The recent drop in oil prices—from a high of $115 per barrel in June 2014 to under $50 today—appears to threaten stability in many oil producing states. But in the Middle East, producers are facing different effects. Saudi Arabia, with its massive foreign currency reserves, seems comfortable allowing prices to drop so it can maintain market share at the expense of its OPEC competitors and the United States. Iran, although already plagued by economic sanctions and vulnerable to low prices, is weaker in the short run but better equipped in the long run to deal with lower revenues. Algeria’s low debt levels and ample cash reserves may be able to forestall an economic crisis, but the government is now acutely aware of the long-term risk of heavy dependence on energy exports. However, prospects are bleakest for Iraq: the war-torn country must deal with the burden of low oil prices as it ramps up an expensive war against the Islamic State.
Four oil experts explore the impact of falling prices on the economies of key regional producers. Please join the discussion by sharing your own views in the comments section.
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Oil Price Decline and Breakeven Points for 2014
Saudi Arabia’s Plan
Nathan Hodson
Nathan Hodson, PhD candidate in Near Eastern Studies at Princeton University, studying Saudi economic history.
Saudi Arabia has decided not to cut oil production in response to falling prices because it determined this was in its long-term economic interests. Saudi Minister of Petroleum Ali al-Naimi has consistently held that Saudi oil policy is motivated by a desire to defend market share and to drive the least efficient producers from the market.
Naimi’s logic certainly stands up to scrutiny. Saudi Arabia’s extremely low cost of oil production, its spare capacity, and its abiding interest in profiting from its enormous reserves govern Riyadh’s rational market strategy, marked by an unwillingness to cut production. Low production costs and excess capacity together make Saudi Arabia’s calculus very different from that of other producers. If and when Saudi decisionmakers decide to introduce some of the kingdom’s nearly 3 million barrels per day of additional oil, they stand to make a great deal of money, whatever the price. In the meantime, by preserving its status as the only swing producer, they ensure Saudi Arabia maintains considerable power in oil markets.
The harm done to Riyadh’s geopolitical rivals has been a nice ancillary benefit, but it was not a central motive, despite what analysts and even heads of state—such as Iran’s Hassan Rouhani—have argued. The claim that the Saudis would cripple their main source of revenue in order to punish Iran and Russia is a dubious one at best. Throwing away billions of dollars in the faint hope of achieving distant foreign policy goals directly translates into much less money for salaries, subsidies, and development projects. And as Fahad Nazer has pointed out, if the Saudis were targeting their enemies, the timing also makes little sense.
The decision not to try to keep oil prices high is indeed a big bet. But the Saudis had few pragmatic policy options. Cutting production would only allow the Russians and others a free ride, encourage new production, and thereby depress prices further. So instead the Saudi leadership, confident that oil prices will recover relatively quickly (that is, within two or three years) and that the government can manage the effects of reduced oil revenues, chose door number two.
Nonetheless, low oil prices are a glaring reminder to Saudi officials that they must get serious about diversification efforts and begin to implement real spending and labor reforms. Yet they do not imply the implosion of the Saudi economy or the collapse of the state. Indeed, the Saudi government can withstand several years of low oil prices, but in the long run it will confront major challenges unless major reforms are enacted. Yet the big question is when: if the price of oil settles in the $50-$60 range—as analysts at most major banks are predicting—and the Saudi government can implement even moderate reforms, then it may be several decades before the kingdom faces a serious fiscal crisis.
Without a doubt, a sustained period of significantly reduced revenues would require the Saudis to find creative ways to cut spending. But the government will delay cuts to salaries and subsidies for as long as possible. For the time being, the 2015 budget indicates that the government is willing to keep spending, even on capital projects, in order to maintain confidence in the Saudi economy. Interestingly, while absolute spending has risen dramatically since 2002, and especially since 2011, it has remained steady as a percentage of GDP (between 30 and 35 percent) since the early 1990s.
Many analysts have paid lip service to Saudi Arabia’s privileged financial position, but its vast reserves are not fully appreciated by most. The government could run a deficit of $38.6 billion—the projected amount for 2015—every year for over a decade before its reserves dry up. Although nobody expects spending to remain flat, Saudi Arabia could certainly borrow if needed, as the country has the lowest debt-to-GDP ratio in the G20. This is to say nothing of the potential to increase returns on foreign holdings. Minister of Finance Ibrahim al-Assaf recently rejected calls to establish a sovereign wealth fund to more aggressively manage Saudi reserves, which are thought to be invested quite conservatively. But if the Saudis wanted to try to make money, the returns could be substantial and would therefore improve the kingdom’s finances.
Within Saudi Arabia, there are open calls for transparency, good governance, and economic diversification. There is also a healthy dose of skepticism about whether the Saudi government is pursuing the right approach. Managing public perception will be key for the Saudi government. So too will expanding the role of the private sector in the Saudi economy, as public spending will eventually be scaled back.
In several years and with the benefit of hindsight, the Saudi decision to maintain production will be considered either brilliant or boneheaded. But for now, it seems to be a strategic one that just might be the Saudis’ best bet.
Iran’s Resilience
Robin M. Mills
Robin M. Mills, head of consulting at Manaar Energy and author of The Myth of the Oil Crisis.
Oil prices affect Iran in the short, medium, and long terms, albeit in different ways. With a budgetary break-even price of $131-36 per barrel,1 Iran appears to be one of the most vulnerable countries to lower prices. Already, the budget for the fiscal year beginning March 2015, which assumed an export oil price of $72 per barrel, is out of date with Brent crude oil now trading around $50 per barrel.
But Iran’s oil income had been hurting long before prices began dropping in June 2014. Oil production already had fallen from 3.58 million barrels per day (bpd) in 2011 to 2.77 million bpd in December 2014 due to sanctions. Even without them, Iran’s oil production was set to decline due to the accumulated effect of maturing fields and past underinvestment and mismanagement.
Now with cheap oil available elsewhere, Iran’s attractiveness to customers willing to brave sanctions has diminished. The oil Iran does manage to sell below the radar will fetch lower prices. At the same time, its deposited revenues in accounts in India, China, and elsewhere, which can only be bartered for goods from these respective countries, will buy less. If there is no deal over the nuclear program, Iran faces the prospect of low oil prices exacerbating the slow deterioration of its oil sector, along with continuing economic stagnation.
But with minimal foreign debt and a rather autarkic economy, Iran is less vulnerable to an external debt or currency crisis than either Russia or Venezuela. Iran’s devaluation, though inflationary, has made its non-oil exports more competitive. Additionally, its population, though certainly unhappy about persistently high unemployment and inflation, has become accustomed to economic hardship. The contractionary budget for the fiscal year beginning March 2015 already plans for spending cuts alongside increases in tax and privatization revenues.
Lower oil prices could also be offset by rising oil exports should there be a gradual easing of sanctions following a deal on Iran’s nuclear program. Yet even these would not earn the lost revenues Iran would have expected in the middle of last year. Complicating things further, recovering Iranian output would keep global oil prices lower for longer, and oil minister Bijan Namdar Zanganeh has made it clear that Iran will seek to regain its lost market share, “even if the price drops to $20.” This would have an even greater impact if combined with continuing production gains in Iraq.
These two factors together would create an interesting dynamic within OPEC. Iran and Iraq, two political allies with the largest and lowest-cost conventional reserves after Saudi Arabia, would be challenging their rival in Riyadh—a contest the Saudis have historically always won, though at a cost. But at the same time, Tehran and Baghdad would be scrambling for each other’s market share.
In some ways, however, lower oil prices may actually work in Iran’s favor. A post-sanctions Iran would seek to attract foreign investment to rebuild its oil production capacity and grow gas output further. Its large, low-cost fields have gained in relative attractiveness versus high-cost ventures in U.S. shale, deepwater drilling, or the Arctic. Its proposed contract, now in the drafting stage, which offers investors a fixed fee of a few dollars per barrel, was unappealing when oil sold for $100 per barrel but appears steadier and more enticing at $50.
But regardless of the price of oil, Iran has advantages in the longer term to help it ride out a prolonged slump better than the monoculture economy of its rival Saudi Arabia. Iran has a relatively diversified economy with a sizeable (albeit ramshackle) industrial base, the world’s largest or second-largest gas reserves, a large and well-educated population, and a highly strategic location nestled between the Persian Gulf and the Caspian Sea. Additionally, Iran is not plagued by the desperate security challenges of Iraq, Libya, or Nigeria.
In many respects Iran resembles Russia more than it does Saudi Arabia: the threat of oil prices is more stringent in the short term, but more manageable in the long run. At 30 percent, oil is a smaller share of Iran’s GDP than Saudi Arabia’s (45 percent), Kuwait’s (nearly 50 percent), and Qatar’s (50 percent). Driven by the urgent need to diversify away from oil earnings, a political and economic re-opening, genuine privatization of some state entities, and accessibility to foreign investment, Iran could experience an economic boom like that under President Rafsanjani following the end of the 1980–88 Iran-Iraq War.
1. Estimates by Citigroup, Reuters, IMF ↩
Algeria’s Silver Lining
Lies Sahar
Lies Sahar, journalist covering Algeria’s oil and gas sector at the French-language Algerian daily newspaper El Watan.
The dramatic drop in oil prices—and the low likelihood that they will return to above $100 per barrel—have Algerian authorities worried, given the country’s heavy reliance on hydrocarbons revenues. According to official data, they account for about 97 percent of total export revenues, almost 30 percent of GDP, and 60 percent of state revenues.
However, Algeria has some breathing room. Public debt does not currently exceed 9 percent of GDP, and the government has on hand foreign exchange reserves totaling $185 billion. Under present circumstances, this will allow the Algerian government to finance all of the country’s imports for three years. Additionally, foreign debt is relatively small at $3.7 billion, and the government has a revenue regulation fund worth about $60 billion. Together, these factors will ease the burden of low oil prices.
More importantly, however, falling oil prices are signaling a new era in Algeria’s economy. Budget deficits will be the norm despite a fifteen-year period of surpluses. And even if oil prices recover, the deficit will remain. Indeed, revenues from hydrocarbon exports in Algeria have plateaued (about $60 billion in 2014) while expenditure on imports of goods ($59 billion in 2014) increased by more than 6 percent due to growing demand for foreign goods. On the one hand, the past era of surpluses allowed Algerian authorities to repay foreign debts early on, establish a revenue regulatory fund, and accumulate significant foreign exchange reserves. But this period has not been put to good use in terms of speeding up reforms that would have paved the way for the much-needed diversification of the Algerian economy. In particular, the government has failed to create a financial market that would have had the capacity to support the private sector and the country’s economic development. Instead the focus was on infrastructure construction and a policy of untargeted price subsidies, all of which has caused operating expenses to surge without changing the nature of the Algerian economy.
Clearly, the current economic model has become unsustainable and Algeria has no other choice but to carry out structural reforms. The government must do so quickly so as to avoid the inevitable slide into a serious crisis whose impacts will be severe if not addressed in the long run.
Iraq’s Catch-22
Ruba Husari
Ruba Husari, independent consultant and editor of the Iraq Oil Forum.
As oil prices dwindle, Iraq needs to increase its oil output to offset missed production targets over the past few years. Yet the more the Iraqi government produces, the more it will contribute to downward pressure on global oil prices.
The oil price collapse comes at an inopportune time for Iraq. The defense and security budget is planned to balloon to nearly 25 percent of total expenditures in 2015 as the war against the Islamic State intensifies. The government must now resort to borrowing at home and abroad to cover the 2015 draft budget’s projected deficit of $21.8 billion.1 The lower oil prices drop, the bigger the deficit will grow, and this will force more borrowing and the need to increase production capacity.
The last time oil prices dropped—from a peak of $146 per barrel in mid-2008 to $38 per barrel at the beginning of 2009—the government of Nouri al-Maliki slashed its national budget from $72 billion in 2008 to $58 billion in 2009 and opened its oil sector to foreign oil companies. Due to accumulated surpluses from previous years and the inability to spend its capital budget, the impact was hardly felt by Iraqis. Prices recovered quickly, and the 2010 national budget was again up to $71 billion.
Today, however, prospects are bleaker. The bad policies and widespread corruption of previous governments further intensify the impact of the drop in oil prices. When oil prices climbed after the 2008–2009 economic crisis, instead of pushing for a market economy and the emergence of a healthy and vibrant private sector, Iraq used soaring oil revenues mostly to fuel public sector employment. Ruling parties have used this to expand their patronage locally and nationally. In successive budgets over the past five years, allocations set for operational expenditures—mainly salaries, pensions and social safety nets—hovered around 70 percent of total expenditures. Indeed, salaries and benefits, especially to senior officials and parliamentarians, soared at the expense of developing a viable economy. They also precluded badly needed investment in oil infrastructure.
The Abadi government’s response to the latest price drop has been to resort to borrowing. Under a proposed 2015 federal budget—calculated on the assumption of $60 per barrel of oil—the state is borrowing back from state employees by introducing a forced savings system where employees will be paid only a share of their salaries and benefits. In a novelty which is not certain to materialize, article 34 of the 2015 draft federal budget law stipulates deferring payments to international oil companies, instead issuing them treasury bonds worth up to $12 billion. This is tantamount to borrowing back foreign companies’ due fees for producing the oil, with interest. According to article 2 of the draft budget, each Iraqi province will also be allocated the equivalent of $2 per barrel of crude oil it produces or refines, of which only up to 50 percent will be dispensed and the other 50 percent subject to an increase in oil revenues during 2015. The remainder of the petro-dollar allocations are deferred to 2016.
As with previous cycles, oil prices will eventually rise again. Cuts in global capital expenditures on oil exploration and development, driven by falling dividends, will eventually lead to lower output expectations and thus higher prices—though the jury is still out as to when this upturn could happen and by how much prices could rebound. Until then, Iraq’s vicious oil Catch-22 will continue. The country must maximize its oil production in the short run and rake in more oil revenues to sustain its spiraling spending. But this will come at the expense of doubling down on an unsustainable economy dependent on the sale of oil.
1. The draft budget was approved by the cabinet in December. Parliament is yet to vote on the final budget law. ↩
