In a late September piece, I argued that the Gulf would not be immune from the current global financial crisis. One reason cited was the volatility of oil and gas prices as a result of the crisis. This month, oil prices remain volatile and show a strong downward trend, dipping well into the $60s per barrel and closing yesterday around the $70 level. While it remains unclear where the oil price will settle, the implications of a cheaper barrel are evident for GCC economies and their role in capital markets. A key framework for understanding the effect is the “arithmetic of surplus.”
Some oil-producing countries, such as Norway, use oil revenues principally for national savings and investment. If the price of a barrel drops from $100 to $70, the amount of new wealth that can be invested in capital markets goes down by 30% plus an adjustment due to the cost incurred in producing the oil. Nonetheless, the relationship of oil price to new, invest-able wealth is largely linear beyond the adjustment for production costs.
In the Gulf, however, the matter is fundamentally different. Oil and gas revenues are the principal source of income for most Gulf federal governments and are used to fund the daily operations of the state. When revenues exceed expenses, there are surpluses. These surpluses provide the new, invest-able wealth which flows into global capital markets. Strong surpluses have enabled the large investment flows we have witnessed in recent years.
Imagine, hypothetically, that a certain state needs an oil price of $60 to meet its budgetary needs and its cost of production. If oil is trading at $100, there is a surplus of $40 per barrel. If the oil price comes down to $70, the surplus per barrel becomes $10. Although the absolute price of oil goes down by only 30%, the surplus – the new, invest-able wealth – decreases by a full 75%. Thus, budgetary requirements mean that changes in the oil price have a disproportionate effect on the amount of new wealth.
In reality, each Gulf state has its own “break even” price and a $70 barrel still allows sizable surpluses. As recently as 2006, Saudi Arabia’s break even price was understood to be in the $40s. Today, it is almost certainly higher due to expanded needs and a weaker dollar. Below the break even figure, the country would need to dip into its capital reserves – as it has done in previous low-oil-price eras – to meet its domestic financial needs. New foreign investment would be highly constrained.
The UAE, Qatar, and Kuwait, by contrast, have far smaller budgetary burdens to bear, and a bulk of their budgets is allocated to capital projects rather than immediate needs. These countries therefore still enjoy large surpluses at today’s oil prices. At $130 per barrel, however, their new invest-able wealth was growing far faster. The confidence of Gulf investors – naturally linked to their confidence in future energy price – will be shaken as a result of the current volatility.
The Gulf’s role in global capital flows is fundamentally linked to the “arithmetic of surplus.” As discussed, dips in absolute oil prices have disproportionate effects on budget surpluses. As long as healthy surpluses remain, however, the GCC can continue to play the pivotal role it has adopted in the world’s capital markets.