The analysis and opinions expressed hereby reflect the author’s personal points of view. They do not embody the institution to which the author belongs.
Can you go back to the reasons for the fall in oil prices since mid 2014?
Oil prices dropped 60% from June 2014 to January 2015, with the Brent Crude benchmark going from $115 to $46. The main reason was a surplus on the market, but the extreme fluctuations in price cannot be solely explained by a market imbalance that was historically fairly small.
Recent dramatic price fluctuations can be explained by a combination of fundamental reasons, trading patterns, and the effects of recent announcements.
1) If we look at the fundamentals of the supply market, around the summer of 2014, it became very clear that a - slight - surplus was forming on the market. This was due to the fact that Iraq was increasing exports and US domestic production of non-conventional hydrocarbons had shut down a massive market . Plus, all of this was suddenly compounded when Libya quadrupled its output in a matter of a few months. Crippled by internal conflict, Libyan output had plunged to an average of 0.2 m b/d (million barrels a day) in Q2 2014. But by the autumn, output was back at 0.9 m b/d (October output) , a substantial increase that represented the majority of the excess supply in the world.
On the demand side, there were increasing reports that an increase in oil demand growth might not be as high as expected and that demand growth forecasts would have to be reduced, notably from China. Oversupply is not necessarily a problem if the market believes that it can/will be absorbed soon by rising demand. But worries were growing that there might not be new demand. By mid October 2014, the Brent Crude had dropped over 20%.
2) Trading patterns play a role as well, especially when fundamentals cannot explain everything. For example, a 60% fall in one price for an oversupply estimated to be historically very moderate means either that the market has been mispricing the asset for a long time or there is a structural change in the market dynamic. It is hard to properly explain asset mispricing, because determining the right price of an asset class will always remain elusive outside strict supply-demand dynamics. But it is undeniable that a growing number of oil exploration and production facilities have seen their costs increase significantly over the years for many reasons that include: diminishing yields of aging fields; increasingly complicated geologies of new ones (such as: deep offshore, shale oil, tar sands, extreme terrains, and arctic explorations); and increasing safety and environmental costs (especially after the Gulf of Mexico BP disaster). All in all, from the beginning of the decade to June 2014, the market seemed to have found stability in a fairly tight trading range hovering around $105-$115 (Brent). The “fair” market price was generally considered to be $100 a barrel. At the same time, that summer, many other assets seemed to be going through a reassessment of their price amidst growing concerns that years of ultra lax monetary policies had led to too much money (liquidity) chasing a limited range of financial assets. This resulted in a mispricing of a number of financial assets, especially commodities. In other words, many market investors began to fear the existence of asset bubbles on certain traded products. It is also important to understand trading models and patterns. Once an asset class breaks what is called a ’resistance level’ of a certain trading range within which it was trading for some time, the market might lose its sense of direction and it will take time to find the new ’resistance level’ or put simply, what is deemed to be the ’right’ price point.
3) Finally, “announcement effects” brought the last hit during the fall of 2014, which triggered a self-fulfilling news cycle. First - as mentioned above - in its September 2014 report, the EIA announced that due to a "pronounced slowdown" in the Chinese economy, demand growth from China in the upcoming months would be significantly lower than first estimated. Consequently, it cut Chinese oil demand growth for 2015 from 1.2m b/d. to 0.9m b/d. Asian oil demand growth has been the largest absorber of global oil production growth. Oil market participants started to anxiously cut their positions further, and multiple reports tended to show how the US shale oil and gas boom was bringing an end to high oil prices, thus accelerating the bearish market. Then, on 27 November 2014, despite the pressures to cut production to push prices back up, the Saudi-led OPEC meeting issued a press release clearly stating that it was satisfied with the oil market dynamic and saw no need to cut output. In a matter of a few weeks, Brent went from $80 levels to $46 in early January 2015. Since then, the market seems to have stabilized around the $60-65 range, albeit with a 40% increase.
Will the new agreement with Iran drive more uncertainty?
Iran opening up will most likely not be a game changer for the oil market, at least not in the short term. Iran produced up to 6mbd in the 70’s (more than double today’s 2.9mbd). But even with a return of investments, there are many hurdles that will prevent a rapid rise in output. Lasting damage was caused to oil reservoirs during a strike in the late 70’s, compounded by the chaos of the Iran-Iraq war of the 80’s. Production never got back to its previous level and struggled to reach (briefly) the 4mbd level in 2010. Capital and equipment shortages, the lack of investment in aging oil fields all mean reduced potential capacity further. At the best, it will take 18 months for Iran to meaningfully increase its production and this marginal supplementary output will hit the market at a time when the global supply-demand will most likely have returned to deficit.
What are the economic and budgetary consequences of this fall for the oil producing countries in the Middle East and the Gulf?
Not all GCC countries have been equally affected by the steep drop in oil revenues. Bahrain and Oman - the smallest economies of the GCC - appear to be the weakest. Both also face fast dwindling oil reserves, have comparatively low cash buffers, and had the highest fiscal break-even points. The four other economies - Saudi Arabia, UAE, Qatar, and Kuwait - have substantial buffers to ride the storm.
Despite what is sometimes said, we are seeing fiscal restraint in all countries. This period of lower oil prices is also an opportune time to reassess the energy subsidy system in place in the Gulf, the most expensive in the world. Energy subsidies represent around 12% of GDP in Saudi Arabia and about $260B are spent on energy subsidies per year in all.
The problem is that a combination of high subsidies and public expenditures dominated by salaries, pensions, and social spending have ’rigidified’ the budget, with recurrent spending representing close to 90% of government spending in a country like Bahrain. Consequently, in times of decreased government revenues, there is less leeway and any cutbacks affect capital expenditures - the most productive part of public spending.
It is important is to keep in mind a few points:
The fiscal break-even point (the oil price needed so a given country can balance its budget) has been one of the most talked-about issues relating to oil producing countries and how vulnerable they are to oil prices going under the $90-100 level. Indeed, in the run-up to the oil price collapse, many GCC countries had fiscal break-even points way above the $100 limit.
But while certain GCC countries with diminishing reserves and aging fields (Bahrain, Oman) require increasingly expensive extraction techniques, most GCC countries have among the lowest oil extraction costs in the world - under $10 per barrel. So, with low extraction costs and accepting that the fiscal breakeven point can vary (provided they manage to curb public expenditures), the GCC can recover some fiscal flexibility, even if it takes some time.
The second point - and it relates to the first question - is that I am not sure that the current oil price is at an unsustainable level for GCC countries. If Saudi Arabia pressed ahead with unchanged oil production despite the oil price fall, it was partly because it knew that it was in the best position to win any price wars - a flexibility that other non-Gulf oil producing countries do not have. It has already gained 40% from a low of $46, and we are near levels to which I believe GCC countries can adapt.
The most problematic aspect for GCC countries is addressing the rigidities of their public expenditure, and a lot of it relates to the unspoken social contract of cheap energy for its citizens. Some of these countries have experimented with trying to get prices closer to their recovery costs, at least for the expatriate population. In GCC countries such as Qatar or the UAE (with 80%-90% expat populations) it could drastically correct the economic imbalances. However, in Saudi Arabia, it wouldn’t make a big difference. Also, governments have been trying to reduce some energy subsidies in certain industries.
Until now, Saudi Arabia has decided to rethink some of its non-strategic projects while pushing ahead with many others and choosing to draw on its cash reserves (and possibly bond market) to fund them. Qatar and the UAE are discreetly pushing back some projects or reassessing other non-strategic ones.
Outside the GCC, Iraq is worth mentioning as the other main (and growing) oil producing country in the region. It is on the verge of becoming a major player on the oil market. Iraqi oil production keeps beating records. In June, production was up 15% from the previous month at 4.4 m b/d, which makes it the second most productive OPEC country after Saudi Arabia. But Iraq faces major fiscal challenges as funding a war, dealing with a humanitarian crisis, and salvaging essential infrastructures have caused its public spending balloon. The combination of higher public spending and a drop in oil proceeds mean that the country will have to find outside sources of funding to plug the gap.
Finally, Algeria is the other major oil producing country that is going through hard times, albeit for other reasons. The massive gas producer has seen its hydrocarbon-based economy struggle amidst a regulatory environment that is unfavourable to foreign investors. External expertise is needed to modernise and further explore certain geologies in Algeria, but reticence to accept the terms imposed by International Oil Companies has stifled increase in output. At the same time, the country has not done enough to wean itself of its hydrocarbon dependency and its import bill has ballooned to a point that exports do not balance it out in times of lower oil revenues.
What are the social consequences?
In order to understand and anticipate the potential corrective actions the oil producing countries will undertake, it is important to assess the social impact of these events. In fact, the social dimension is probably already dictating economic policies. GCC countries have been reluctant to implement bold subsidy reforms, as they are afraid to upset a delicate social fabric that is already being tested by domestic and regional political and ideological conflicts.
Could this fall represent a risk for the political stability of these states?
Not at this stage, I don’t think so. But this view is underpinned by the idea that oil prices are back to levels that the GCC can adapt to and the fact that GCC states are extremely conservative when handling any social fallout from changes in public expenditures. Dealing with political and religious tensions and defining how much space should be left to dissent (in any form) are a bigger challenge.
How are other states in the Middle East affected by the fall in oil prices?
If one goes beyond the oil producing countries, it is interesting to note that the dynamics of oil prices might not impact countries the way one thinks. According to World Bank figures World , almost half of MENA (Middle East and North Africa) remittances come from the GCC. If we take Lebanon (a net oil importer) for example, its very large exposure to oil exporting countries (most notably GCC through remittances of its diaspora and business investments) means that any benefits of lower oil prices is tempered by lower dollar flows from the GCC. Typically, when oil prices were around the $110 mark, Lebanon’s economy was nevertheless booming. Its debt to GDP ratio narrowed, and fiscal metrics improved. For now, the main factor impacting the economy of both Lebanon and Jordan is geopolitical instability, which has crippled their growth drivers- notably tourism and investments – which are quite dependent on confidence.
In the rest of the region, Egypt’s economic fate tends to be closely linked to the economies of the GCC as well (73% of remittances come from the GCC ); but Gulf countries have spent unprecedented sums supporting President Al-Sisi’s government. This has triggered a return of confidence from both the market and foreign investors. This has helped to give Egypt a sense of return to stability, at least on the surface. Nevertheless, the security situation is far from being resolved. Here again, the main narrative for the Egypt macro story is not necessarily tied to oil prices.
As for Morocco and Tunisia, lower oil prices have undeniably helped alleviate external accounts. In the case of Morocco it has also helped implement one of the most courageous subsidy reforms (on gasoline, which represented the majority of subsidy spending) in the region.