MENA (Middle East and North Africa) oil exporting countries have been hit by two severe shocks: COVID-19 and the oil price collapse. Together, they have had a massive adverse impact on their economies and key sectors and exposed some of the challenges and vulnerabilities these economies faced even before the virus. In 2019, even with an average Brent price above USD 64 per barrel, most MENA oil exporters were running a budget deficit. In this current low oil price environment, budget deficits as a percentage of GDP are expected to rise sharply. All MENA countries are projected to run large deficits both in 2020 and 2021, and their debt ratios are likely to deteriorate as they increase borrowing to cover deficits and stimulate their economies. However, the stimulus packages announced thus far have been relatively small and limited in scope, a reflection of the impact of lower oil prices on government revenues. The result may be a much slower economic recovery.
The priority is to consolidate the public purse
In the short to medium term, MENA oil exporters’ focus has been on fiscal adjustment. MENA oil exporters have attempted to stabilize their fiscal expenditure and partially decouple it from oil price cycles through a mix of fiscal and monetary policies, increased government saving rates and the build-up of foreign assets. However, due to a mixture of political and social considerations, regional competition, corruption and mismanagement, procyclical fiscal policies whereby government spending expands during periods of high oil prices and contracts during downturns have been the key feature of most oil exporting countries’ economic policy. The challenge is that expansionary fiscal policy during boom times forces oil exporters to adopt painful choices when oil prices fall. As a result of this imprudent fiscal policy, many countries do not have the strong fiscal and financial positions that would provide room to maneuver during oil price downturns. Oil exporting countries are also major importers, and their current account balances fare no better. In 2019, even with a relatively high oil price environment, the majority of MENA oil exporters ran current account deficits. In the current crisis, there are opposing effects on the current account. The reduction in oil revenue will widen the current account deficit while the likely reduction in consumer spending, attendant lower imports and the large exit of foreign labor and the associated decline in remittance flows will narrow it. But overall, the reduction in oil revenues is likely to dominate, and in 2020 and 2021, MENA oil exporters are projected to run large current account deficits, particularly in Iraq, Algeria and Oman. If these countries are to address the fiscal and current account deficit by hydrocarbon export revenues, the price of oil must be higher. The breakeven price for fiscal balance ranges from around USD 45 per barrel for Qatar to around USD 245 per barrel for Iran. Regardless of the limitations of breakeven indicators, the point is that current oil prices are much lower than breakeven prices and budget deficits are not sustainable in this low-price environment. Reducing the gap entirely through budget cuts is challenging, as it requires a massive reduction of government spending in some critical areas such as public wages, health and social development, education and the military. Despite these challenges, governments can reduce the budget deficit, to some extent, through, for example, the reduction of public wages and subsidies or the delaying of capital projects (measures that have already been taken in a number of countries). In severe cases, they can depreciate their currency, but to the extent that these measures reduce the welfare of citizens and impact negatively the private sector, they will face public and private sector backlash. Governments will have little choice but to rely on external and domestic borrowing. The external debt to GDP ratio in most countries is relatively low with the exception of Bahrain, Qatar and Oman but because of the crisis debt rules may be relaxed. But the downside is that external debt exposes the country to exchange rate and credit risks whereas financing the budget deficit by domestic borrowing can deprive the private sector of much needed credit and further drag down private sector activity. Those countries with a large enough buffer in the form of a sovereign wealth fund or foreign currency reserves (FX) are in a better position to withstand a period of low oil prices. Given the wide uncertainty that oil-exporting countries face, one would expect a cautious fiscal policy, but this is not the case for some of these countries. Countries such as Bahrain and Oman seem especially vulnerable to oil price shocks, as their foreign reserves are only equivalent to between 1.1 and 6 months of imports in 2020. Countries like Saudi Arabia and Algeria have accumulated large FX reserves. However, a deeper look at these countries reveals that these reserves have been falling. For example, in Algeria FX reserves were USD 194 billion in the first quarter of 2014 but at the end of the first quarter of 2020 they stood at USD 60 billion. At this rate of decline, reserves will be exhausted in 2022.
Focus on oil production strategies
Along with cutting current and capital expenditure, MENA oil exporting countries could pursue oil output strategies to boost their revenues, but this approach involves important trade-offs. On the one hand, adopting a high volume or market share strategy risks a fall in oil revenues as the higher revenue due to higher volumes may not compensate for the loss in revenues due to the lower oil price. This is especially true in the short term, as low oil prices may not result in the immediate shut in of production in high cost producers, but the uncertainty also pertains to long-term revenues if other producers turn out to be more resilient to a low oil price environment and/or if demand does not strongly recover. On the other hand, cutting output to support prices may result in loss of market share and may not result in large increases in revenues if the cuts are replaced by increases in output from non-participating producers. Also, depending on the size of the demand shock, the output cut may not be big enough to raise prices for a sustained period. Finally, as recent events have shown, negotiating a sustained output cut among large number of producers is becoming increasingly difficult given the size of the cut, the diverse nature of players and their different interests. MENA oil exporting countries are also exposed to long-term challenges related to the energy transition and increased uncertainty about oil demand growth. The main challenge for oil-exporting countries is loss of the revenues essential for the functioning of their economies. Another challenge is the ability to monetize their large reserve base. For some resource rich countries, the proved reserve to production ratio extends to several decades, beyond all peak oil demand forecasts. This brings into focus the difficulty in monetizing the reserve base.
Three risk management strategies
MENA oil exporters can adopt three possible strategies to manage their long-term risks whether it is from sustained low oil prices due to persistence of shocks or as a result of structural changes due to the energy transition. These strategies include conservative bet-hedging (always play it safe), diversified bet-hedging (don’t put all your eggs in one basket), and a combination of the two. Over the last few decades, the focus has been on diversification. Initiatives on economic diversification in the national development plans of MENA oil exporting countries have been proposed since the 1970s with the aim to provide a safeguard against commodity price fluctuation and to prepare for an era of depleted oil reserves. Since the turn of the new century, however, energy transition changed the discourse from peak oil supply to peak oil demand. This has given new momentum to diversification efforts in these countries. However, these countries face real challenges to their attempt to realize a meaningful diversification strategy. This is because diversification is only successful if it offers risk reduction by pooling uncorrelated income streams. In other words, if these countries diversify into sectors where inputs rely on hydrocarbon infrastructures, they may not achieve sufficient risk reduction. On the other hand, if they diversify into substantively different areas that have little in common with their current primary industry, which constitute their core competitive advantage, they run the risk of failure of establishing viable non-resource export sectors. Furthermore, achieving diversification requires building human capital, improving education systems and the introduction of extensive reforms to improve the business environment, transparency and economic governance. Fiscal diversification requires the introduction of taxes, both direct and indirect. It also needs streamlined procedures, the reduction of excess monopoly rents in non-tradable sectors and the removal of barriers to private sector participation. There is uncertainty about whether and how quickly such extensive economic and institutional reforms can be implemented in these countries. Another strategy is for MENA oil exporters to focus on their competitive advantage and increase their resilience through a conservative bet hedging strategy. Conservative bet-hedging is defined as a strategy that decreases the fitness of a player to its environment in their typical conditions in exchange for increased fitness in stressful conditions. How can this strategy be translated in the context of some MENA oil exporting countries? The core sector of oil exporting countries is the extraction and exportation of crude oil, natural gas, natural gas liquids, and condensates. This is a high return, but also a high-risk business given the volatility in the oil price and the potential change in demand patterns. Adopting a conservative bet-hedging strategy to shield against the risks of revenue disruption involves taking a set of key measures:
- Improving the cost efficiency of the oil and gas sector so the energy sector can compete in a tough environment;
- Decarbonizing the production process of oil and gas as this constitutes a new source of comparative advantage;
- Decarbonizing the final petroleum products to ensure greater acceptance and demand for your key products.
For cost efficiency oil exporters can, for example, focus on investments which are low on the cost curve, run them efficiently and take measures that optimize operations and capture operational synergies across various elements of the value chain.
The sustainability of the oil industry
For decarbonization, these countries can reduce the carbon intensity of oil/gas production process and decarbonize the end products through a combination of change in the operational procedure and investment in low carbon technologies. For example, investment in carbon capture, storage and utilization (CCUS) enables these countries to decarbonize their final products and thus strengthen the economics and sustainability of their oil/gas industry. The key part of a conservative bet hedging strategy, in this context, is to replace oil exports, as oil demand declines, with new energy carriers that are clean and can be produced using existing oil and gas infrastructures. The return on a conservative bet hedging strategy is undoubtedly lower than the current default strategy of oil and gas exports given the costs involved in decarbonization and the lower margins in low carbon businesses, but its risk profile is also lower. This strategy is less complex to implement given its close relationship with the existing hydrocarbon business and countries can build on their core strengths. Currently many of the decarbonization technologies such as CCUS are very costly but this means there is significant room for cost efficiency gains and R&D that these countries can exploit. During the transition era these countries can still export oil/gas and benefit from the generated rents, while at the same time, improve the return on decarbonized products. However, this strategy suffers from two main drawbacks. First, there is some degree of correlation between the prices of all energy products when there is, for example, a global decline in energy demand. Second, with the growth of decentralized technologies, future energy systems will be characterized by a high level of competition and the absence of energy superpowers. This means it becomes increasingly difficult to extract rent beyond marginal costs. It might also not deliver other government objectives such as job creation for local workforces as the energy industry is very capital-intensive. Most likely MENA oil exporting countries with developed energy sectors and stable investment and political environments will pursue a combination of conservative bet-hedging and diversified bet-hedging strategies to varying degrees. But irrespective of the strategy taken, in the face of disruptive forces such as the energy transition, there is a fundamental trade-off: the cost of reducing the long-term risks and increasing resilience is to accept lower expected return on existing assets by investing in measures that align their hydrocarbon sector with low carbon scenarios. In other words, policymakers need to realize that while decarbonization policies come at a cost and thus lower the overall return, they also reduce the risk of disruption of their energy sector and economies in the long run.
The authors: Bassam Fattouh and Rahmat Poudineh
Bassam Fattouh is the Director of the Oxford Institute for Energy Studies and Professor at the School of Oriental and African Studies, University of London. He specialises in international oil pricing systems, OPEC pricing power, security of Middle Eastern oil supplies, and the dynamics of oil prices and oil price differentials.
Rahmat Poudineh is Senior Research Fellow at the Oxford Institute for Energy Studies. He has published numerous peer-reviewed academic articles on a number of key issues relating to the energy sector, including: electricity market design, power system flexibility, renewable support schemes and the implications of the energy transition for oil companies.
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