Low oil price are here to stay, at least in the short to medium term

A recent Reuters poll of 29 economists and analysts forecast average oil prices at just over $42.5 a barrel for 2016, the biggest drop in monthly forecasts in a year. Oil has fallen from a peak of $115 a barrel in June 2014 to current rates of $35.10 a barrel, a fall of approximately 70%.

The difference this time is that both supply and demand side dynamics are putting downward pressure on price. There is excess oil supply due to Iran formally being allowed back into the market, US increasing its oil production market share through shale oil and both OPEC (mainly driven by Saudi Arabia) and non-OPEC (Russia refusing to decrease its output) unwilling to trust each other to coordinate a cut in output. This all at a time when demand from China, Japan and other major net importers of oil being weak from the slowdown in their respective economies not to mention the regional proxy war being played out in the Middle East. How will the GCC countries fair in such a volatile economic and geopolitical environment?

Dealing with the new economic reality

The International Monetary Fund recently advised GCC countries to start actively reducing government spending and increase non-oil revenues in order to cope with the drop in petrodollar income. With oil prices dropping by more then two-thirds from their most recent peak the Middle East and North Africa oil exporters will have lost more than $340 billion of revenues last year, an amount that equates to approximately 20% of their combined gross domestic product (IMF 2015).

Although some of the GCC countries are sitting on substantial reserves, others will face acute pressure on their budgets and spending programs (in particular Oman and Bahrain). Some countires have already been downgraded by the rating agencies. Fiscal deficits are expected to be 13% of GDP in the GCC and 12% of GDP in non-GCC countries in 2015 (IMF). Because the oil price drop is likely to be large and persistent, oil exporters will need to adjust their spending and revenue policies to secure fiscal sustainability, boost private sector growth including reform to incentivize foreign direct investment, and gradually tilt the economies away from oil dependence. The speed of adjustment should depend on the availability of buffers and fiscal prudence. Secondly, Central Banks in each member country will need to monitor bank liquidity and asset quality as weaker economic growth could negatively impact both.

The IMF has advised a number of measures to regional governments to shore up their finances, and these public recommendations have provided some governments with political cover to make difficult decisions that could lower living standards of their citizens. In particular, the discussion to remove fuel subsidies (the UAE and Saudi Arabia have already acted on this front), reducing public sector incentives and benefits and introduction of sales tax (UAE has announced a 5% tax to start from 2018) are some of the areas of focus. For instance, a low single-digit VAT rate could bring in as much as 2% of GDP. The governments have also been urged to cut red tape and make it easier for foreign investors to set up and manage businesses in the GCC friendlier including possible removal for requirement of a local sponsor.

What does this mean for foreign investments?

The IMF estimates oil exporters holding $4.2 trillion in global equities, bonds and currencies may be forced to shed nearly $1 trillion of their assets over the next five years to fill emptying government coffers. These liquidations could increase market volatility across the globe. For example, the Saudi Arabian Monetary Agency, reportedly pulled $70 billion from external managers in 2015, and Lyxor estimates assets managed by state-backed investment vehicles in the Gulf region dropped by $300 billion in recent months.

Furthermore, we are seeing an increasing tilt towards Asia as a regional allocation with SWFs looking to increase their portfolio allocations vis-à-vis the developed markets. For example, Qatar Investment Authority (QIA) plans to spend up to $20bn in Asia in the next five years, in industries including health care, infrastructure and property. Abu Dhabi Investment Authority (ADIA) invests a minimum of 35 per cent in North America and 20 per cent in Europe, while ploughing a minimum of 10 per cent into developed Asia and 15 per cent into emerging markets. It is looking to raise its Asia allocations with India and China as stand out country contenders to participate from the long term societal growth dynamics.

In the family office investor segment, we expect to see an increasing trend to deploy funds outside of the Gulf region. This is due to a number of reasons such as regional geopolitical insecurity, attractive exchange rates with a weaker euro and sterling as well as a hedge against a slowing Gulf market. This is evidenced by discussions with investors who are increasingly looking at, for example, US and European real estate assets, as well as emerging market private equity investments across Asia and Africa.

Although the fall in oil prices has been dramatic and largely unforeseen, it could allow Rulers in the region the cover they need to push through much delayed market reforms and reduce public subsidies. In addressing the historic overreliance on oil income revenue however, it is hoped that this transition is managed in a careful manner so as not to create social discontent within the Gulf societies.

As shared with IFIN Panorama Editorial Team


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