Oil prices, bonds, sovereign debt and foreign investments: trends in the Middle East’s political

Middle-East countries – particularly the GCC (Gulf Cooperation Council countries including Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates) – have long made the headlines for dominating the world’s oil & gas markets. But the political economy of the region is shifting because of various factors, including an unprecedented fall in global oil demand and prices forcing oil-rich powers to start relying on foreign capitals including international bond markets (i.e. sovereign debt) and foreign direct investment to compensate for rarifying development-funding petrodollars.

On paper, the GCC countries are doing fairly well in comparison to other economies around the world. For instance, while for 2016 the World Bank expects a 2.8 per cent in US GDP growth and the European Commission aims at a 1.7 per cent rise for the Union, the numbers are much higher for the GCC members which are expected to reach a 2.7 per cent GDP growth for the same period (IMF). At the same time, these obviously flattering GDP estimates only provide half of the story.

In reality, GDP hopes are improving in the US and the UE, but they are rather worrying for the Gulf governments because they have been constantly decreasing from 3.9 percent in 2014 to 3.2 percent in 2015 (Sources: IMF / WB). Particularly because of a historically strong fall in oil prices which, sooner or later, will force these countries to fundamentally review their policymaking strategy if they want to preserve their influential position on the global and regional political economy balance.

Regional economic governance and the issue of oil prices

Economic governance in the Middle East very largely hinges on oil revenues and government-spending. In GCC countries, in particular, oil is the main export & trading asset available and, as such, constitutes the major source of fiscal income for the region’s leaders which then redistribute benefits to the population, invest in regional health, education and infrastructure developments as well as in diverse industries and assets through sovereign wealth funds, whether locally or as part of foreign investment strategies.

Thus, as long as the oil prices were significant enough to compensate for costs and provide for public spending, the economic & governance has been both sustainable and fruitful in terms of economic development.

Over the last year, however, the trend has shifted. Oil prices have plummeted by approximately 70 percent moving from $115 in 2014 to $30 in early 2016, by the same token, the petrodollar budgets made available to those states have significantly decreased.

The fall in oil prices may be explained by various converging factors. The increased recourse to shale gas by the US industry has had an impact on price and, with a slow in China’s growth, the demand for oil supply has globally decreased. At the same time, the oil production and offer on international markets have not been adjusted and the recent return of Iran on oil markets will further increase the worldwide production of crude oil barrels which could by the same token help lowering the oil prices by a further 13 percent (World Bank). Besides, the reduction in oil demand added to the lack of production adjustments has led to accumulating stocks which, in turn, also contribute to feeding the price reduction circle.

International community reactions to drops in oil prices

The international community has not reacted much. Some initiatives have been taken to reduce production, particularly in China, but there the closure of four production sites by Sinopec aimed at significantly reducing fixed production costs rather than influencing the international demand and offer balance.

More significantly, various countries – starring the GCC members – have made an attempt to discuss common cuts in production so as to manage stocks and price drops. A provisional agreement between Saudi Arabia – as the OPEC leader (OPEC produces about 1/3 of world oil reserves) and Russia was discussed on February 16th, 2016 so as to freeze outputs, but the condition there was that all major oil producers had to agree by the terms.

A couple of days before, however, Mr Sechin – Head of the state-owned Rosneft oil company – had clearly indicated that Russia would not play such a game because Iran and Saudi Arabia would never agree to cut production and even criticized middle east producers for deliberately “flooding” the markets with excessive stocks (Financial Times, 11/02/16). Russia, later on, suggested the possibility of controlling outputs by ensuring that production levels for 2016 essentially remained at the 2015 levels rather than clearly reducing them.

Despite this bad start, countries such as Qatar, Venezuela or even Nigeria – as Africa’s largest producer – considered the possibility of cutting outputs but Iraq and Iran decided to play their own way. In the case of Iran, this can particularly be explained by the fact that the country – which recently celebrated the end of its nuclear sanctions and thus regained access to international markets – rather decided to preserve their re-nascent oil industry and re-and develop their share of international oil sales. Simply put, the 2015 production pace of 2.8 million barrels per day could reach 3.7 million barrels per day at the end of 2017 when the country’s offshore stocks (between 30 and 50 million barrels) is used for exports and new oil fields are exploited.

Ten days after it was first discussed, as a result, the provisional agreement was already a debate of the past.

Shifts in regional policymaking

When the question of the impact of price drops was asked to GCC officials about a year ago, the official answer tended to be that oil prices had no impact on Gulf economies. Nowadays, however, the situation has changed. And the oil price backlashes are forcing various countries – including Russia (FT 13/01) – to operate cuts in their budgets and / or review their financing policies.

Clearly, when a country such as Qatar needs a $60 barrel to balance its domestic budget (IMF), it is easy to guess that business-as-usual policymaking cannot be sustained when the per barrel price is half that. Thus, the once dominating oil-rich countries are now facing deficits and the IMF now expects that the fiscal balances (cash in vs cash out) and the current account balances (trade in vs trade out) in the region will be massively deteriorating.

The energy diversification option

Various options have been considered by the affected countries, amongst which is the energy diversification strategy. In particular, the Emirates have been largely communicating on the post-oil era at Davos.

Over the last years, it is no secret that the diversification trend has gone much deeper than merely energy resources and some countries have reconsidered their economic model at large, so as to shift from domestic oil revenues into foreign investment aimed at generating incomes from abroad.

The energy Minister of the Emirates, in fact, went so far as to suggest in Davos 2016 that – thanks to the transition efforts, the former revenues from the oil industry would actually become “luxury”, i.e. “an additional profit that’s going to be reinvested and not to have it as a major contributor in our budget”.

The fiscal policy options

In addition to this, fiscal policy re-orientations are also being considered and the once generous Middle East policymakers are now considering taking measures to increase pressure on domestic economic actors.

Some have decided to curb their nascent deficit issues by introducing sales-tax on their economies, while the fuel subsidies which seemed a logical and popular choice in oil-rich environments might soon become a residue of the past.

Saudi Arabia, also, is considering selling shares in the world’s largest oil producer Saudi Aramco, but the country’s public authorities – as well as Oman’s – have also started to mitigate public expenses by reducing public-sector remuneration.

Bonds, sovereign debt & international markets: the new trend

Obviously, however, such a system can’t last for long and in reality the idea of reducing subsidies, selling shares in industry champions or relying on cash reserves is not durable.

More significant, therefore, is perhaps the decision of several leaders to shift their economic governance models by moving from an oil revenue system into a market-based fiscal policy orientation relying – as in most economies – on bonds and sovereign debt. A bond, as a reminder, is a debt security denominated in foreign currency (dollars, euros …) which is issued by a sovereign government with interest rate guaranteed in the medium/long term in exchange for fresh cash.

In practice, oil-rich countries never had recourse to debt because the petrodollars cashed-in were more than necessary to float their boat. With the persisting fall in oil prices, however, markets have become a landmark alternative B plan.

In Saudi Arabia where deficits in the range of $90 billion in 2015 for instance contributed to weakening reserves from $737 billion in 2014 to approximately $640 billion in early February (FT / Business Insider), recourse to international markets has become a major way to avoid depleting budgets any further. Debt was first issued from domestic banks in June and August (2015) but, in order to avoid taking liquidity from private sector lending the government eventually considered from November 2015, the government the idea of creating dollar debt in early 2016 from the international bond market.

Their move has actually been described as ‘one of the most successful debuts on bond markets’ (FT, 03/02/15) because, amongst other factors, the country remains the largest producer of oil in the OPEC organization and thus still receives significant oil revenues capable of providing convincing guarantees to foreign capital lenders.

Despite this, Saudi Arabia’s credit grade as well as four other oil-producers’ (such as Oman or Bahrain) were downgraded two levels by Standards & Poor’s in mid-February 2016, less than four months after S&P had already reduced the country’s rating to A+ when oil prices went below the $50 per barrel benchmark.

Saudi Arabia is not isolated in this and, in fact, a Middle East bond trend is now emerging. Qatar has been following the move and already used the bond mechanisms with success considering that its 2015 operation was four times oversubscribed. Bahrain, similarly, has relied on foreign debt on different occasions – but at a rather expensive 7.4 percent and 5.7 percent interest rate (Bloomberg).

Not to forget… the foreign investment trend

Considering the fact that government-spending is the key engine of economic growth in oil-exporting Middle-East countries, another significant shift in policymaking flowing from the fall in oil prices finally relates to a new foreign investment trend.

As mentioned previously, oil-rich countries – particularly in GCC – have been known for their diversification strategies which, amongst other aspects, consisted in investing the proceeds of oil production abroad.

It seems that the trend might increasingly be going in reverse, however, with oil-producing countries in the Middle-East now seeking foreign capitals as a means to lower public expenditures and develop their infrastructure and economy in general.

Following the lifting of its nuclear sanctions, Iran for instance set a benchmark in January in declaring that, in addition to recuperating its once-frozen $30 billion in assets, the country would now seek to re-develop strong business relationships with the rest of the world so as to attract capital flows. Oil production and selling on international markets, in other words, will make part of Iran’s development strategy and is likely to grow in the future, but the government only seems to considers petrodollars in terms of extra cash, on side of foreign investment promotion and non-commodity export policymaking.

Saudi Arabia, similarly, has been increasingly looking for foreign investors in addition to its recent operations on the bond markets, particularly in relation to the retail, healthcare, tourism and manufacturing sectors while a greater recourse to PPP projects has also been considered in relation to infrastructure development.

Policy challenges ahead: re-equilibrating the influence balance

All in all, the severe evolutions of oil prices over the last year has already had some consequences on Middle-East economies and, without doubt, will have serious implications on the political economy of the Middle-East region as a whole.

In particular, new and significant trends have emerged in relation to fiscal policy, debt markets and foreign investment, and the tendency of GCC countries to operate budget cuts while relying on foreign capitals – whether in the form of foreign investment or in the form of bonds and sovereign debt – cannot be ignored.

The irony, of course, is that whilst the US has developed shale gas to lower their dependence on oil originating from increasingly powerful Arab countries, the Middle-East producers which once flooded the world with abundant resources have now become victims of their own successes and try to secure private funds from US capital holders to reduce government-spending without reducing development needs.

The political economy in the Middle East depends on a tridimensional equilibrium based on influence, oil and cash. With too much oil and not enough cash, however, the influential position enjoyed by these countries might sooner or later shift from sweet to sour and regional leaders might lose their position of strength on the political economy’s balance. Unless they find a way to re-equilibrate the system, that is.

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