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Gulf Economies Confronted with the New Oil Market

BLOG - 1 April 2019

The oil market is not what it was in the heyday of OPEC. It is now caught between sluggish global growth, dwindling oil consumption per unit of GDP, and the shale oil technology revolution, which has brought the United States back to the top position in the world of oil production. For the economies of the Persian-Arabian Gulf, which are essentially dependent on hydrocarbons exports, to which they owe most of their growth and the enrichment of their populations since the 1960s, the challenge is existential. If they do not prepare for the post-oil era now, their regimes and populations will be threatened with a chaos that would affect far more than just the region.

The new oil market: weakening demand, technological revolution...

The persistence of a price per barrel of over $40 since 2004, the competitive pressure of other energy sources (gas, renewable energy) and de-carbonization efforts undertaken in developed countries, have reduced oil consumption per unit of global GDP (measured in volume terms) by 56%.

A combination of powerful structural factors, including the persistence of a price per barrel of over $40 since 2004, the competitive pressure of other energy sources (gas, renewable energy) and de-carbonization efforts undertaken in developed countries, have reduced oil consumption per unit of global GDP (measured in volume terms) by 56% since 1980, and by 34% since 2000. In other words, for the same barrel of oil, we now produce 50% more GDP. This secular downward trend will continue, thanks to global pressure to reduce CO2 emissions, especially in China, where growth is also structurally slowing down. With world growth of around 3.5%, demand for oil will hardly exceed 1.2% a year. We are far from the 2% average recorded in the years preceding the 2009 crisis of 2009.

On the supply side, the technological breakthroughs (horizontal drilling and hydraulic fracture) that allow to extract oil and gas from tight oil formations have dramatically boosted the United States’ production. In 2017, the latter held 14.1% of the world market, ahead of Saudi Arabia (12.9%) and Russia (12.2%). These technologies are improving continuously, thus reducing the operating breakeven point, and their exploitation is highly flexible. The market saturation strategy, which Saudi Arabia pursued for a little while in order to suffocate these new competitors, has failed. This led to a production reduction agreement with Russia in 2017, aimed at boosting prices, to the benefit of shale producers from Texas and North Dakota.

Oil consumption per unit of real GDP keeps falling

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...and the end of the oligopoly of the Arabian Peninsula

Until recently, the oil market was dominated by Saudi Arabia, the only "marginal" producer, that is, able to increase or decrease its output in order to influence the market. Also capable of modulating its production according to prices, US shale oil companies have arisen as a competing marginal producer of equivalent size. The oligopoly of the Arabian Peninsula is thus gone, at least until the reserves of shale oil are exhausted, which shouldn’t happen anytime soon. Indeed, according to the BP Statistical Review, a reference in this field, Canada and the United States have combined reserves of 220 billion barrels, which is close to Saudi Arabia’s (266 billion) and well above Russia’s (106 billion).

The oligopoly of the Arabian Peninsula is thus gone, at least until the reserves of shale oil are exhausted.

The main consequence of this new market structure is that, unless there is a sudden and large-scale supply disruption, caused for example by a military conflict with Iran, oil prices should fluctuate within a range of $40 to $70/bbl. for annual averages. Good news for the world economy, which is still dependent on oil - even if much less so than 20 or 30 years ago -, but bad news for the oil monarchies.
 
In both Riyadh and Abu Dhabi, there has been a long-standing awareness of the structural changes in the market, and efforts have been made to implement adaptation strategies. Whether or not they are up to the task remains an open question.

Rich and sparsely populated, Qatar and Kuwait are hardly concerned

The case of Qatar is peculiar. Sparsely populated (2.8 million inhabitants, only 11% of whom are nationals), this country holds 13% of the world's reserves of natural gas. The gas market differs from that of oil because of its shipping costs, but also because of its lower carbon content, which makes it a very sought-after substitute for oil. From a strictly economic point of view, Qatar is therefore not really in trouble.
 
Kuwait, which is more populated and whose wealth essentially consists in oil, is nevertheless in a similar situation to that of Qatar, because of the importance of its reserves in proportion to its population (more than 90 years of production at the current rate). Besides, over the last decade, Kuwait has had an average budget surplus of 20% of GDP.

Things are different for Saudi Arabia and the United Arab Emirates.

Already in the 1990s, the low level of oil prices after the first Gulf War had undermined Saudi Arabia's public finances, although in a limited way. The gap between government revenue and spending peaked at 9% of GDP in 1998, before being rebalanced and moving towards revenue, up to a surplus of 29% of GDP in 2009. The fall in the price of oil in 2015 and 2016 caused public revenues to drop again, just when the Kingdom had to spend more to try to meet the aspirations of a youth frustrated by the lack of prospects and the rigidity of their society. As a result, government spending rose to 40% of GDP in 2015-16, while revenues fell to 23% of GDP. Only by selling a share of the assets accumulated by its various sovereign funds was the Kingdom able to limit the call to the market to finance a public deficit of 16% of GDP on average over these two years.
 
By comparison, the situation in the UAE is less alarming: thanks to a better control over public spending, the deficits caused by the drop in revenue were limited to 2.5% of GDP on average during the two black years.

 

Saudi Arabia: the deterioration in public finances is structural

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​​Three different strategies: massive investment, institution-building, Singapore

Although they are multifaceted and partially determined by the economic, social and political structures of each state, adaptation strategies fall into the three following categories: (1) using accumulated savings to create a sustainable non-oil economy; (2) building governance institutions that are as politically independent as possible; (3) attracting talent and using the regional oil rent to develop a financial industry and other services.

Saudi Arabia is ready to spend a lot, but it won’t be enough

The Kingdom’s economy is more diversified than the Gulf monarchies’.

Saudi Arabia has chosen the first strategy, with its Vision 2030 plan. The goal is to recycle surpluses that were accumulated in the past to develop a non-oil economy through massive investments. A populated country - 33 million people, which is twice as much as in 1990, with a large Shia minority in the oil region - the Kingdom’s economy is more diversified than the Gulf monarchies’: its non-oil sector generated 65% of GDP in 2018, of which the manufacturing industry contributed for 9%, and construction and real estate for 12%.

Yet we should not let ourselves be fooled by these figures: the public sector, the financing of which is based on oil revenue, accounts for 55% of the country's value added. Vision 2030 includes financing infrastructures from airports to universities for touristic, leisure and technology projects such as New Taif and Al Qidiya, and a pharaonic project, NEOM, aiming to create a whole free-zone economy at the entrance to the Gulf of Aqaba, for an estimated cost of $500 billion. Meanwhile, the strategic plan includes some structural reforms, such as a first small step towards the liberalization of the status of women, a simplification of the bureaucracy and the project, so far postponed, of floating the public company Saudi Aramco. Therein lies the problem: the Saudi economy will have to implement way more radical structural reforms in order to truly emancipate from its oil dependency. It should, for instance, work on changes in education and vocational training, on equal rights for women - who, economically speaking, represent the largest labor force available - and on the consolidation of the rule of law without religious interference in the economy. Even if these necessary conditions are understood by the new generation of leaders, which in itself is not a given, there is still a long way to go.

Dubai’s Singapore strategy: a success, but the hardest is yet to come

In the United Arab Emirates, Dubai, which has only limited hydrocarbon resources, has long referred to and embraced the "Singapore" strategy. Dubai’s success is indisputable: it has become the region’s financial, commercial and touristic hub and its main trading partners are China, India and the United States, before Saudi Arabia.

Like Singapore at the beginning of its economic rise, Dubai positioned itself at the center of the financial flows of the region.

Emirates, which was conceived from the start to be at the heart of the "South-South" traffic and inspired by Singapore Airlines, became the world's fourth airline company, and even the second in terms of freight. Like Singapore at the beginning of its economic rise, Dubai positioned itself at the center of the financial flows of the region, in order to take advantage of the oil rent windfall its neighbors enjoyed. Like Singapore in the past, Dubai has not always been very scrupulous over the origin and destination of funds, as evidenced by the EU's attempt to add the UAE to its list of non-cooperative tax jurisdictions, which was finally blocked by Italy. The financial windfall has also resulted in the Emirate’s excessive indebtedness Its real estate sector would have gone bankrupt in 2009, had it not been bailed out by the neighboring Emirate, Abu Dhabi.
 
Although Dubai still indirectly depends on the regional oil rents, the success of its Singapore strategy is undeniable. But to keep pace with Singapore, which has invested heavily in education, research and digital innovation to gain a foothold in the knowledge economy, Dubai has some hard work to do.

Abu Dhabi: the role of governance

Meanwhile, similarly to Saudi Arabia, Abu Dhabi invests some of its considerable financial reserves in projects for economic diversification, but the emphasis on governance suggests that success is more likely to be met, eventually.

The strategy pursued by the Emirate of Abu Dhabi, which is a little less populated than Dubai, but holds vast oil reserves (nearly 100 billion barrels according to BP, comparable to that of Saudi Arabia, in proportion to the population), was influenced by Dubai’s success. Yet this strategy was applied with great caution, the Northern Emirate’s reputation being too sulfurous for Abu Dhabi’s reigning family Al Nahyan. The path taken by the Emirate is strategically different, although many functions, starting with monetary policy and banking supervision, are shared, given the UAE’s federal structure. Having become a global reference for the quality and professionalism of the management of financial reserves (essentially by the sovereign wealth fund ADIA), Abu Dhabi has drawn inspiration from it to bet on the long and difficult construction of institutions that guarantee the good governance of the economy.

While Saudi Arabia spends large amounts of money to attract well-known academics to its universities - where they usually don’t stay long -, Abu Dhabi has privileged partnerships with the best foreign universities, from NYU to Paris-Sorbonne, and its Al Khalifa University was ranked 32nd among the 360 Asian institutions assessed by Times Higher Education. Institutions that explicitly aim to streamline governance and make it more transparent have been created, starting with the Abu Dhabi Accountability Authority. For example, according to the 2017 report of the Authority, 21 of the 55 institutions examined by its auditors were declared deficient in terms of internal audit. Meanwhile, similarly to Saudi Arabia, Abu Dhabi invests some of its considerable financial reserves in projects for economic diversification, but the emphasis on governance suggests that success is more likely to be met, eventually.
 
At the end of the day, the future of the region rests in Saudi Arabia, given the latter’s size. Although pressure from part of the public opinion and declining oil revenues have led the Kingdom on the path towards reforms and diversification, there are still serious doubts regarding the method employed. Moreover, structural reforms to make the economy more efficient and more independent from the dynasty are unconvincing. From this perspective, it is to be hoped that the path taken by the UAE, be it the Singapore strategy or the establishment of governance institutions, will inspire the new Saudi leaders.

 

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