Saudi Arabia’s Fossil Fuel Subsidies: Understanding the Problem

This is part one of a two-part series on Saudi Arabia’s fossil fuel subsidies. This post discusses existing problems with Saudi Arabia’s subsidies program.

The governments of developing, oil-exporting countries tend to maintain domestic fossil fuel prices at levels significantly lower than the free-market prices. Selling fossil fuels at domestic prices below the market leads to the implicit subsidization of petroleum consumption.[1] These governments believe that subsidizing fossil fuels ensure that their citizens, particularly the poor, enjoy cheap consumption of their own country’s resources. Such efforts are believed to generate higher consumption of other goods and services, leading to overall economic growth. However, studies have shown that fossil fuel subsidies do more harm than good. Fossil fuel subsidies lead to economic inefficiency, adverse impacts on social equity, and high fiscal cost for these governments.

As for the Kingdom of Saudi Arabia, its citizens enjoy one of the lowest fossil fuel prices in the world. Diesel and gasoline sold in Saudi Arabia are about 12 percent and 30 percent of international reference prices, respectively.[2] Saudis enjoy the second lowest domestic fossil fuel prices in the world, behind only Venezuela. In 2009, the Kingdom spent a total of $32.5 billion on fossil fuel subsidies. In 2010, this figure increased to $43.6 billion. In 2011, it ballooned to $60.9 billion.[3] Of its total subsidy spending in 2011, 76 percent went to subsidizing oil, while 24 percent went to electricity, which is also derived from oil. Riyadh is currently the second highest spender on fossil fuel subsidies in the world, second only to Tehran, which spent $82.2 billion in 2011.[4] Commendably, however, the Iranian government successfully carried out significant subsidy eliminations in 2011.

The Kingdom’s rationale for keeping the domestic prices of fossil fuels low is multi-faceted. As the world’s largest producer of oil, Saudis expect and demand that their national resource be made available to them at cheap prices. The rulers see subsidies as an easy means to distribute state benefits to the citizens without the need for complex administrative capabilities and income testing.[5] Fossil fuel subsidies are also believed to help alleviate poverty by making energy economically accessible to the poor. Furthermore, there is a prevailing belief that fuel subsidies will promote industrialization and help generate employment opportunities. Keeping energy prices low has also been a tool of the government to manage inflation. Finally, given the ongoing Arab Spring revolutions in the MENA region, maintaining low fossil fuel prices could help deter potential protests in the Kingdom.[6]

In reality, however, the negative impacts of fossil fuel subsidies outweigh the benefits. Saudi Arabia, like other countries artificially keeping energy prices low, has been hurt by fossil fuel subsidies in several areas: economic inefficiency, adverse impacts on social equity, and high fiscal cost for the government.

Economic Inefficiency

Fossil fuel subsidies generate a pricing scheme that deviates from efficient pricing, leading to a dead-weight welfare loss. This occurs when the government’s lost revenue from subsidizing domestic consumption (instead of exporting) is greater than the increase in domestic consumers’ surplus.[7] Fossil fuel subsidies lead to a mis-allocation of resources, preventing the country from optimizing the use of its oil reserves, and encourage over-usage of energy, which leads to a high fuel consumption growth rate.

In fact, Saudi Arabia is the world’s largest consumer of oil per capita (37.2 barrel per year), and the growth rate of such consumption is 7 percent a year. This is higher than the Kingdom’s annual population growth rate of 3.2 percent. Some analysts even predict that by 2030, Saudi Arabia will need to import oil if domestic use continues to outpace production gains. [8] Furthermore, these subsidies discourage productivity improvements and investments in energy-efficient technology. The low domestic prices of fossil fuel products in Saudi Arabia also lead to rampant problems of smuggling and corruption.[9]

Adverse Impacts on Social Equity 

Although one of the intended outcomes of fossil fuel subsidies is for the poor benefit from cheaper energy costs, subsidies are not an efficient means of improving access to energy and redistributing income to the poor. In fact, fossil fuel subsidies are highly regressive, as richer households benefit more than the intended poor. Fossil fuel subsidies have also diverted substantial resources away from other pro-poor investments in health, education, infrastructure, and other better-targeted social welfare programs. In fact, the Kingdom spent more on fossil fuel subsidies (10.6 percent of GDP) than on health (about three percent of GDP) and education (about six percent of GDP) combined.[10]

High Fiscal Cost

As mentioned above, the Kingdom spent $61 billion on fossil fuel subsidies in 2011. This figure was equivalent to 10.6 percent of the country’s GDP. In total terms, Saudi Arabia is the second highest subsidizer in the world with the average subsidization rate of 79.5 percent.[11] Its subsidy per capita in 2011 was at $2,291, making the country also one of the highest subsidizers per capita in the world. The only countries who spend more on fuel subsidies in per capita terms are Kuwait, the UAE, and Qatar.

In the short run, such high spending on subsidies seems unlikely to pose a significant problem, other than preventing investments in other pro-growth and pro-poor sectors. However, in the long run, this could become a huge burden for the Saudi government as the consumption rate continues to rise.

The increasing need for domestic consumption of oil would shrink government coffers while the expenditure would rise. There would be less oil for export. This is particularly alarming, considering oil exports account for 86 percent of the Saudi government revenue. Furthermore, high subsidies would hinder the development of non-oil private sector, especially the small and medium enterprises required for job creation in order to meet the job demand of a growing Saudi population (more than 50 percent of whom are under the age of 25).[12] The current growth rate of the private sector has slowed down to 4 percent in recent years, but economists estimate the level needed to sustain youth employment should be about 6.5 percent.[13]

Recommendation: Cut Fossil Fuel Subsidies in Saudi Arabia

Given the negative implications of fossil fuel subsidies for Saudi Arabia, the logical next step for the House of Saud is to cut these subsidies. However, cutting subsidies by raising domestic prices of fossil fuels is not an easy task. Phasing out subsidies is a highly sensitive topic in most countries, particularly net-oil exporting ones, including Saudi Arabia. The Kingdom will need to consider different strategies in removing these subsidies and pick the one that is most politically feasible. The next article will detail these policy options and offer a path forward.