Low Oil Prices: Causes, Consequences and Challenges

KUWAIT: A general view shows the Shuaiba oil refinery yesterday. Oil workers plan to go on strike today in protest against what they call the government’s plan to cut their annual benefits and bonuses. — Photo by Yasser Al-Zayyat
KUWAIT: A general view shows the Shuaiba oil refinery. — Photo by Yasser Al-Zayyat

In the past few months, crude oil prices have registered record low levels which have resulted in a state of confusion around the world, especially in the Arab Gulf countries, whose economies and public budgets are heavily dependent on oil revenues.
As a result of these dramatic changes, the Arab Gulf countries moved quickly to reconsider their sources of income and patterns of spending. They announced policies aimed at lowering their annual budgets and formulated future visions to reduce their dependence on oil exports as a main source of income.

What’s behind the fall?
Before talking about the consequences and the challenges associated with the drop in oil prices, we briefly review some of the reasons that precipitated the significant decline in world crude oil prices.
First, Iran’s return to the international oil scene. No doubt that the recent signing of the US-Iran nuclear deal on 14 July 2015 paved the way for removing the international sanctions against Iran. This allowed Iran to return to the oil market and expand its oil production to approximately 3.6 million barrels of oil per day. This major increase in world oil supply led to a large surplus in oil supply.

Second, the increase in the production of other oil producing countries and the continuing efforts of the shale oil producers in the United States to maintain output despite the high cost of production.  Indeed, according to a report issued by the US Energy Information Administration, the United States has increased the pace of its oil production, reaching 9.2 million barrels per day in 2015 compared to 7 million barrels in 2013 and raising US inventories to around 400 million barrels.

Third, it is known that there is an inverse relationship between oil prices and the price of the dollar in international currency markets. Given that oil is priced in US dollars, there is no doubt that the strength of the dollar negatively effects oil demand and consequently the prices. The strong dollar in the past year combined with incremental increase in oil production by the Organization of Petroleum Exporting Countries put additional downward pressure on oil prices.

Fourth, the global recession and very low rates of economic growth in most of industrialized countries and the emerging economies significantly added to the lower oil prices. For example, the Japanese and the Russian economies are witnessing a noticeable recession; also, China, India and Brazil are experiencing lowest economic growth rates in decades.

Lastly, the most important reason is OPEC’s policy regarding oil production. No doubt that the role of OPEC’s policy in determining the price of oil is critical and significant. Once OPEC declared that it would not reduce production to support prices, the price of oil began to fall more and more (OPEC collectively produces about 31 million barrels per day). It is important here to emphasize the leading role of Saudi Arabia which is the most important oil exporter in the world (it produces about eleven million barrels per day). Saudi Arabia declared that it is not in its national interest to reduce production to protect its market share unless there is cooperation among all members to freeze output collectively.

As the Arab Gulf countries currently are facing the challenges of low oil prices, it is required of them to reconsider how to manage revenues and their spending.  It is known that in the past few years, oil revenues were huge when the oil price was its peak of $147 in 2014. The paramount role played by oil revenues in the Gulf states was the source of expanding public spending on vital sectors such as education, health, defense and raise the wages of the public sector.

Currently, oil price has lost 60% of its value, compared with 2014 prices which has alarmed the Gulf states and forced them to consider tightening their budgets and consider various means of raising revenues including the possibility of imposing taxes. Saudi Arabia, the United Arab Emirates, Qatar, Oman, Kuwait and Bahrain have all taken steps to reduce their spending and boosting revenues in the past six months. For example, Saudi Arabia, quickly announced a plan and economic vision to reduce dependence on oil by the year 2030 and floated the idea of possible privatization of a part of Aramco, which is one of the most expensive companies in the world.

An opportunity for reform
In addition, it raises the price of gasoline by about 50 percent, with the lifting of tariffs on electricity and water.  Kuwait recently announced that it is prepared to reduce subsidies for fuel, public utilities, and freezing or slowing the growth of public sector wages, as they try to curb big budget deficits caused by low oil prices. All GCC countries have declared a series of procedures which differs in its degree from one country to another, but the main goal was cutting spending.

Nevertheless, Gulf countries can adapt to the drop in oil prices in the short term but the cope over the long term will be linked to the extent of their ability to diversify their economic base. In other words, the effect of lower oil prices in the short term will be limited because Gulf countries possess the largest oil reserves in the world with that it has the cheapest cost of oil production per barrel in the world.

Gulf states combined possess sovereign funds, which manages assets of about $2.5 trillion, equivalent to 37% of the total assets of sovereign wealth funds in the world and that can be resorted if needed.  In addition, Gulf states have strong financial base due to the huge revenues accumulated over years of high oil prices. Also, the past borrowing has been almost virtually non-existent. In fact, most of the GCC countries are net lenders to the outside world.  For example, if these countries were forced to resort to issuing government bonds it would be an easy task.  In light of these factors, we can say that the GCC countries are able to weather the storm even if it faces a deficit in the next few years.

This is in the short term, but in the long run, low oil prices can serve as a good opportunity for the GCC countries to seriously consider economic diversification and put the development of economic reforms into practice. Also, it can be an opportunity for these countries to review their demographic composition. It is known that the Gulf countries suffer from an imbalance in the population structure. The proportion of foreigners is extremely high in the Gulf states compared with the national population.

Furthermore, a very high percentage of employees working in the public sector. For example, the government sector in Kuwait and Saudi Arabia, employs about 90 percent of the citizens. This situation puts these countries in a great challenge.  So, economic diversification is very important and giving a more important role to the private sector can help significantly in addressing these imbalances.  In conclusion, success of the Gulf countries in reducing their dependence on oil in the long term depends largely on the ability of these countries to diversify their economies and translating all the policies and procedures and visions that are currently announced into real action.
Sbeiti is an associate professor at the American University of Kuwait in the department of finance.

By Dr Wafaa Sbeiti

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