Editor’s Note:
Earlier this month SUSRIS provided the International Monetary Fund’s readout from its consultations in Saudi Arabia — an annual event that allows the IMF to assess the health and prospects of the economy. This spring’s IMF team reported that:
“The decline in oil prices is resulting in substantially lower export and fiscal revenues, but the effect on the rest of the economy has so far been limited. Real GDP growth is projected by IMF staff at a healthy 3.5 percent this year, unchanged from 2014, with an increase in oil production and continued government spending expected to support the economy. Growth, however, is projected to slow to 2.7 percent in 2016 as government spending begins to adjust to the lower oil price environment. Over the medium-term, growth is expected to be around 3 percent. Inflation is likely to remain subdued.”
SUSRIS also provided an assessment today from Jadwa Investment that examined the intersection of oil prices and the recent opening of the Saudi stock exchange, the Tadawul, to qualified international investors.
For your consideration here we are providing a report from the International Monetary Fund’s (IMF) Middle East and Central Asia Department addressing the challenges to growth in the Saudi economy with special emphasis on a discussion of the impact of oil prices.
[Complete report: Saudi Arabia: Tackling Emerging Economic Challenges to Sustain Growth.]
Saudi Arabia: Tackling Emerging Economic Challenges to Sustain Growth
Ahmed Al-Darwish, Naif Alghaith, Alberto Behar, Tim Callen, Pragyan Deb, Amgad Hegazy, Padamja Khandelwal, Malika Pant, and Haonan Qu
Introduction
Saudi Arabia’s economy has grown very strongly in recent years as it has benefited from high oil prices and output, strong private sector activity, increased government spending, and the implementation of a number of domestic reform initiatives. Rising oil prices and oil production have also resulted in large external and fiscal surpluses, and government debt has declined to very low levels.
The economic outlook remains favorable. Nevertheless, the substantial drop in oil prices since the summer of 2014 is an important risk to the outlook. The Saudi Arabian economy remains very dependent on oil revenues to support growth and fiscal and external balances — over 90 percent of fiscal revenues and 80 percent of export revenues come from the sale of oil. Developments in the global oil market are therefore central to the economic outlook. Lower oil prices will have an immediate negative effect on the fiscal and external balances, and over time will also likely lead to slower growth.
The reliance of the Saudi Arabian economy on oil revenues raises two key challenges for policymakers. The first is how they should best manage the country’s current heavy dependence on oil revenues and ensure that the domestic economy is insulated to the extent possible from volatility in the global oil market. The second is how they can help the economy to diversify so that the current reliance on oil revenues is reduced over time. The four chapters in this paper, which were written as background papers for the Article IV consultation with Saudi Arabia during May 2014, address important aspects of these challenges.
Chapter 1 assesses the outlook for the oil market in the face of ongoing developments in the demand and supply of oil — specifically subdued global growth, the rapid increase in oil production in the United States, and ongoing security issues in a number of key oil-exporting countries. It develops scenarios of what different oil market developments could mean for the oil production and fiscal policy outlook in Saudi Arabia. It concludes that although there is considerable uncertainty about the oil market outlook, there is the potential for oil supply to grow more quickly than oil demand in the coming years, which would put downward pressure on oil prices (a scenario that has occurred in recent months). How Saudi Arabia responds with its own production will have important implications for the global oil market and for the fiscal outlook in Saudi Arabia. Nevertheless, whether oil prices or output adjust downward, the fiscal (and external) balance will deteriorate.
Chapter 2 looks at the key fiscal policy challenges facing Saudi Arabia, including the need to insulate the economy and the budget from large or sudden fluctuations in oil revenues (that is, revenue fluctuations should not feed into the non-oil economy through procyclical spending decisions), the need to ensure that oil revenues are used efficiently for development purposes, and the need to save enough of the current stream of oil revenues for use by future generations given that oil is a nonrenewable resource. The chapter looks at the experiences with fiscal rules and medium-term budget frameworks in other natural-resource-producing countries and sets out a fiscal reform agenda for Saudi Arabia. In particular, it suggests that this agenda should include strengthening the annual budget to make it a better guide to the government’s fiscal policy intentions; introducing a medium-term fiscal framework to guide spending decisions on a multi-year basis; using a structural budget rule to guide decisions under the medium-term fiscal framework (without at this stage introducing a formal fiscal rule); and reviewing the public investment management framework.
Chapter 3 looks at the role of monetary and macroprudential policies in Saudi Arabia given the Saudi riyal’s long-standing peg to the U.S. dollar. The peg has served the country well by providing credibility to monetary policy and stability to trade, income flows, and financial assets. Under the peg, fiscal policy is the primary macroeconomic management tool, although there is a complementary role for liquidity management operations and macroprudential policy in macroeconomic and financial sector management. Large external surpluses and fiscal spending, supported by oil revenues, have resulted in a liquidity surplus in the banking system. Although SAMA is developing its liquidity management tools, more could still be done to develop policy instruments, and a liquidity forecasting framework is needed to manage banking system liquidity. Regarding macroprudential policies, the chapter argues that Saudi Arabia would benefit from setting up a formal macroprudential framework, with SAMA as the designated macroprudential authority, to help manage systemic risks. The publication of early warning indicators and risk assessments and the development of a broader array of countercyclical macroprudential policy instruments would also help identify and manage financial sector risks in the face of volatile oil revenues.
Chapter 4 looks at Saudi Arabia’s experience with economic diversification as it attempts to move away from its current reliance on oil. The government has utilized rising oil receipts to increase spending on infrastructure and education, and in tandem has taken steps to improve the business climate and increase access to finance, especially for small and medium enterprises. The share of non-oil output in GDP has increased steadily, although export diversification has been more limited. Although non-oil exports have grown quite strongly, they remain a small share of total exports and are largely concentrated in products closely related to oil (such as petrochemicals). Saudi Arabia does not appear to suffer from traditional Dutch disease problems holding back the development of a competitive non-oil tradable sector, but the chapter argues that oil revenues may crowd out tradable production in other ways. The relatively higher wages and benefits available in the public sector compared to the private sector mean that the former is often a more attractive employment choice for nationals, particularly the lower-skilled. For firms, producing goods and services to meet the consumption and investment needs of the domestic market is a more reliable profit source than gearing business plans toward riskier export activities. The chapter argues that addressing these incentive issues can help resolve a missing element in Saudi Arabia’s diversification strategy.
In sum, two overriding policy messages can be drawn from the chapters in this paper. First, although the Saudi Arabian economy has performed very well and is in a position of strength, there is scope to strengthen macroeconomic and financial policy frameworks to ensure that policymakers have the tools, incentives, and authority to address future challenges as they emerge. Second, given the outlook for the global oil market, Saudi Arabia will not be able to rely on rising oil prices and increasing government spending to drive economic growth in the future. Rather, a more diversified economy needs to emerge to sustain growth and generate the jobs that the young and growing population desires.
Outlook for the Global Oil Market and the Implications for Saudi Arabia
Malika Pant and Alberto Behar
A number of factors are likely to affect the global oil market in the coming years, including the strength of the global recovery, the path of oil production in the United States, and the extent of supply outages in countries experiencing conflict and political instability. Although these factors mean there is considerable uncertainty about the oil market outlook, there is potential for supply to continue to grow more quickly than demand in the coming years. In the past, Saudi Arabia has shown an ability and willingness to respond to changing conditions in the global oil market to help balance demand and supply. How it responds in the future will have important implications for the global oil market as well as for fiscal and external balances in Saudi Arabia.
Outlook for the Global Oil Market
The global oil market has been affected by competing factors over the past several years (Figure 1.1). Global oil demand has increased modestly over the past three years (by 2.5 million barrels a day or mbd), driven by demand in nonmember countries of the Organization for Economic Cooperation and Development (OECD). Substantial oil production outages in Libya and Iran have reduced output by more than 2 mbd in several quarters when compared with production levels at end-2010. At the same time, oil production in the United States has increased by more than 2 mbd since the end of 2010, output in Saudi Arabia has risen, and supply from countries such as Iraq, Kuwait, and the United Arab Emirates has increased. Overall, these developments resulted in broadly stable oil prices, which hovered within the $100–$120 a barrel range between 2011 and August 2014. Prices, however, have dropped by more than 25 percent since the beginning of September 2014 and, at the time of this writing, stand at about $75 a barrel,1 their lowest since September 2010.
In the near term, although demand for oil should increase given the projected pickup in the global economy, supply uncertainties remain. These include uncertainties about how the ongoing violence in Iraq will affect its future production path, and uncertainties about the situation surrounding Ukraine. Even amid deepening turmoil, Libya’s oil production recovered from June 2014 onward, but the future path of recovery in output remains uncertain given the ongoing unrest. Besides Libya and Iran, supply disruptions in Nigeria, South Sudan, and Venezuela could adversely affect oil output. Additionally, falling oil prices may hurt further investments in oil capacity in areas where the production costs are high (IEA, 2014a). Nevertheless, if U.S. production continues to exceed expectations, the political situation in Libya and Iraq stabilizes, or sanctions against Iran are eased, oil supplied to the global market could exceed expectations.
Over the medium term, the rate of increase in the supply of oil will be determined by the following factors:
The ongoing boom in unconventional U.S. oil. The continuing surge in light tight oil production is expected to increase total oil production in the United States, including natural gas liquids (NGLs), by 2.8 mbd by 2019 according to estimates by the International Energy Agency (IEA). The U.S. Energy Information Administration (EIA) projects relatively smaller increases in production over the medium term and light tight oil output to peak around 2018, while BP estimates tight oil production to grow quickly by 1.5 mbd between 2012 and 2015 and then to grow at a much slower pace, to reach 4.5 mbd by 2030. Estimates by the Organization of the Petroleum Exporting Countries (OPEC) are broadly in line with the EIA baseline in the medium term (see Box 1.1).
Other non-OPEC producers, such as Canada and Brazil, increasing their oil production. Unconventional oil from the Canadian oil sands is estimated to increase non-OPEC supply by 1.2 mbd by 2019, while Argentina and Brazil are expected to add another 1 mbd and 0.8 mbd, respectively (IEA, 2014). Altogether, the non-OPEC oil supply could increase by 6.3 mbd (including NGLs) by 2019 as a result of these developments and those in the United States (Table 1.1).
Increases in production capacity in some OPEC countries. Estimates are that OPEC production capacity will increase by 2.1 mbd by 2019, largely due to increases in Angola, Iraq, and the United Arab Emirates, although the uncertain situation in Iraq could reduce this. Uncertainties surround the production outlook in Iran, because of the sanctions, and also because of uncertainties about how quickly production could be increased if sanctions are eased.
The decisions of Saudi Arabia. IMF staff projections assume that Saudi oil exports remain broadly unchanged over the next five years, but that production (9.7 mbd in 2013) increases modestly by 0.5 mbd, reflecting growing domestic energy consumption. Saudi Arabia has traditionally maintained excess production capacity.
On the demand side, although OECD demand is likely to remain subdued, higher consumption in non-OECD countries is expected to keep global demand strong in the medium term. The projected increase in global oil demand of 7.7 mbd by 2019 is driven mainly by non-OECD demand, which is projected to increase by 19 percent or 8.6 mbd. Non-OECD demand growth in the past few years has been driven by the rapid growth in BRICS (Brazil, Russia, India, China and South Africa). Saudi oil consumption is expected to remain strong, but decelerate slightly in the medium term (IEA, 2014a). Demand growth is also projected to pick up in several other non-OECD economies, including some African economies. Demand for oil in OECD countries is expected to decline due to gradual changes in energy consumption patterns, improved energy efficiency, and incentives to switch from oil to alternative fuels due to high oil prices and increased availability of natural gas. BP’s long-term projections up to 2035 suggest further declines in OECD countries’ demand for oil, particularly in the transport sector, driven mainly by improvements in energy efficiency. Eventually, global demand for oil in the transport sector is also expected to slow after 2025 driven by similar efficiency gains and fuel switching away from oil (BP, 2014a).
Putting the demand and supply outlooks together suggests that the oil market will be oversupplied, although there are considerable uncertainties. The medium-term outlook for the global oil market, anchored on the latest available IEA forecast, suggests that supply could continue to exceed demand, assuming only marginal inventory accumulation in the forecast period (Table 1.1). Despite a 7.7 mbd increase in global demand by 2019, high non-OPEC oil supply (6.3 mbd by 2019) would imply that the demand for oil from OPEC would remain broadly unchanged for the next few years and increase only marginally to 31.2 mbd by 2019 (versus 30.5 mbd in 2013). This implies that the baseline projection for the OPEC crude oil supply (32.7 mbd in 2019) would be much higher over the medium term and more than the demand by 1.4 mbd in 2018 and 2019. This outlook could sustain the downward pressure on oil prices unless production adjusts to partially reduce the excess supply. The price downside, however, would be limited by the high breakeven cost of the unconventional oil producers.
Projections for the demand and supply of oil are subject to considerable uncertainty. With regard to U.S. oil production, uncertainties regarding the actual level of resources available, evolution of technologies, and the associated cost to recover them are captured by the high and low oil resource cases developed by the EIA.2 The update from the EIA in May 2014 raised the base case for U.S. oil production in line with the EIA’s previous upside scenario following the substantial increase in U.S. tight oil production in 2013. This update illustrates the ongoing uncertainties surrounding the outlook for U.S. oil production over the medium term. Also, the uncertainties seen in other key oil-producing countries in recent years may continue, restricting the increase in supply. On the demand side, weaker growth in China, not only through the direct impact of lower demand for oil from China but also from the cascading effect of spillovers of slower Chinese growth, could affect demand for oil in other economies.
The wide range of uncertainties regarding the outlook for the demand and supply of oil over the medium term could affect the call on OPEC. To illustrate the range of uncertainties around the call on OPEC, the impact of different global oil demand and non-OPEC supply outcomes are considered (Figure 1.2). The demand-side risk to the baseline is defined as the change in global oil consumption from a 1 percent shock (both positive and negative) to world GDP growth, assuming no change in income elasticities. On the supply side, uncertainties around non-OPEC oil supply are based on the above-mentioned high and low resource scenarios for U.S. oil production from the EIA. If the combined downside risk scenario of higher non-OPEC supply and lower global demand compared to the baseline were to materialize, demand for OPEC oil would be much lower than the OPEC production in the baseline. The estimated excess supply over demand would be about 3.9 mbd (versus 1.4 mbd in the baseline). On the other hand, the combined upside risk would result in excess demand over supply of about 2.1 mbd by 2019. This may require Saudi Arabia to use its spare capacity to produce more to meet demand (Saudi Arabia’s spare capacity is about 2.7 mbd).
Additionally, if the ongoing unrest in some OPEC countries affects their production, excess supply could be lower than the baseline. The baseline assumes that production in Iraq would increase in line with its production capacity, while Libya would continue to produce slightly above the 2014 level over the medium term. If instead production in Iraq and Libya were to remain unchanged over the medium term at their current production levels (reported at 3.3 mbd and 0.7 mbd, respectively, in the November 2014 IEA monthly oil market report), excess supply in the baseline would be reduced to around 0.4 mbd (from 1.4 mbd).
Saudi Arabia’s Role in the Global Oil Market
Saudi Arabia is a key player in the global oil market, accounting for more than 16 percent of global proven reserves. The country and has been able to scale up its production quickly because of its high spare capacity of more than 2.7 million barrels a day, which accounts for more than half of global spare capacity (Table 1.2).3 This enables Saudi Arabia to play a key role in the global oil market and contribute positively to global economic stability and growth.
In the face of supply interruptions in other countries or demand surges, Saudi Arabia has responded by increasing its production to help balance demand and supply in the oil market (Figure 1.3). For example, during the first Gulf War (1990–91), the Venezuelan strike and the second Gulf War (2002–03), Hurricane Katrina in 2005, the surge in China’s demand in 2004, and the Libyan crisis (2010–11), Saudi Arabia increased its production to ensure that demand for oil was met in the face of declining supply from other sources (IMF, 2013b). Similarly, at times of weak or declining global oil demand or supply recovery, such as the U.S. recession in the early 2000s and the global financial crisis (2008–10), Saudi Arabia scaled back its production in response to market conditions (by 1.6 mbd and 1.4 mbd, respectively, in these periods).
In the recent past, Saudi Arabia has continued to help balance the global oil market. It raised its oil production in the first half of 2012 as sanctions on Iran were tightened, but then scaled back production in the second half of 2012 as output in Iraq, Libya, and the United States increased. It then increased production again in the second half of 2013 as Libyan production fell. However, the rapid increase in U.S. oil production since late 2012 resulted in less of an increase in production by Saudi Arabia to meet supply shortfalls elsewhere than during 2011. According to the most recent months available (up to October 2014), Saudi production has remained broadly unchanged despite the drop in oil prices.
A strong starting fiscal position has helped Saudi Arabia manage periods of lower oil production (Figure 1.4). The periods when oil production was reduced occurred at times when the budget was in substantial surplus in the year before the cutback.
Potential Implications of Global Oil Market Developments for Saudi Arabia
The uncertain medium-term outlook for the oil market could have implications for Saudi Arabia. The baseline scenario suggests that the supply of oil could exceed demand by up to 1.4 mbd. If OPEC supply does not respond, then oil prices would likely fall. The upside and downside scenarios suggest that there are considerable uncertainties around the outlook.
How Saudi Arabia chooses to respond to future demand and supply trends will be important for the dynamics in the oil market. Three illustrative cases are considered for how Saudi Arabia responds (no adjustment, adjustment by half, and full adjustment) under three different assumptions about the price elasticity of demand for oil (−0.2, −0.1, and −0.05).4 The impact of different responses under the baseline, downside, and upside scenarios in 2015 on the fiscal balance in Saudi Arabia is shown in Table 1.3.
The full adjustment response assumes that Saudi Arabia will cut its own production in 2015 to absorb all the excess supply of 0.6 mbd under the baseline. Consequently, there is no impact on prices. As a result, the fiscal balance would deteriorate by 2 percent of GDP in 2015 (Figure 1.5).
The no adjustment response assumes that Saudi Arabia does not adjust its production and continues to produce the amount assumed in the baseline and as a consequence oil prices fall. Since output remains unchanged, the impact on revenues reflects the price effect alone, and differs significantly depending on the choice of the estimate of the price elasticity of demand. If a higher estimate of demand elasticity of −0.2 is used, then oil prices would need to fall by less to balance demand and supply (by 3 percent) and the fiscal balance would fall by 1 percent of GDP. However, if a smaller estimate of the demand elasticity of −0.05 is assumed, then oil prices would fall more substantially by 12 percent. Consequently, the fiscal balance would drop by 4 percent of GDP from the baseline in 2015. However, the extent of the fall in oil prices could be limited by the high breakeven cost of shale oil production, which could provide an effective floor for oil prices.
The adjustment by half response, under which Saudi Arabia cuts back production by half of that needed and prices partially adjust, falls in between the above two scenarios in terms of the impact on fiscal revenues.
The impact on fiscal balances is larger under the downside scenario compared to the baseline, but the fiscal balance could also improve if the upside risks materialize (Table 1.3). With a higher excess supply of 1.6 mbd in 2015, the impact on the fiscal balances under the downside scenario would be much larger for each of the three sets of price elasticities. On the other hand, the upside scenario suggests an excess demand of 0.6 mbd, which if met fully by Saudi Arabia, would improve its fiscal balance by 2 percent of GDP. Thus, the wide range of uncertainties in the global oil market would impact Saudi’s oil revenue through changes in both the level of oil production and prices.
Conclusions
There are considerable uncertainties surrounding the outlook for the oil market. Demand for oil is set to increase, driven by strong growth in emerging markets, but supply increases from the United States and other countries have also surprised on the upside. However, the economic viability of unconventional oil production will depend on the future trend in oil prices. If oil prices remain at current levels, this could result in downward revisions in the medium-term outlook for unconventional oil supply. This creates further uncertainty regarding the outlook for U.S. production, which will depend on oil prices and technological and policy developments. Other uncertainties are also considerable, including from the global growth outlook, and the political situations in a number of key oil-producing countries. Indeed, there have been many negative supply shocks in the recent history of the global oil market. On balance, however, it appears that oil supply will continue to exceed demand in the coming years, sustaining the downward pressure on oil prices. Saudi Arabia has adjusted production several times in the past to balance the market. How Saudi Arabia responds in the future will have important implications for the global oil market and for Saudi Arabia’s own fiscal and external balances.
References
BP. 2014a. Statistical Review of World Energy. London: BP.
———. 2014b. “BP Energy Outlook 2035” (January). BP, London.
Energy Information Administration (EIA). 2014. Annual Energy Outlook. Washington, DC: U.S. Energy Information Administration.
Energy Information Administration (EIA). 2013. Annual Energy Outlook. Washington, DC: U.S. Energy Information Administration.
International Energy Agency (IEA). 2014a. Oil Market Report (June). Paris: IEA.
———. 2014b. Oil Medium-Term Market Report. Paris: IEA.
International Monetary Fund (IMF). 2013a. “Special Feature: Unconventional Oil and Gas in North America: What Are the Implications?” In Economic Prospects and Policy Challenges for the GCC Countries, report prepared for the Gulf Cooperation Council Annual Meeting of Finance Ministers and Central Bank Governors. Washington, DC: IMF. http://www.imf.org/external/np/pp/eng/2013/100513b.pdf.
———. 2013b. “Assessing Saudi Arabia’s Systemic Role in the Oil Market and Global Economy.” Selected Issues Paper, in Saudi Arabia: Staff Report for the 2013 Article IV Consultation. Washington, DC: IMF.
Organization of the Petroleum Exporting Countries (OPEC). 2013. World Oil Outlook 2013. Vienna: OPEC.
International Energy Forum (IEF). 2014. “A comparison of recent IEA and OPEC outlooks,” (January).
International Monetary Fund (IMF), 2014, World Economic Outlook, Special Feature on Commodity Prices and Forecasts, April 2014.
Kilian and Murphy (2012), “Why Agnostic Sign Restrictions Are Not Enough: Understanding The Dynamics Of Oil Market Var Models,” Journal of the European Economic Association, European Economic Association, vol. 10(5), pages 1166-1188, October.
Footnotes
Prices as of November 14, 2014.
Projections for the high and low oil resource cases versus the baseline (reference case) are reported in EIA (2014). Trends in the high and low oil resource scenarios are superimposed on the IEA baseline for U.S. oil production to derive the range of uncertainties around the baseline.
Spare capacity is defined by the IEA as additional production capacity levels that can be reached within 30 days and sustained for 90 days.
A wide range of estimates of the demand elasticity of oil in response to a change in price are found in the literature. For example, the IMF’s World Economic Outlook reports in April 2005 and April 2011 estimated short-term demand elasticities of −0.02 and −0.1, while Kilian and Murphy (2012) estimate −0.25, and the analytical work underpinning IMF (2014) estimates quarterly elasticities of −0.07 to −0.2. Supply outside of expected to hold as long as the oil price level stays above the breakeven cost for shale oil production because, if oil prices drop below the cost of producing unconventional oil, then the producers of unconventional oil may scale back their production, reducing the total supply of oil. We also assume that the supply from other OPEC and non-OPEC producers remains unchanged from the baseline.
Source: IMF
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