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Targeting a stable oil price As a matter of Saudi policy, we would expect a preference for oil market stability over volatility, in line with recent official pronouncements. Although volatility makes it more difficult for high cost unconventional producers to operate, volatility is also damaging for Saudi Arabia and long-term planning domestically. For instance, no budget was announced for 1986 due to uncertainties in the world oil market, with monthly current appropriations set at one-twelfth of estimated actual expenditures for the prior year. We think Saudi authorities view possible eventual sharp upward price spikes in the oil price as damaging to both oil-consuming and oil-producing countries. Future investment decisions will be critical for oil prices Spare capacity is an important policy parameter for Saudi Arabia. In addition to its influence on prices through its ability to adjust production, Saudi can decide on the pace of its reserves development which would potentially affect future supply. There are distinct trade-offs in this decision. If Saudi Arabia is producing at close to its maximum capacity, it will have little control over sharp upside movements in oil prices. If excess capacity is large, oil prices are likely to be under downward pressure. In the near-term, given the uncertainty in the market, in our view, there is likely little incentive for Saudi Arabia to embark on a program to invest and increase capacity from the current level. New investments may still be made to offset declines in existing fields. Over time however, our commodities research medium-term oil balances suggest that Saudi’s spare capacity would be eroded over time unless further increases in spare capacity take place. Our BofAML commodities research medium-term supply-demand balances suggest an increased call on OPEC and need to increase production capacity. In 2004-09, Aramco invested cUS$100bn into its largest-ever capacity expansion program, which increased total capacity from 10mn bpd to 12.5mn bpd. For now, Aramco has suggested it will not slow down its hydrocarbon capex program for the next three years as cuts were achieving through savings in drilling costs and supplier discounts. Energy policy is likely to be less aggressive going forward We expect a less aggressive energy policy going forward, particularly as the NTP suggests a constant oil production capacity and an increase in gas production domestically. This is in line with Saudi Minister of Energy, Industry and Mineral Resources Al-Falih’s pronouncements during the June Ordinary OPEC meeting. While his comments served to project increased OPEC institutional credibility and increased rapprochement with fellow OPEC members, he suggested that Saudi Arabia will remain responsive to customer needs but dismissed fears that increasing Saudi market share would take place in an aggressive manner (that could drive prices lower again). Downstream operations - increased focus Saudi Aramco’s downstream integration drive is likely being pursued for two core reasons: (1) to support demand for Saudi crude (placing own crude in own refining capacity) and (2) a risk reduction mechanism in a highly volatile oil environment (having an integrated value chain allows capture of margins from well to the forecourt, promoting stability). In reflection, Saudi Aramco is building highly sophisticated refineries domestically, in addition to already completed joint-ventures and stakes in refineries abroad (China, US, Japan, South Korea, Indonesia). Domestic joint-venture (JV) refineries Satorp and Yasref added 400k bpd each of capacity in 2H14. With the completion of the fully-owned Jazan 400k bpd refinery in 2018/19, overall total refinery capacity would stand at 5.7mn bpd, of which Saudi Aramco’s share would be 3.3mn bpd. This would allow Saudi Arabia to guarantee security of demand for its heavy crude, increase domestic job creation and diversification, build an export base of refined products (likely middle distillates to the EU) and lower imports of refined products. 12 GEMs Paper #26 | 30 June 2016 38 Merrill Lynch HOUSE_OVERSIGHT_016122