Sunday, 19 February 2017

OPEC cuts - a short-term gain for a long-term pain?

OPEC’s strategy has worked so far, but could end up being self-defeating.

OPEC surprised markets on 30 November 2016 by agreeing to cut oil production in an attempt to support prices. The cuts were meant to reduce OPEC’s production by roughly one million barrels per day (mb/d), effective from 1 January 2017. Data released in the last few days provide the first test about whether the cuts have been successfully implemented. The bottom line is that: compliance has been high helping prices to move up; the overall movement was beneficial for the finances of OPEC members; but could prove to be short lived as it gives a lifeline to US shale producers, who are likely to ramp up production and depress prices. Below I elaborate on these points.

1. OPEC members have complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d, lower than the 32.5 mb/d ceiling that had been agreed on. Every single country reduced its production compared to October 2016 levels (see chart). Some have made substantial reductions as in the case of Saudi Arabia, which lowered its production by 598 kb/d.

2. The cuts have moved oil prices to a new and higher range. While oil prices hovered around $45 per barrel before the cuts, they have been fluctuating around $55 per barrel since the agreement. This represents an increase of about 22%.

3. The cuts have so far benefited OPEC finances as the gain in prices more than offset lower production. The rise in prices has far exceeded the cuts in production. For example, Saudi oil output has fallen by 6% since last October, while prices have risen by 22%. If current prices and production were to be sustained for the whole year, Saudi oil revenues would be higher by around $27bn compared to what would have happened without the deal.

4. But higher oil prices may not be sustained as US shale oil could make a comeback. Higher oil prices are making US shale oil profitable again. US production rose in December after several months of continuous decline. The International Energy Agency is reporting increased investment in US shale oil, implying more supply to come in 2017. Higher US supply would lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC successful implementation of production cuts has pushed prices higher and benefited the revenues of its members. But the strategy could be self-defeating as it is giving US shale oil producers a lifeline to increase their production and depress prices again. If this does happen, then OPEC would either be required to support prices by making further cuts or make a U-turn on its strategy.

Sunday, 9 October 2016

How much oil does Iraq produce?

Disagreements about Iraq’s oil production could derail the recently-announced OPEC deal.

OPEC surprised markets by agreeing, in principle, to limit the oil production of its members to a range between 32.5 and 33.0 million barrels per day (m b/d). The agreement is preliminary and its ratification will be discussed on 30 November. Given that OPEC produced 33.5m b/d in August, according to the International Energy Agency, the agreement would result in a cut of 0.5-1.0m b/d, if implemented. Soon after the announcement, Iraq expressed its dissatisfaction with the deal. It claimed that the OPEC’s production numbers underestimate Iraq’s true output figures by nearly 300k b/d. If Iraq is right, then the rest of OPEC will need to cut their production even deeper to remain within the newly-agreed bounds.

Why is there a discrepancy in production numbers? OPEC publishes two sets of data. The first is based on “direct communication” relying on official sources from member countries. The second is based on “secondary sources” compiled by independent companies and observers watching the movement of tankers in and out of the world’s main terminals.

The two sets of figures can be quite different. In the case of Iraq, production figures from secondary sources were higher than those based on direct communication up to the end of 2015. The average discrepancy was nearly 300k b/d. Curiously, however, the relationship has flipped since the beginning of this year – Iraqi official numbers are now reporting production that is almost 300k b/d higher than secondary sources (see chart). It is not clear to me why this has happened.


Which number should be trusted? Oil analysts have always considered the data based on secondary source more reliable. They are less likely to be manipulated by governments to show, for example, that their production is within an agreed quota or exaggerated in order to have a room for growth in case of a production freeze agreement. Even OPEC seems to trust secondary sources more. The headline OPEC production number and the recently-announced production limits are both based on secondary sources.

What does this statistical discrepancy imply for the OPEC deal? It leaves it open to three scenarios. The first involves Iraq accepting secondary sources data as a basis for the allocation of the overall production to individual countries. The second involves the rest of OPEC acknowledging Iraq’s objection and cutting their production by 0.8-1.3m b/d to remain within the agreed targets. The third scenario is that the production limit in its current form will not be implemented as disagreement over the numbers continue. As things stand, the third option seems the most likely outcome.

Sunday, 31 July 2016

What does an IMF programme mean for the Egyptian pound?

After many false dawns, Egypt is set to agree a deal with the IMF which could stabilise its battered currency.

Egypt’s currency crisis has been an important theme since the revolution of 2011. The crisis has intensified in recent months, with the price of the US dollar in the black market deviating by as much as 30-40% from the official price. But news surfaced last week about a possible loan package from the International Monetary Fund (IMF) and other lenders totalling $21 billion over three years, increasing hopes that this could stop the freefall of the Egyptian pound. The latest developments raise two questions: Will Egypt conclude an agreement with the IMF before the end of the year? And will the agreement prevent the official price of the US dollar from sharply increasing again this year, say to above 10 pounds, by the end of 2016?

Will Egypt conclude a deal with the IMF before the end of this year?

Despite some scepticism, a deal is likely to be agreed. The scepticism stems from previous false dawns (in June 2011 and November 2012), in which Egypt seemed to be on the verge of an agreement with the IMF only to pull out in the last minute.

But the potential for reaching an agreement this time is more credible for three reasons. First, there has been official statements from the minister of finance, the prime minister and even the president admitting negotiations have been taking place for three months and suggesting a deal is likely to be in the offing. Second, Egypt is in a rather desperate position now given the large deviation between the official and market exchange rates, the low level of reserves and the reduced support from the Gulf. Third, there has been progress on the implementation of some of the policies required by the IMF, including the recent approval of the civil service law (which controls spending on public sector employees) and the value-added tax (VAT), which is expected to be approved by parliament in September.

All in all, the likelihood of a deal is high, probably around 80%.

Will the official price of the dollar increase above 10 pounds by end-2016 if an agreement is reached?

Historical experience suggests not. Egypt had three programmes with the IMF in the 1990s, and none of them resulted in a devaluation of the official rate by more than 3% four months after the start of the programme. This is quite far from the 14% devaluation required to push the official exchange rate (currently at 8.88) above 10.

Furthermore, for every argument favouring sharp devaluation, there is a counterargument against it:
  • Yes, the IMF would favour a flexible exchange rate regime, which is likely to result in a depreciation of the pound closer to the market value. But inflation is high (14%) and should rise with the likely implementation of the VAT. This may convince the negotiating parties to delay the depreciation until inflation has moderated.
  • Yes, the projected $7bn of loans per year fall short of Egypt’s financing needs, forecast at $8bn in 2016 ($12bn current account deficit minus $4bn foreign direct investment). But the gap is small and could be filled with support from the Gulf, higher foreign investments or other financial flows.
  • Yes, the Egyptian authorities may devalue the currency ahead of the deal as a sign of goodwill towards the IMF. Indeed, a large devaluation had preceded the programme of 1991-93. But any devaluation should be delayed until sufficient reserves have been built up to ensure its stability. Otherwise, the official price may end up chasing its tail.

Overall, the likelihood of a sharp devaluation of the official exchange rate is low; maybe as low as 25%.

Conclusion. Egypt is likely to agree on a loan deal with the IMF. The IMF team has started a visit to Cairo on 30 July and a staff-level agreement may be concluded at the end of the two-week trip. The agreement could get formal approval from the IMF Executive Board by September/October. It is unlikely to lead to a large devaluation in Egypt’s official exchange rate before the end of the year. 

Sunday, 26 June 2016

Brexit and the Arab World

Limited economic consequences from Brexit on the Arab World.

Against the odds, rational arguments and cost-benefit analysis, the good people of the United Kingdom voted to leave the European Union in a referendum on 23 June. The news sent shockwaves throughout the world and a long period of institutional uncertainty is likely to follow. The UK economy is expected to be hit hard by the decision, with growth being flat or negative. The uncertainty could spill over to neighbouring European countries, and forecasters around the world are revising down growth projections as a result.

How does an event of such seismic proportion impact the economies of the Arab world? The short answer is: not much for now.

For the long answer, we need to consider three channels.

1. The trade channel. If Brexit leads to slower growth in the UK or a recession, then the demand for imports in the UK will fall, hurting the UK’s trade partners in the Arab world. But the impact of this channel is limited because the UK is not a large export destination for any country in the region.

Take Qatar for instance. It is the UK’s largest trade partner in the Arab world, but the value of its exports to the UK is still small relative to the size of the economy at only 1.6% of Qatari GDP. Even if UK imports drop by 12% this year (one of the most pessimistic estimates), the impact on the Qatari economy will be small at only 0.2% of GDP.

2. The financial channel. Brexit has spooked financial markets, causing investors to hold safe assets such US or German bonds and shun riskier assets like stocks or emerging market bonds. This was evident in the stock-market meltdown on Friday 24 June, following the announcement of the referendum results.

How does this affect the Arab world? Many countries in the region, especially oil exporters, are looking to borrow from global markets to finance their deficits following the decline in oil prices. Analysts expect 2016 to register record borrowing from the Middle East on global financial markets. But the appetite from global markets to absorb this might diminish as a result of Brexit. Consequently, Arab countries might find it more challenging to finance their deficits with external debt.

But even the impact from this channel is mitigated by three factors. First, some countries in the region, such as Oman, Qatar and the UAE, have already secured funding from global markets, and have little need or requirement for further borrowing. Second, some countries, especially Algeria and those in the Gulf, have significant foreign reserves which they could use to finance themselves if global conditions tighten. Third, other countries are on a programme with the International Monetary Fund (most recently Iraq, Jordan and Tunisia) and can secure their funding requirements through the IMF.

3. The investment channel. Some Arab countries have investments in global firms and real estate through their sovereign wealth funds. And return from these investments could be hit by Brexit.

But again, the impact from this channel is likely to be limited as sovereign wealth funds have long investment horizons and are less sensitive to short-term movements in the value of their assets. Indeed, even the global financial crisis of 2008 did not seem to cause lasting damage to the region’s sovereign wealth funds.

So the bottom line is that the economies of the Arab world are relatively immune from Brexit, provided that Brexit remains localised and does not trigger an outright global crisis. In the meantime, the region is far more exposed to oil prices, attempts to diversify many of its economies and security issues, which pose more immediate and serious problems than Brexit.

Saturday, 30 April 2016

Will Saudi Arabia end its addiction to oil?

Optimism over the Saudi national vision is premature.

On 25 April, Saudi Arabia unveiled its national vision, a set of goals it wants to achieve by 2030. A central theme in the Vision 2030, a brainchild of the Deputy Crown Prince Mohammad bin Salman, is putting an end the country’s chronic reliance on oil. Some have lauded the announcement as the long-awaited push Saudi Arabia has always needed. Others called it a mere public relations exercise. On balance, caution must be the order of the day. Any claims that Saudi Arabia is already on track to end its “addiction to oil” in the next few years are premature for four reasons.

1. Announcing a national vision is not new in this region. In fact, Saudi Arabia is a late joiner. BahrainKuwaitOmanQatar and the United Arab Emirates (ie all other Gulf countries) have all published their own national visions years ago. The publication did not ensure timely implementation or immunity from the decline in oil prices.

2. Vision 2030 is a set of long-term goals or targets, not a concrete plan of how to achieve them. A plan should be released in May/June under the title of National Transformation Plan after a few months’ delay. But to put it briefly: a vision is not a plan; and having a plan does not guarantee execution.

3. Execution of any plan is likely to prove difficult. There are signs of difficulty even this early in the process. Only days before the announcement of the vision, the Saudi water and electricity minister was fired following public outcry over higher utility tariffs. Public dissatisfaction could intensify as more difficult measures are rolled out.

4. One of the most headline-grabbing measures—the plan to replace oil revenues with the proceeds from a $2 trillion sovereign wealth fund—is unrealistic. Even if the fund reaches the required size and somehow manages to increase the share of its foreign investments to half from 5% currently (domestic holdings are mostly oil related), an optimistic return of 7% on overseas assets would generate only $70bn per year. This would not be enough to replace oil revenues and finance the expected budget deficits, which together totalled $216bn in 2015 for example. 

Overall, the attempt to transform Saudi Arabia’s economy away from its oil dependence is needed, and steps taken towards this are positive. But a viable plan is required to show how this ambitious target can be achieved. Even then, the actual implementation of the plan will be key.

Monday, 18 April 2016

Iran-Saudi competition poses a risk to oil market recovery

An escalation of the Iranian-Saudi competition could decelerate the ongoing rebalancing in the oil market.

Oil markets are rebalancing. US production is falling and demand is proving resilient. The misalignment between demand and supply is being reduced as a result. The hope was that the meeting between some of the world’s largest oil producers in Doha on April 17 would help accelerate the rebalancing process. Despite scepticism about the actual impact on demand/supply balances, the optimists felt encouraged by the willingness of the producers to sit together and address the problem. Indeed, the early signs of a deal were positive and oil prices rallied ahead of the meeting.

But while expectations about the impact of the Doha summit ranged between neutral and positive before the meeting, the assessment of its no-deal outcome was decidedly negative. The meeting showed that the competition between Iran and Saudi Arabia is spilling over to the oil market. If this translates into an escalation of the market share war between the two countries, then the ongoing rebalancing in the oil market could be derailed.

What are the signs of increased Iranian-Saudi competition in the oil market?

First, there were reports of a price war between the two countries. Following the lifting of its sanctions in January, Iran has been offering aggressive discounts on its oil in order to gain market share in Asia.

Second, the non-participation of Iran’s oil minister in the Doha meeting, after weeks of speculations, showed that Iran was not willing to join other producers in freezing its output. Perhaps convincingly after years of sanctions.

Third, the comments from the Saudi Deputy Crown Prince, one day before the meeting, emphasising his refusal to participate in any production freeze unless Iran joins in. He also threatened to increase production by one million barrels per day immediately. “I don’t suggest that we should produce more, but we can produce more,” the prince was reported to say. 

If this threat is implemented, it can flood the oil market with yet more supply. But it is not expected to, because it is in nobody’s interest to do that. Nonetheless, it would be worth watching production data closely in the coming months.

Monday, 11 April 2016

The Saudi fiscal plan is more austere than Greece

The Saudi austerity plan is too stringent and, if implemented, could be damaging for growth.

The fall in oil prices has hit Saudi public finances. The government’s budget balance switched from a surplus of 6% of GDP (a measure of the size of the economy) in 2013 to a large deficit of 15% in 2015. At this level, the Saudi budget deficit is unsustainable.

In an interview with Bloomberg last week, the Saudi deputy crown prince, Mohammed bin Salman, and his team reiterated their plans to achieve a balanced budget by 2020. If this plan is implemented, Saudi Arabia will embark on an austerity programme more stringent that the one which had sent Greece into a depression. And it will be executed under more challenging economic conditions that the ones Greece had faced. The plan could prove more damaging than helpful for the Saudi economy. Therefore, it is unlikely to be strictly implemented.

What is the Saudi plan on the deficit?

Mohammed bin Abdulmalik Al-Sheikh, a Minister of State, said during the Bloomberg interview that: [B]y 2020, our plan is that we will have a balanced budget.”

- This echoes what was said in an earlier interview with the Economist: “he [Mohamed bin Salman] plans to balance the budget in five years.”

How do they plan to balance the budget?

- Through raising $100bn of additional non-oil revenue by 2020. The new sources of revenue include the introduction of a value-added tax (VAT) and other fees and the removal of subsidies.

- Assuming no additional oil revenue (“We try to focus on the non-oil economy,” bin Salman said), and public spending that is fixed at 2015 levels, the additional $100bn of non-oil revenue should be enough to balance the books.

How large is this austerity programme?

- A move from a deficit of 15% of GDP to a balanced budget within five years is very large.

- Such programme would be more stringent than the austerity programme which had sent the Greek economy into a depression. Greece reduced its budget deficit from 15% of GDP in 2009 (similar to Saudi Arabia today) to a deficit of 4% five years later (Saudi Arabia plans 0%).

- It would also be more austere that the programme implemented by the Conservative-led government in the UK, where the budget deficit went from 13% of GDP in 2009 to 4% in 2014.

What is the likely economic impact of the Saudi austerity plan?

- Judging by the experiences of Greece and the UK, the plan is likely to be quite damaging for growth in Saudi Arabia.

- Moreover, the Saudis will be implementing their austerity measures under more difficult conditions than the ones either Greece or the UK had faced.

- While their governments were engaged in austerity, the central banks in both Greece (the Euro Area) and the UK reduced interest rates in an attempt to boost growth by stimulating lending and investments.

- Saudi Arabia does not have that luxury. Saudi interest rates are linked to the US because of the currency peg to the US dollar. Indeed, when the US raised interest rates in December, the Saudis swiftly followed.

- US interest rates are expected to rise over the medium term, which means that Saudi rates will also rise, increasing the cost of borrowing for households and businesses and inhibiting consumption and investment.

- The private sector is unlikely to step in to fill the hole left by the government. It will face increasing costs as subsidies are removed and VAT is implemented.

What is the way forward?

- Saudi Arabia needs to reduce its budget deficit. A deficit as large as 15% of GDP cannot be sustained beyond a few years.

- But the plan to balance the budget in five years is too ambitious and could be damaging for growth and counter-productive for debt sustainability. It is therefore unlikely to be strictly implemented.

- The optimal speed of fiscal consolidation is somewhere between the two extremes of doing nothing and doing too much too fast. Let’s leave identifying this speed to future work.