A fine balancing act for petro-states

This article appeared originally in Gulf News: link to original article

Petro-states enjoyed a surplus that enabled most, if not all, to stash some for rainy days whether by holding reserves in foreign currencies or by depositing these into their respective Sovereign Wealth Funds (SWFs).

Historically, whenever oil was found and extracted, countries would be working out their budgets according to anticipated revenues from oil exports based on market prices or those quoted and locked in contracts.

For those of you following the hike and then fall in oil prices, the most recent one, you would have noticed that different oil prices were quoted for countries to balance their budgets with these increasing when oil prices dropped further. Such a calculation would be very accurate if petro-states balanced their budgets as described.

The case is, however; slightly different.

I collected the date for the 10 top oil exporters for 2012 in order to do some further analysis. The reason behind choosing the year is because it’s when crude oil prices averaged at around $111 and would have therefore been the optimal year of choice for petro-states to spend lavishly, save a bit of money in central bank reserves, and invest the rest abroad.

So was that the case? And were budgets based on an oil price of $111? The top 10 oil exporters in 2012 were: Saudi Arabia (at number one), Russia, UAE, Iraq, Nigeria, Angola, Canada, Venezuela, Kazakhstan, and Kuwait.

To carry on the analysis, I obtained mainly the budgets of these countries, their total reserves as per the World Bank, and calculated the revenues collected from taxes and other based on percentages provided by the CIA’s ‘Fact Book’. Though the figures are of 2013 and 2014, it is assumed here that there would be no major shifts in the fiscal policies of those countries between 2012 and 2014 because oil prices were still high before its downfall later in the year.

I have added Norway to the list, though not among top 10 exporters, to be the control country in the analysis as I would say it’s the petro-state better suited to hedge the current drop in oil prices.

The dependent variable in the analysis was the total reserves amassed by the petro-states included in the study. The first finding was that total reserves are highly positively correlated with the oil revenues generated by the countries with a confidence level exceeding 92 per cent.

The same regression was run with Norway included. The same correlation was proved with the confidence level still above 91 per cent.

Now saying that the total reserves accumulated by a country increased with its oil revenues is somewhat stating the obvious, but what does that do to the assumption of oil price budgeting? And the inclusion of Norway shows that the above assumption is not inclusive of the top oil producers but is rather a trend.

It should be noted here though that the total reserves used in the analysis do not include SWFs of these countries. In other words, the total reserves held at central banks are completely independent of what is going into SWFs. I will get back to this point later on.

In the same analysis, I aimed at also finding out if oil revenues are also used to balance the budgets of countries or were just, as highlighted earlier, used to build up larger reserves. So I carried on additional regressions to see if other revenues of countries do lead to an increase in total reserves.

The results showed no correlation with the confidence level being severely low. This is true for Norway as well. When comparing the non-oil revenues generated by the countries, the budgets of these countries were almost balanced with non-oil revenues.

The lower those were, the higher the budgeting of the oil price and the forecasted deficit. In deficit cases, these are quite low and could not undermine the financial stability of petro-states in the short run.

With a better understanding of the scenario preceding the drop in oil prices, what could be happening today?

Different publications have hinted that petro-states have been withdrawing cash out of funds managed abroad to meet financial obligations. A recent report by the ‘Financial Times’ pointed out that the actions of these countries have been justified by the shift in investment attitudes towards having SWFs managed in-house instead of otherwise, partly due to the desire to cut down on management fees charged.

Another reason to which the withdrawal of funds could be attributed is capital appreciation for certain asset classes or the desire to diversify away from certain investments. So are petro-states withdrawing funds to fill budget holes?

The analysis has shown that petro-states have been moving away from balancing their budgets in accordance to generated oil revenues. The shift is especially apparent in countries were other revenues are of a greater share from total state’s revenues — Kuwait’s non-oil revenues stand at70 per cent and thus has the lowest budgeted oil price among GCC petro-states.

That does not mean that countries would not revisit their budget calculations whenever an unaccounted for expense is incurred. An important outlier here would be the war in Yemen and its financial ramifications for Saudi Arabia and the UAE.

One would expect that would definitely have Saudi Arabia withdraw from its SWF, SAMA, or use part of its stashed foreign reserves. The same goes for UAE’s ADIA.

Saudi Arabia is said to have withdrawn an amount close to $70 billion and has also issued bonds worth a bit more than $5 billion to supposedly support its budget. UAE’s government deposits have dropped by about $15 billion between September 2014 and September 2015 (Reuters).

Saudi Arabia could issue additional bonds at favourable rates because of its worldwide lowest debt-to-GDP ratio. Saudi Arabia would nevertheless need to embark on long-term reforms to safeguard its financial stability, not least by modifying its fuel subsidy policy — the second lowest cheap fuel worldwide.

The UAE has already addressed its fuel subsidy policy. With the expected introduction of Vat and corporate taxes, the UAE’s percentage of non-oil revenues, calculated at about 33 per cent, is expected to increase.

Petro-states need now to start cutting down their government expenses by reducing their ownership of state companies whether by straight forward privatisation, public-private ownerships, or by publicly listing the stocks of state-owned companies.

India, a net importer of oil, is in the process of reducing its stake in government-owned companies. The motive for petro-states should be reduced state expenditure, increased non-oil revenues, and the diversification of the economy away from oil.

Norway, which has been included in the earlier analysis, reduced its transfers to its SWF in September 2015 (Reuters). Norway did not stop the transfers altogether despite the plunge in oil prices, with foreign reserves being the buffer between its budget deficit and what gets transferred to its SWF.

The same could be said of petro-states in the analysis, with the percentage of what goes to central banks and what goes to SWFs being subject to how much oil revenues are being generated. What’s important for petro-states, especially in the GCC, is to have their non-oil revenues fully balancing out their budgets, with any deficit later on made up for by raising additional taxes or issuing bonds.

Until then, transfers to SWFs would be reduced rather than halted, if necessary, until full independence of oil revenues is achieved. The UAE announced its 2016 budget with no deficit which defies all that has been speculated before the announcement.

It is no secret that this is partially due to the reform of its fuel subsidy policy. For the UAE, next steps should include the quick introduction of the proposed taxes, the reform of other subsidies such are those for water and electricity, and the exploration of other taxes and fees that could be introduced into the country with hindering its economic progress.

This could possibly include a gasoline tax that prevents fuel dropping below a minimum price given that very cheap fuel will diminish benefits realised from fuel subsidy reform.

The last thought that I want to leave you with: since no fuel price bands have been set; what will happen when oil prices start increasing again?