By Luis Fierro Carrión (*)
(A Spanish version of this article was written for the February 2015 edition of Revista Gestión, Ecuador).
The international price of crude oil has dropped by 50% between June 2014 and February 2015 (the benchmark West Texas Intermediate - WTI - has dropped from $ 105 US dollars per barrel to $ 50, while the Brent fell from $ 115 per barrel in June to $ 61 in February).
While it is difficult to predict the future evolution of economic variables, it is not impossible - in September 2013 I had already predicted a fall in the oil prices, in an article published in Revista Gestión No. 231 (http://goo.gl/qZJin8) and in my blog (http://goo.gl/BsKHab).
Several structural factors in the oil market lead us to believe that the price will remain at around current levels, and take time to recover:
• Supply has increased, particularly with the expansion of oil production in North America, which has led the US to replace Saudi Arabia as the world's largest oil producer; and that Canada has entered the list of the 10 largest oil exporters. It is estimated that there is an oversupply of 1.5 million barrels per day (bpd).
(See chart on changes of oil production on p. 160 of goo.gl/JY5lnG).
• Reduced demand due to the promotion of renewable energies and energy efficiency, the persistent recession in the European Union and Japan, and slowing economic growth in the BRICS countries (Brazil, Russia, India, China and South Africa - particularly Russia, which has entered into an economic crisis, and Brazil, which will also see an economic contraction).
• In 2014, there was a total of $ 310 billion invested in clean energy, the issue of "green bonds" tripled to $ 38 billion, and the capacity of renewable energy generation reached 1,560 GW (http://goo.gl/5xQpQt, http://goo.gl/b1FBfs).
• An additional factor was the appreciation of the US dollar against other currencies (by 10% over 2014), which implies cheaper dollar-denominated commodity prices.
In addition, Saudi Arabia and other oil exporters in the Middle East changed their strategy, from the defense of high prices to the defense of market share, to the extent that Prince Alwaleed bin Talal of Saudi Arabia stated that the price of oil will never again reach $ 100 per barrel, due to changes in supply and demand. There were also reports that Saudi Arabia was using the oil market to pressure Russia to abandon its Syrian ally, Bashar al-Asaad (http://goo.gl/4nbQQV).
Some OPEC members may also be seeking to pressure some high-cost producers such as those drilling using hydraulic fracturing ("fracking"), the tar sands of Canada and Venezuela, and those who drill on offshore platforms in inhospitable areas (such as the Arctic Ocean). There has already been a decline in investment in new wells, with the suspension of investments for several tens of billions of dollars (http://goo.gl/Yi9rDb). The bet of some Middle Eastern producers is that, after several years of reduced exploration in new wells, global supply will fall, they will regain market share, and prices will rise again.
Goldman Sachs predicted that WTI will remain at $ 39 per barrel over the next six months, and will reach $ 65 within 12 months (previously, it forecasted $ 75 and $ 80 at 6 and 12 months) (http://goo.gl/vXhvXa).
The oil exporting countries exported a total of about 43 million barrels per day (of which about 30 million were from OPEC). Of this total, 75% corresponds to the 10 largest exporters. Export revenues amounted to US $ 1.56 trillion, at an average price of $ 100 per barrel and $ 784 billion at an average price of $ 50 per barrel - that is, those countries have lost approximately half of their oil revenues (in practice, even more than half, as part of the production is performed by private companies, that participate in the rent - or, in the case of Ecuador, have a guaranteed price for their provision of services).
Among the top 10 exporters, oil revenues represent an average of 24.5% of GDP; the impact on GDP growth rate is estimated between -3.8% in Saudi Arabia and +0.2% of GDP in Canada (in Canada the ratio of oil in total GDP is minimum, 3.2%).
In the case of Ecuador, oil’s share of GDP in 2012 was 19.1%, and Maria de la Paz Vela estimated in issue No. 247 of Revista Gestión, in a low scenario, with an average oil price of $ 61.5 per barrel, GDP growth would be between 1.8 and 2.3%, i.e. about 2% below the initial projection of the government. The average impact on GDP for OPEC countries for which there are estimates is -1.9%.
Oil exports also represent a significant percentage of total exports, which fluctuated in 2013 – according to OPEC – between more than 99% of exports for the cases of Angola, Libya and Iraq, 96% in Venezuela and 33.2 % in the case of the United Arab Emirates (UAE). Ecuador was in an intermediate point between OPEC countries, with 54.9%. According to the Central Bank of Ecuador (BCE), this percentage dropped to 51.3% in the third quarter of 2014 (reflecting the initial drop in prices).
But what is more serious is the impact on tax revenues. The dependence on oil revenues in some OPEC countries in 2013 amounted to over 90% of total tax revenues (Saudi Arabia, Iraq and Libya). Venezuela was in between, with 46.6%, while in Ecuador it was about 30%.
Another way of looking at fiscal dependence is the price of oil that is required to balance the fiscal accounts. Here the range is between $180 US dollars per barrel for Libya, to $ 137 for Iran, about $ 120 for Ecuador and Venezuela, and $ 68 for the UAE.
The difference between the level of dependence on oil for revenue and the price per barrel that is required to balance the budget is because some countries were already dragging a large fiscal deficit and foreign debt. In Venezuela, for example, the fiscal deficit had already exceeded 14% of GDP in 2014 - before the collapse of the international price of oil - while in countries like Iraq, Ecuador and Algeria, the fiscal deficit already exceeded 4% of GDP.
In part, the fiscal deficit in some oil exporting countries is due to the high subsidies offered to energy consumption. According to IMF estimates for 2011 (http://goo.gl/n45CYl), Iran offered energy subsidies (oil, gas, electricity and coal) amounting to 50.94% of total tax revenue. Second among oil exporters stood Venezuela, with 20.38%; then Saudi Arabia with 18.66%, UAE with 16.25%, and Ecuador fifth with 15.88% of tax revenue. Since then, Iran and other countries (Egypt, India, Indonesia, Malaysia, among others) have significantly reduced their energy subsidies. Some analysts and institutions have suggested that now is the best time to reduce subsidies, since prices have dropped, so the impact of the elimination of subsidies will be reduced.
Economic policies to address the fall in oil prices
With respect to the response that major oil exporters have adopted to the fall in international prices, we can divide the exporting countries into three groups:
a) Countries with high international reserves and sovereign wealth funds
Many countries exporting oil and other commodities took advantage of the windfall gains of the last decade (with high prices) to accumulate international reserves, sovereign wealth funds (SWF), pre-pay their debts, and accumulate other net assets. That is to say, they followed anti-cyclical policies, and saved during the time of "fat cows".
For example, Saudi Arabia currently has reserves of $ 740 billion, equivalent to 60 months of imports (five years); additionally, it has two SWFs with a current value of $ 762 billion. In other words, it can overcome a prolonged period of low prices without any difficulty (and, additionally, has proven reserves of 265 billion barrels, which means it could continue producing at current levels for 28 years, without any additional exploration).
In the case of the UAE, while reserves only cover imports for 2.8 months, it has the second largest amount invested in sovereign wealth funds (after China), with a total of $ 1,078 billion. Adding the reserves and the funds, it has enough to cover 54 months of imports.
Norway and Canada, which are the ninth and tenth largest oil exporters, have the third and seventh largest amount invested in sovereign funds, $ 893 and $ 416 billion respectively.
b) Countries with average levels of reserves and sovereign wealth funds
Another group of oil-exporting countries whose reserves allow them to import between 8 and 20 months of goods are: Angola, Iraq, Russia, Iran, and Nigeria. All these have sovereign wealth funds, with amounts ranging from $ 1.4 billion for Nigeria to $ 181.8 billion in the case of Russia.
In each of these cases, there are, however, other complicating factors:
• Russia and Iran are subject to international sanctions (for the invasion of parts of Ukraine in the case of Russia, for the enrichment of nuclear material in Iran's case). In both cases, they also face significant fiscal deficits and foreign debt.
• In the case of Russia, the ruble has lost half of its value in the past year; the stock market has fallen 48.5% since last year; a fiscal deficit of 3% of GDP is forecast; and a GDP contraction of 4-5% in 2015. The rating agency Moody's downgraded the Russian debt to Baa3, or “junk” category. It is uncertain what the effect of the severe economic crisis might be on Russia’s foreign policy, particularly regarding the intervention in several former Soviet countries (Ukraine, Georgia, Moldova, etc.).
• As for Iran, its currency (the rial) has lost two thirds of its value against the dollar in recent years; it has already reduced subsidies to energy and basic goods; and 20% spending cuts were announced. Iran is likely to consider the desirability of reaching an agreement regarding the development of nuclear materials to remove sanctions (which have led to reducing oil exports in half).
• Iraq faces internal conflict, which has recently evolved into the occupation of part of its territory by the Islamic State, and the growing autonomy of the Kurdish region. Given the severe impact of the falling price of oil on their tax coffers, it will probably have to reduce energy subsidies, and make other spending cuts, while at the same time trying to consolidate the power of the central state.
• Nigeria also faces ethnic conflicts, particularly by the Islamist group Boko Haram. It also suffers from problems of governance and corruption. The rebel groups steal some of the oil production; and in late 2013 the Governor of the Central Bank reported that the State oil company had failed to deposit $ 50 billion in oil revenues.
• Angola is nominally a country ruled by a Marxist party that led the process of independence with support from Cuba. However, the daughter of President José dos Santos (in power for 35 years), Isabel, is the richest woman in Africa, with a fortune estimated at $ 3 billion; his son, José Filomeno, was named Manager of the (public) sovereign wealth fund of Angola, and also founded a private bank in Switzerland. Angola will likely cut government spending.
c) Countries with meager reserves, high fiscal deficits
Finally, we have the cases of Ecuador and Venezuela, which have reduced amounts of international reserves; a sovereign fund with very meager investments in Venezuela ($ 800 million) and none in Ecuador; which were already facing high fiscal deficits for several years (despite high oil prices); and which have also been increasing their indebtedness rapidly in recent years.
According to a study by the Institute of International Finance, "Weaker public finances will dim the growth outlook for net oil exporting countries such as Ecuador, Venezuela and some in MENA (Middle East and North Africa), where rising oil revenues boosted fiscal spending in recent years… Countries with an already high current account deficit, such as Colombia and Ecuador, could come under additional pressure. Venezuela and Ecuador in particular have a low reserve coverage ratio and fragile capital market access, posing financing risks” (http://goo.gl/ipGyGU). The two countries also have high levels of energy subsidies.
The Presidents of the two countries traveled to China in January to try to get new credit.
In the case of Ecuador, the official news agency ANDES announced a line of credit from Eximbank of China, to finance the export of goods and services from China, amounting to $ 5,296 million; $ 250 million of the same entity for the import of induction stoves; $ 1,500 million from the China Development Bank (CDB) to partially finance the investment plan of Ecuador; and $ 480 million from the Bank of China to finance Millennium Schools and other infrastructure projects. The Finance Minister subsequently reported that, of this total, about $ 4 billion would enter in 2015. The Inter-American Development Bank (IDB) would provide $ 800 million. These new loans will help to close the funding gap in the budget, estimated at $ 10 billion after the fall of oil prices.
With these loans, total debt to China (including the balance of oil pre-sale credits) exceed $ 10 billion; and constitute almost half of the public external debt, that with these new resources would amount to $ 21,713 million. Total public debt, including domestic, would represent more than 30% of GDP, still below the legal limit of 40%.
Unlike other producers of oil, Ecuador is dollarized and therefore cannot devalue or promote a depreciation of the exchange rate (in fact, as was noted above, the dollar has appreciated against other currencies). This has led the government to impose trade safeguards against imports; restrict the import quota of vehicles (assembled and CKD); and adopt other import restrictions. Some fiscal measures were also adopted to try to raise the non-oil tax revenues (surtax to telecommunications companies that dominate the market, limits to the distribution of private company profits to their employees; 100% tax to stoves, water heaters and other appliances that use gas; among others).
The government cut by 3.9%, $ 1,420 million, the 2015 budget (in part, by suspending the salary increase to public employees of 5% that had initially been considered).
Venezuela presents a more complicated picture, given the high dependence of the economy on oil: 96% of exports, 26.7% of GDP and 46.6% of tax revenues. The public external debt reached $ 118 billion in 2013. In recent weeks, the "country risk" has risen to 3,100 points, insurance in case of moratorium (CDS) has soared, to reflect a moratorium probability of 81% in a year; and the risk rating has fallen to near-moratorium levels (Moody's downgraded to Caa3 from Caa1, just one step above moratorium).
The fiscal deficit, which had already reached 14% of GDP, could increase despite the announcement of a 20% cut in spending. The bolivar is currently handled in various exchange rates, and there is growing scarcity of commodities. The official inflation rate has exceeded 63%, the highest in the world.
Other Policy Recommendations
In its study on "Global Economic Prospects" published in mid-January 2015 (http://goo.gl/JY5lnG), the World Bank made some policy recommendations against falling oil prices:
• Reduce or eliminate subsidies to fossil fuels.
• Instead, consider introducing fuel taxes (to continue promoting the reduction of energy intensity of GDP, despite the lower oil price).
• "For oil-exporters, the sharp decline in oil prices is also a reminder of the vulnerabilities inherent in a highly concentrated reliance on oil exports and an opportunity to reinvigorate their efforts to diversify. These efforts should focus on proactive measures to move incentives away from activities in the non-tradable sector and employment in the public sector, including encouraging high-value added activities, exports in non-resource intensive sectors, and development of skills that are important for private sector employment" (p. 168).
The collapse in oil prices could help oil producers and exporters to move away from high-emission sectors and industries towards renewable energy and other low-emission technologies.
In the article published in Revista Gestión No. 231 (September 2013), which had anticipated a future decline in oil prices, I added the following: "What can Ecuador do to adapt to this scenario? In general, it should invest windfall revenues currently generated by oil, either through a sovereign wealth fund (á la Norway or Kuwait) or directly in the generation of hydropower and other renewable energy, and development of other sources of revenue." I also recommended "to reduce the subsidy to domestic consumption of hydrocarbons."
In No. 242 (August 2014), Maria Gabriela Vivero and I suggested that "moments of expansion and large inflows of resources such as this should be used to repay debt and build reserves. Therefore, the aggressiveness with which the Government is acquiring new debt obligations is surprising".
(*) Climate Finance Advisor. Economist, Catholic University of Ecuador; M.A. in Economics, the University of Oregon, M. Sc. Econ. and Ph.D. (c), the University of Texas at Austin. The views expressed are personal and do not reflect those of any institution.