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MENA holds sway

Middle East and North Africa countries will continue to rule in the oil market, although budget deficits are a growing threat, according to Cyril Widdershoven 

At a glance

• A growing number of Gulf countries are facing economic pressures unprecedented in recent times.
• Sovereign wealth assets are cushioning the blow of the lower oil price and are expected to offload up to $400bn (€352 bn) in equities.
• Part privatisation of Saudi Aramco would lead to outside scrutiny of the kingdom’s reserve base.
• Geopolitics and short-term factors may lead to prolonged energy market instability.

The Middle East and North Africa (MENA) region, which is host to the overwhelming majority of oil and gas production and reserves in the world, is again the main focus for analysts. At a time that oil prices are showing an upward tendency, but still way below the record price levels of $150 (€132bn) per barrel, analysts have been keeping an eye on the growing signs that OPEC and Russia may be setting up an unprecedented co-operation. The potential of a worldwide oil price agreement between OPEC and other producers is on the horizon, even though many issues resolving. The Arab Gulf states, combined in the Gulf Co-operation Council (GCC), have been weathering the onslaught on the oil market with remarkable success.

In contrast to most assessments, Saudi Arabia (leading OPEC’s strategy for market share), the UAE, Kuwait and Qatar, seem to be committed to keeping overall investment levels in the upstream and downstream oil and gas sectors at the same level as the previous decade. Lower oil and gas revenues have been hitting government budgets hard, leading to Arab sovereign wealth funds (SWFs) withdrawing some of their international investments to cover current deficits. 

At the same time, the region is struggling with increasing political risks. In addition to the repercussions of the Arab Spring, which has brought Syria and Iraq to the brink, low commodity prices are exacerbating tensions and conflict in the Middle East. The increasing international threat posed by the so-called Islamic State, which has also brought about a proxy conflict between Iran and a Saudi-led alliance of Arab states, should not be underestimated.  Part of this equation is the underlying economic implications of lower oil and gas revenues. Crude oil prices, hovering around $40/bbl in early April, are still more than 60% lower than at the beginning of 2014. Not only has crude oil been hit hard, the region’s other commodity, natural gas (or LNG), has faced the same disastrous price slump. After hitting price levels of above $17/MBTU in Asia, the same commodity is now trading below $6. There are no real indications that natural gas prices will increase in the foreseeable future, so the slump is even greater than the one currently facing the oil market. 

Impact on sovereign wealth

The impact of growing government budget deficits in the GCC region is clear. Several Arab countries, especially Saudi Arabia and the UAE, have already decided to radically change their overall domestic economies. In recent months, a growing line-up of Arab oil and gas producers have lowered not only their energy subsidies but also put in place plans to introduce sales taxes. Analysts would have laughed both away a year ago. The need to change the overall welfare state approach in these countries is supported not only by the International Monetary Fund and the World Bank, but also by Arab economists. These changes have become necessary to counter the bulging deficit levels of all GCC countries, which is a clear and present danger. 

The international investments of Saudi Arabia, Qatar and the UAE, almost all through sovereign wealth funds, have been hit. Saudi Arabia has been using the financial cushion of its SWF to lessen the blow of cheap oil and since 2014 has been using around $105bn per year of its foreign assets. Nevertheless, the country is far from imminent ruin and at the end of 2015 the kingdom still held around $625bn in assets worldwide. At around 5.8% of GDP, Saudi’s debt is very low in comparison with European countries. Yet Moody’s is very negative about GCC budget deficits, noting recently that deficits across the GCC could reach around 12.5% of GDP, with Saudi Arabia, Bahrain and Oman to be hit the hardest; in 2015, the overall fiscal deficit was around 9%. GCC countries are split, with the UAE, Kuwait and Qatar expected to see single digit deficits, while Saudi Arabia’s could hit 17%. All this predicated on low oil prices, however.

Lower yields on investments in Europe and the US have come about at a time when domestic rentier state income has dwindled, but there is a hidden positive side for the medium to long term for GCC countries. SWFs have been hit by lower yields on their investments in the West, while being confronted by the fact that domestic oil and gas revenues have dwindled due to lower price settings. 

GCC governments have reacted with a two-prong approach, including lower energy subsides, cuts in welfare, and retraction of non GCC investments, while at the same time restructuring their economies. If oil and gas revenues increase, bringing in additional cash, GCC countries and SWFs will be able to invest in domestic growth potential while also yielding higher revenues outside of the GCC. In the end, economic and financial crisis has pushed the GCC countries to set in place hard-needed restructuring of their own economies and government budgets. When oil revenues increase once more, the total picture will show more robust and flexible national economies than at any time in the last 40 years.  

A mixed price picture

But for investors at present the oil market future looks dark. If you take into account the multitude of analysis and assessments in the media, the outlook for oil looks gloomy. After reaching its peak when crude hit $150/bbl, the overall economic picture at present indicates a sector struggling on all sides. Peak oil and renewables zealots have been proclaiming the end of the ‘oil era’. It is claimed that lower global oil and gas investments, and predictions that another $90-100bn could be slashed in 2016, have put the future of oil at risk, with the decline in investments due to lower oil prices and an expected lower demand in the future. But these assessments are however not based on reality. 

Even if 2013-15 has been harsh for most operators, some light is showing at the end of the tunnel. The International Energy Agency and OPEC have both reported that demand will still continue to grow. Lower investments will bring total supply-demand into a new equilibrium, possibly pushing prices quickly up again. Extremely low investment levels have not only put current production at risk, but have also led to a vast amount of new project deferrals, which will lead to a potential shortage of new oil volumes in the market. As the IEA indicated in its latest Oil Monthly Report, oil prices could have hit the bottom.

There are still challenges and opportunities to be assessed. The most remarkable development in recent months was the statement by Saudi government officials that the world’s largest oil and gas company Saudi Aramco, producing around 12mbpd, five times that of Royal Dutch Shell, could be heading towards a partial privatisation. Saudi Arabia’s Deputy Crown Prince Muhammad bin Salman surprised the world with a statement that the kingdom could be looking at offloading a stake in Saudi Aramco through an IPO. The latter would not only bring Saudi Arabia a vast amount of cash but also completely change the overall setting of the oil market. Some Saudi analysts have noted that Saudi Aramco’s IPO will be a major strategy change and that bringing a Saudi asset to the market would mean opening up its overall reserve base to financial scrutiny. If the total reserve base of Aramco (and by extension that of Saudi Arabia) is not as high as officially stated, the oil market and the position of the kingdom will become very unstable for a long period. 

Instability and opportunity

For the foreseeable future, the oil market will remain in flux. Not only will speculators be a major part of the ongoing volatility in the market, but geopolitics will increasingly have an impact on the MENA region. Continued low prices have already increased regional instability due to economic worries and budget deficits. 

At the same time, growing regional tensions, especially between the Iran-led Shi’a block, including Iraq, Syria and Russia, and the Saudi-led Sunni Arab countries, will have potentially disastrous effects. 

A new tide of conflicts and tensions is starting to show, as the situation in Syria, Iraq and Libya worsens. Internal instability in Saudi Arabia, where the Eastern Province (the Saudi oil region) is showing increased violence, in Bahrain where the royal family is under pressure from the Shi’a majority, and in the Levant (Lebanon-Jordan) and Egypt, could lead to more threats to the world’s predominant oil and gas producing region. In the case of a full return of Iran to global markets, Arab countries will not sit back. 

Based on the above picture, the international oil and gas markets are heading for a continuing stormy period. Increased conflict in the MENA region will put severe pressure on oil and gas exports, leading directly to a major price hike. All things being equal, growing demand will not be countered by increased volumes, as OPEC is producing to its limits. Prices will increase in the next couple of months, perhaps reaching $45-60 per barrel by the end of 2016. For regional SWFs, this situation could be very positive. Higher prices will increase government revenues, which in turn will remove part of the pressure on SWFs to diversify investments and sell off investment stakes in the EU and US. 

The latter could dramatically counter current negative market feeling. At present, financial parties are also looking at the option of public offerings. As budget deficits force GCC governments to look at the domestic holdings of SWFs, opportunities could be very interesting. Sovereign investors own over 40% of overall MENA markets’ total capitalisation, a report by GOVERN recently stated. Secondary public offering will possibly attract foreign investors. Foreign ownership has already been increased in Qatar (2014), while the Saudi Capital Market Authority has opened the market to foreign investment. But overall the market still looks very gloomy.

SWFs already are expected to withdraw around $400bn from stock exchanges. The Sovereign Wealth Fund Institute (SWFI) stated that 2015 was the first year that there was a decline in sovereign wealth fund assets since 2001. 

At the end of 2015, oil and gas based investment funds  make up 56% of the SWF fund market, a stark decline in comparison to the 71% in 2006. The SWFI indicated in its report, based on an oil price of between $30-40/bbl, SWFs could withdraw a total of $404.3bn from global listed equities by the end of 2016. Analysts expect that equity markets will face a tidal wave of selling pressure. 

Yet when looking at the overall value of contracts, such oil, gas, infrastructure or real estate, the impact of the current low oil prices is limited. The total value of contracts in 2015 has been set at around $197bn; for 2016 around $167bn is expected, a slight drop. In 2010-11 the situation was much worse. Investments are currently focusing on transport, infrastructure, IWPPs and industrial diversification. Kuwait even recorded the highest levels of investments ($35bn) in 2015, with Qatar coming in at $34bn and Oman at $18bn.

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