil products coming out of a refinery over the crude oil input – are related only weakly to the price of that crude oil. The prices of petrochemicals follow oil, but are not as volatile – steel is partly correlated. On the other hand, aluminium prices closely follow those of oil.

These heavy industries involve advanced technologies and hence enable the host country to make its way up the ladder of technological sophistication. The basic materials industry does not employ many people, but Gulf producers are now moving into speciality chemicals such as synthetic rubbers.

Petrochemicals are forecast to be the only major sector of oil demand where long-term growth is assured. They are much less exposed to action against climate change than other uses that burn oil.

Downstream investment thus appears as a necessary consolidation of the energy sector, and expansion into a closely-related industry where skills should be readily transferrable. Other such areas include solar power, inorganic chemicals, metal processing and oil services, such as drilling, production technologies and oilfield engineering, a major high-tech export industry for Norway but one where the Gulf is relatively weak.

However, these businesses are all competitive and have become even more so with the rise of cheap US shale gas. They do not offer the easy, long-term flow of rents that flow from large, easily produced oil and gas reserves. As they diversify, governments have to find a way to fund themselves.

Low taxation, along with cheap land, labour and energy inputs, have been the major draws for investment. As these advantages recede, they need to be replaced by world-class infrastructure and efficient regulations.

Every nation needs to shoot for Mars. But in tandem, the steady work of building on the energy industry offers more solid, although more limited, gains than seeking the far frontiers of new technologies.

Petrochemicals are forecast to be the only major sector of oil demand where long-term growth is assured

Robin Mills is CEO of Qamar Energy, and author of The Myth of the Oil Crisis