Ever since the first significant Saudi oil well discovery in 1938, policy-makers have been worrying about the dangers of becoming dependent on a single resource.

In recent years, economic diversification has been the goal of every minister planning a new project in Saudi Arabia, be it an economic city, tourism development or real estate scheme.

In the mid-1970s, the government launched plans for the massive industrial cities of Jubail and Yanbu to showcase the kingdom’s industrial achievements and outline its ambitions.

At the time, there was widespread scepticism about the cities’ ability to add value to the kingdom’s oil resources. Some 30 years on, such doubts have been dispelled thanks to the successful development of downstream industries such as petrochemicals.

But the drive for diversification only gained serious traction in the late 1970s after Riyadh, buoyed by the oil boom that started in 1974, ploughed its first wave of oil revenues into creating a modern infrastructure, with roads, rail, water and electricity networks.

Saudi Basic Industries Corporation (Sabic) was formed in 1979 with a mandate to build up export-oriented, non-oil industries, chiefly petrochemicals. By the mid-1980s, the kingdom had encountered the first major oil price slump. This was to prove a major trigger for its ambition to further diversify the oil-dependent Saudi economy.

Economic plans

A series of five-year economic development plans were drafted to transform the economy, channelling investment into a host of energy-intensive industries. The third five-year plan, from 1980-1985, was the first sign of the authorities’ willingness to spread the economic base beyond hydrocarbons.

By 1985, the industrial cities of Jubail and Yanbu were largely completed, and private investment started to flow into industry, agriculture, banking and construction companies, supported by generous government financing and incentive schemes. Sabic has steadily rolled out a series of petrochemicals projects, joined by a wave of privately backed plants, since the early 1990s. Since 2000, non-oil sectors have emerged as the key drivers of economic growth.

Yet despite strong non-oil-sector growth, averaging more than 5 per cent in recent years, the Saudi economy remains overwhelmingly hydrocarbons-based, with more than 90 per cent of state revenues derived from oil exports.

A strategy paper released by US consultant Booz & Company in 2008 questions whether the Saudi investment programme is correctly balanced. Booz & Company says it is unclear whether sufficient capital and labour are being routed to productive economic sectors, such as manufacturing, rather than support sectors, such as construction and real estate, infrastructure, and logistics.

The one sector in which Saudi Arabia has established a sizeable non-oil industry is petrochemicals. This is an industry that is just one step removed from the original source of wealth, and where advantageous feedstock prices have strengthened the economic case for further investment in the sector. The chemicals and plastics industries now comprise more than 70 per cent of the country’s non-oil exports.

Although the kingdom enjoys a wider industrial base than its Gulf neighbours, boasting steel, plastics, light manufacturing, building materials, cement, aluminium and minerals mining, these have yet to seriously compete with petrochemicals as a source of wealth generation. To boost these industries’ contribution to gross domestic product (GDP), the kingdom’s new industrial and economic cities will focus on energy-intensive industries such as aluminium and steel.

Competitive advantage

“The government would like the private sector to focus on those areas where the kingdom has a comparative advantage that could be turned into a competitive advantage,” says Said al-Sheikh, chief economist at Jeddah-based National Commercial Bank (NCB).

The six economic cities are key delivery channels for the Saudi diversification programmes. The cities will focus on four core industrial sectors: aluminium, steel, fertilisers and petrochemicals. The latter is particularly important, and the economic cities’ master-plans call for the creation of several petrochemicals-based industries: 310 packaging facilities, 130 tyre and automotive component manufacturing plants, and 150 toy factories.

“Nobody said the economic cities were expli-citly part of the diversification process but when you examine it, it does represent an impressive example of diversification,” says Leroy Levy, a Dubai-based partner at UK law firm Trowers & Hamlin, which has had an advisory role on several of the economic city projects.

But the country still has a long way to go. In 2008, non-oil private sector growth slowed to 4.3 per cent, from 5.8 per cent in 2007, the weakest performance since 2003. The collateral damage of the global financial crisis has evidently left its mark on the kingdom’s industry. The Saudi industrial sector grew by 5.4 per cent in 2008, well down on the 8.6 per cent growth rate in 2007.

The slowdown in the non-oil industrial sector is predicted to continue in 2009. According to Saudi bank Sabb, petrochemicals and plastics, historically good export earners, will decline this year.

The country’s industrial plans have suffered a series of setbacks as a result of the global fallout from the sub-prime crisis. The biggest came in December 2008, when UK/Australian mining giant Rio Tinto announced it was unable to finance its 49 per cent stake in a $10bn aluminium joint venture in Saudi Arabia with Saudi Arabian Mining Company (Maaden), because of the global crisis. Alumco, the company formed by Rio Tinto and Maaden, was planning to develop the 740,000-tonne-a-year (t/y) aluminium smelter using bauxite from Saudi mines.

“The kingdom’s plans - such as the Maaden project, which is now up in the air - have hit a rocky patch,” says Eckart Woertz, economics progamme director of Dubai-based economic think tank the Gulf Research Centre.

Mining is intended to play a prominent role in the broadening of the kingdom’s industrial base. Maaden is investing SR60bn ($225bn) in projects to mine phosphate, bauxite, gold and other metals and minerals. Its most prominent scheme is a proposed $5bn aluminium smelter at King Abdullah Economic City, in partnership with Dubai’s Emal International, which will have a 700,000-t/y capacity.

Diversifying mining activities through the domestic processing of raw materials into semi-final or final products would increase the sector’s contribution to the economy. Riyadh’s eighth development plan, for 2005-10, is aimed at achieving the highest level of integration of all processes, leading to the manufacture of high-quality products capable of competing effectively in international markets.

According to NCB, the kingdom boasts a proven reserve base of 126 million tonnes of bauxite, with about 58 per cent alumina.

Saudi Arabia is also primed to become a net exporter of primary aluminium. Five upstream aluminium projects have been announced, which, if completed according to the timetable, could reach a combined production capacity of 3.1 million t/y of primary aluminium by the end of 2012.

Steel is another prominent candidate for expansion. The Saudi General Investment Authority (Sagia) says Saudi Arabia could supply up to 10-million t/y of direct-reduced iron. According to NCB, local supply of iron and steel products was expected to grow by 14 per cent to 15.6 million tonnes in 2008, with domestic demand set to absorb nearly 90 per cent of that.

New investments include SR7.5bn from the local Al-Tuwairqi Group in an integrated steel complex in Dammam, with total capacity of 4.3 million t/y. A second project, with 500,000-t/y capacity, to manufacture metal bars for railway lines, is also under study. Sabic affiliate Hadeed is expanding its Jubail mill with an investment of SR3.75bn to produce an additional 1 million t/y of steel products on top of its current 5 million t/y.

These projects will all have to contend with a deteriorating economic climate. The dramatic drop in oil prices over the final three months of 2008 has reinforced the need to mitigate the kingdom’s dependence on hydrocarbons, but the economic downturn will clearly undermine the economic diversification programme, as Rio Tinto’s pullout from its joint venture with Maaden demonstrates.

But there may also be an upside to the economic gloom. According to Sabb, the financial crisis represents an opportunity to reprioritise projects and focus on those that have a direct impact on diversification and employment generation. Lower materials and engineering, procurement and construction prices in the latter part of 2008 provide an opportunity to advance the diversification process.

“Slowdown is not an option,” says Ihsan Bu-Hulaiga, an economic consultant and member of the Majlis al-Shura (Consultative Council). “We have the money and there is the need. It would not be advisable to slow the economic development programme down - after all, prices are falling and contractors are looking for jobs, so we will be able to execute projects with very competitive pricing."

Industrial expansion

Before the financial crisis hit the region, the government had attempted to inject new life into its industrial diversification effort, drafting grand schemes such as its Vision 2020 strategy for industrial development, an initiative to promote the expansion of the kingdom’s industrial sector.

The National Industrial Cluster Development Programme was created to grow and diversify the economy by developing targeted industrial clusters that leverage the kingdom’s resources. Five clusters were selected for development covering automotive, construction, metals processing, plastic packaging and consumer appliances.

Manufacturing is another key sector. The Saudi Industrial Property Authority (Modon) is to launch a 1-million-square-kilometre industrial city in Jeddah, aiming to attract up to SR1bn in investment to develop a series of light-to-medium industrial plants.

The sector’s contribution to GDP grew at an average rate of 5.4 per cent a year from 1991 to 2008, according to the Booz & Company report. As a result, per capita manufacturing and industrial activity have surpassed the $900-a-year mark, bringing Saudi Arabia’s manufacturing sector more into line with those of emerging economies such as Brazil. If aluminium and steel have been the immediate priorities of economic diversification, the cement sector - umbilically linked to the booming construction sector - has proved a hardy perennial of the Saudi economy. Investment is flooding into capacity expansion projects amid strong demand for clinker and cement.

From installed capacity of 34 million tonnes of cement in 2008, current expansion efforts are on course to deliver 40 million tonnes to the market by 2009.

Cement demand

“Cement is another energy-intensive sector capable of producing what is needed locally,” says Al-Sheikh. “But they may have to look for export markets to grow the industry."

The expansionary 2009 budget unveiled in December 2008 will sustain investment spending as the Saudi government attempts to kick-start economic activity in the wake of the economic downturn.

The construction sector is receiving renewed budgetary support, with the government hiking development outlays by 36 per cent to SR225bn, which will underscore demand for cement and related materials.

State largesse is much in evidence as the kingdom tries to shore up the economy during the current turmoil. In mid-November, King Abdullah bin Abdulaziz al-Saud announced that $400bn would be invested in the economy over the next five years.

The strategy has widespread support. “It would make no sense to send any signals that the government is not fully committed to its development programme,” says Bu-Hulaiga. “It is very consistent in sending out this message, and public expenditure in 2009 is going to be a record high."

The more ambitious components of the Saudi diversification effort are still in the pipeline. The eighth development plan aims to fine-tune economic diversification, calling for new universities and colleges with technical specialisations. The emphasis is to be on the creation of a knowledge and services industries, notably domestic tourism.

One view is that the government should target industries that encourage the development of new knowledge and technology.

The Booz & Company report says that by focusing on this goal, energy-rich and oil-dependent nations such as Saudi Arabia could escape their existing model, in which they merely export raw materials, earn capital, and then spend portions of that capital on imported goods and services.

The planned Knowledge Economic City (KEC) near Medina is central to the kingdom’s economic plans, and a recognition by the government of the need to invest in a new generation of manufacturing technology. The most ambitious of the economic cities, its mandate is to develop the country’s technology base, with SR26bn in investment in information and technology centred on King Abdullah University of Science & Technology.

These kinds of educational institutions are intended to supply the skilled labour force that is demanded of a modern knowledge-based economy. However, sceptics point out that establishing a knowledge-based economy is no quick fix. “Knowledge is not something you can easily package into a marketable good,” says Weotts.

“The lack of highly qualified labour and research centres - where research and development is able to migrate to the business world - is a problem,” says Al-Sheikh.

Questions have also been raised about the efficiency of the existing industrial focus. As the country’s major social and economic priority is to create jobs, the large capital-intensive heavy industries - such as petrochemicals, steel and aluminium - are ill-suited to that role. Yet these are the sectors where Saudi Arabia’s competitive advantage lies.

Engineering the jump from capital-intensive industries that offer only limited employment opportunities into labour-intensive sectors, such as services, that will create jobs is a major policy challenge.

This could necessitate a reshaping of Riyadh’s diversification strategy away from industrial sectors towards a services economy model that creates more jobs.

Many Saudi business leaders argue that services is the natural, untapped sector for job creation. “We need to develop a service industry,” says one senior Jeddah-based businessman. “Ireland is an example for us as it managed to leapfrog the industrial revolution. They realised they did not need smokestack industries. Saudi Arabia needs to do that too."

That may still be a big task. “It would be great if we could follow Ireland’s example, but that country has invested heavily in education,” says Al-Sheikh. “We need to reform the education system and focus more on engineering and science."

Critics also point out that diversification requires a dramatic improvement in the performance of government. Too many five-year plans have come and gone with targets missed or quietly forgotten.

“The bureaucracy does not have the mindset to be competitive,” says Bu-Hulaiga. “It needs to seize the opportunity to develop the country, to expand exports and increase job opportunities. There is a lot of talk, but implementation is not one of the key performance indicators on which the bureaucracy is measured."

Economic diversification is a massive challenge, and one that Saudi Arabia’s policy-makers cannot afford to duck.

Table: Saudi aluminium sector indicators

f=forecast

Source: NCB