Saudi Arabia's low debt and ample fiscal reserves provide insulation from market forces

The drop in oil prices that began in the second half of 2014 has raised questions about how oil-dependent economies like Russia, Nigeria and Venezuela would cope. However, in the case of Saudi Arabia, large fiscal reserves and low levels of debt have enabled the Kingdom to avert the sort of crisis triggered by oil shocks in the past. The Saudi government has adopted a policy of resolutely defending its share of the oil market – an approach that, as of mid-2015, appeared to be yielding the desired results.

Market Markers

According to the Organisation of the Petroleum Exporting Countries (OPEC), global demand for oil is set to rise by 1m barrels per day (bpd) in 2015. This growth will be driven by non-OECD countries. In an April 2015 report, Jadwa Investment forecast that oil demand would rise by 3.5% year-on-year (y-o-y) in 2015 in the Middle East, 3% in China and 2.9% in India. For OECD member states, while weak demand growth in the EU and Japan should balance higher demand in the Americas, the report noted that “rising US oil demand will not, however, support international oil prices, primarily because y-o-y growth in domestic supply of crude, in 2015, will result in a decline in US imports.” On the supply side, OPEC expects world oil supply growth to outstrip demand. The majority of the supply growth will come from non-OPEC producers, with US shale oil contributing a large part of this rise. The lower price environment may put financial pressure on some of the smaller shale oil producers, with a more rapid slowdown in supply growth predicted in the second half of the year. However, total US crude output is expected to increase by 0.73m bpd y-o-y in 2015, compared to growth of 1.1m bpd in 2014.

Meanwhile, OPEC producers are likely to keep raising supply throughout 2015, with countries such as Saudi Arabia, the UAE and Kuwait seeking to defend their share of the market, while others like Nigeria, Algeria and Venezuela cannot afford to cut supply. Additionally, Iraqi oil production is set to rise over the course of 2015. Iranian supplies are expected to increase too by the middle of 2016 as economic and trade sanctions against the country are lifted.

Oil Price Forecasts

As of the second quarter of 2015, crude stockpiling in the US had reached record levels, putting commercial crude stocks well above the OECD 20-year average. However, an anticipated uptick in global growth in the second half of 2015, coupled with slowing growth in non-OPEC oil production, may lead to a rise in oil prices by the fourth quarter of the year. “Oil prices have been exaggerated on the downside,” John Sfakianakis, Middle East director at UK investment management company Ashmore Group, told OBG. “We see Brent’s fair value as being closer to $70 per barrel and forecast that the price of a barrel will recover to $62 by the end of 2015.”

Similarly, Jadwa Investment’s forecasts put Brent crude at an average of $61 per barrel for the year; however, the investment firm anticipates low oil prices to continue for at least the first half of 2015, due to major OPEC producers maintaining market share and the lower price environment taking time to affect non-OPEC supplies. In another report from May 2015, the firm cautioned that “the combination of a large global oil surplus and record crude stocks could see some major volatility in oil prices before consistent upward movement in the second half of 2015.” This is likely to be driven in part by China and India building up their oil reserves to take advantage of low prices.

Well Prepared

Thus far, it seems that Saudi Arabia has drawn lessons from history on how to handle such a drop. “Based on past experience, we have developed reserves and reduced the public debt burden to see us through a period of low prices,” Hamad Al Bazai, vice-minister of finance, told OBG. Osama Mansouri, advisor to the minister of economy and planning, echoed this sentiment, telling OBG that “fluctuations in the oil price are not unusual” and emphasising that Saudi Arabia was well prepared to deal with these fluctuations. The country’s ample foreign currency reserves are an important tool, allowing the Kingdom to compensate for lower oil revenues. As of the end of 2014, total reserves stood at SR2.68trn ($714.2bn). Likewise, low debt to GDP, at around 1.6%, gives the country even more room to operate. “The Kingdom is much better prepared to weather the fall in the oil price this time than it was in the 1980s, due to its low debt and huge reserves,” Sfakianakis told OBG.

Fiscal Impact

In spite of the Kingdom’s preparedness to withstand the slide in oil prices, in its April 2015 “World Economic Outlook”, the IMF predicted that the drop in oil prices would cause the fiscal balance in Saudi Arabia to “move into substantial deficit in 2015 and 2016”. Furthermore, the government is expected to maintain its expansionary fiscal strategy, which, after taking into account the net effect of lower oil prices and higher oil output in 2015, will yield an even greater fiscal deficit. Assuming that oil revenues fall by one-third over the course of the year, the Kingdom would generate a fiscal deficit of SR397bn ($105.8bn) in 2015, equivalent to 15.6% of GDP. The current account is set to record its first deficit since 1998, albeit a comparatively small $23.1bn, equivalent to 3.4% of GDP. While drawing confidence from the government’s signalled determination to maintain spending, economists remain wary of the effects that a sustained drop in oil prices could have on the wider economy. “Oil remains very important as a growth generator for the whole economy, as it generates income, which the government then spends, thereby stimulating growth across the private sector,” Fahad Al Turki, chief economist and head of research at Jadwa Investment, told OBG.

In an August 2015 report the IMF noted that “the sharp drop in oil revenues and continued expenditure growth would result in a very large fiscal deficit this year and over the medium term, eroding the fiscal buffers built up over the past decade.” According to the IMF, the Kingdom should introduce measures to protect its economic performance including comprehensive energy price reforms, firm control of the public sector wage bill, greater efficiency in public sector investment and an expansion of non-oil revenues, including by introducing a value-added tax and a land tax.

Strategy

How Saudi Arabia would respond to the fall in oil prices has been a critical question for the markets. According to Al Turki, the country’s strategy has been consistent throughout. “Saudi Arabia is sticking to a policy of being a reliable supplier of oil to the world economy – a policy the Kingdom has followed since 1975,” he told OBG. While some analysts have ascribed political motives to Saudi Arabia’s decision to maintain oil production despite falling prices, others believe its policy is a rational response to the changing dynamics of the oil market. “The high-cost producers changed the oil market from an oligopoly to more of a competitive market, so it is natural that producers like Saudi Arabia should respond to this challenge by trying to defend their market share,” Al Turki said, adding that if Saudi Arabia’s oil strategy were really politically motivated, the Kingdom could raise production as high as its maximum output capacity of 12.5m bpd.

Output

Data supports the view that Saudi Arabia is pursuing a strategy of defending its market share, with crude production figures for the first quarter of 2015 remaining unchanged y-o-y at 9.7m bpd. Steady production levels have been accompanied by more aggressive pricing in an effort to maintain market share in the face of rising competition. In the US, Saudi Arabia’s supply of heavier crude has come under pressure from Canadian imports, while in the Chinese market it has seen intense competition from Iraq, Iran and Russia. As a result, China and the US accounted for 26% of total Saudi exports in the first quarter, down from 34% one year prior. Looking ahead, limited change is expected in Saudi crude exports, which are likely to remain at around 7m bpd, as the Kingdom’s efforts to defend market share continue to put downward pressure on the official selling price for crude. However, once the anticipated rise in domestic oil consumption is taken into account, full-year production is expected to average 9.8m bpd, up slightly over 9.6m bpd in 2014.

Swing Status

Saudi Arabia’s status as a swing producer has been questioned in light of its determination to sustain oil production levels at a time of falling prices. However, as Sfakianakis told OBG, “The fact is there just has not been sufficient demand to support Saudi Arabia’s role as a swing producer.” Rather, Sfakianakis pointed to the effects of the Kingdom’s determination to retain market share as evidence of its enduring significance in the market.

“Data from the US, such as the drilling rig count, shows that things are already going Saudi Arabia’s way,” explained Sfakianakis. In January 2015 Bloomberg reported that the US oil rig count had fallen by 209 to 1366 in just six weeks, marking the steepest decline since oil services firm Baker Hughes began recording the count in 1987. By May 2015 this number had fallen to 646. It appears that the Kingdom’s oil-producing competitors are beginning to take note of the country’s determination not to cut back production – a path Saudi Arabia can comfortably afford to follow, at least for the time being, thanks to its present fiscal position.