Nitesh Shah, director and Commodities strategist at ETF Securities and Edith Southammakosane, director Multi-Asset Strategist at ETF Securities comment on the implication of the oil price falling below $35 per barrel.
It has been just over a year since the Organization of Oil Exporting Countries (OPEC) embarked on a new strategy of seeking market share and abandoned its attempts to try to steady oil prices at levels which would help balance its members’ fiscal budgets.
Spearheaded by Saudi Arabia, the strategy was designed to squeeze out high-cost producers who were only able to remain profitable in an elevated oil-price world.
By 2018, if there has not been significant cuts to non-OPEC oil production (and therefore commensurately higher oil prices), Saudi Arabia will admit defeat as access to the international bond markets will become increasingly difficult and its store of assets would be largely dwindled.
As an outside scenario, if prices fail to respond to cuts in non-OPEC production, Saudi Arabia will be forced to cut production in 2018 anyway. If non-OPEC supply is cut and prices rise, Saudi Arabia can abandon the strategy earlier.
Looking at historic episodes of sharp declines in oil prices, Saudi Arabia has cut oil supply as soon as one year after or as long as 5 years after the event with its fiscal deficits reaching up to 25% of GDP before the production cut. But it is hard to extrapolate much from these historic episodes.
The downward oil price shocks in 1982, 1998 and 2008, were driven primarily by changes in the global market dynamics rather than a conscious effort by Saudi Arabia itself to drive prices lower.
Notwithstanding a shock-induced price rebound, we believe that Saudi Arabia will not back down until either other producers have cut back severely or its own financial position simply cannot withstand any more pain.
Saudi Arabia’s government revenues are highly correlated with the oil price, with over 80% of government receipts linked to oil revenue.
Government revenue has been on a declining trend since 2012 and that has been exacerbated by the sharp fall in oil prices that started in November 2014. However, revenues are unlikely to fall in lock-step with oil prices as they did in 2008-09, because Saudi Arabia is aggressively pushing oil sales and gaining market share.
Nevertheless, with government expenditure only expected to be pared back marginally over the next five years, government fiscal balances are likely to be negative and debt will accumulate.
The Saudi Arabian authorities had negligible debts in 2014 and an arsenal of assets coming into the price shock. Saudi Arabia can use these assets to fund current spending. However the accumulation of deficits will see its debts increase substantially.
Its net assets will erode by 2018, as debts are increased and assets are run down. By 2018 gross debt to GDP is likely to hit 33% while net debts will rise to 17% and potentially continue to rise beyond this point.