Analysis: Saudi Arabia’s big oil bet?

Saudi Arabia offered an insight into the full impact of low oil prices when it released 2015 budget projections on Thursday. The Kingdom, which derives 90 percent of government revenues from hydrocarbons, will rack up a budget deficit of SAR 145bn (US$38.7bn) after seeing oil prices slump by almost 50 per cent since June.

Even so policymakers are keeping the economy in an expansionary state supported by substantial reserves.

A statement issued by the Ministry of Finance forecast the 2015 record government spending at SAR 860bn ($229.3bn) , an increase of 0.6 percent compared to 2014.

According to the statement, revenues would fall to SAR 715bn ($190.7bn) generating a full year deficit of SAR 145bn ($38.7bn). Around SAR 377m of expenditure is allocated to education, health and social affairs.

The scale of the projected 2015 deficit at around 5.2 percent of GDP has caught some analysts by surprise. 

Earlier in a research alert in December Fahad Alturki, chief economist and head of research at Jadwa Investment in Riyadh, forecast a deficit of 2.7 and 5.7 in 2015 whilst estimating real GDP to grow 3.4 percent.

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Irrespective the size of the deficit, Alturki says historical portents mean the government will continue spending for some time to come. “We think the government will maintain elevated spending over the next few years which will keep growth of the non-oil sector above 4 percent for 2015-2016.”

In spite of heavy spending, efforts to diversify the economy have had limited success. The private sector is hugely reliant on state spending and any wholesale reduction would have a negative psychological effect, according to Jadwa.

During previous fiscal deficits the government slowed payments to the private sector and delayed new projects.

Still, there is a degree of uncertainty over the actual deficit the Kingdom will accumulate in 2015 as it does not disclose the average oil price it uses to calculate the budget.

Analysts say the Kingdom remains vulnerable to any further deterioration in oil prices and according to a report published on December 4 in Capital Economics in London, Saudi Arabia could see a deficit of 10 percent during a period of prolonged lower oil prices.

In its Regional Economic Outlook in October, the International Monetary Fund estimates Saudi Arabia needs a fiscal breakeven oil price of $106 a barrel in 2015.

Since details of the budget have been revealed, attention is turning to how the world’s largest oil exporter will finance the budget shortfall.

It has been prudent managing revenues when oil prices were high and has amassed substantial capital buffers estimated by Capital Economics at $740bn, to cushion against reduced oil income.

Jason Tuvey, Middle East economist at Capital Economics, says the kingdom has several options although history suggests it will first use its vast reserves.

“When the oil boom of 1970s turned to bust in the 1980s, budget deficits widened dramatically and reached more than 30 percent of GDP. In that instance, the government initially drew down its reserves to finance the shortfall.”

If Saudi Arabia were to use its own savings, that would undoubtedly be the cheapest option. Although the Kingdom’s understanding of capital markets has evolved significantly and if it was to turn to international bond markets to finance its deficit, it could likely borrow at low yields [the return an investor receives on a bond] and maintain its large reserves. 

Nevertheless, Investors remain uneasy over the opacity of information on Saudi Arabia and indeed there is little data about Saudi bond yields.

However, elsewhere in the Gulf spreads of dollar denominated bonds over US Treasuries have remained close to record lows despite the big fall in oil prices. Most Gulf currencies are pegged to the US dollar and investor sentiment towards that form of borrowing is positive.

Saudi Arabia has one of the lowest levels of government debt in the world, which the IMF estimates will be 2.5 percent of GDP in 2015.

As a source of deficit financing, tapping bond markets may help achieve other objectives including deepening the Kingdom’s nascent financial markets.

MSCI (Morgan Stanley Capital International), classifies Saudi Arabia as a Frontier Market and it is clear local bond markets are underdeveloped by emerging market standards.

Issuing government debt would provide more assets to purchase as the authorities prepare to open the market to foreign investors.

Both the UAE and Qatar were upgraded to Emerging Market status in 2014 and many investors believe the Kingdom has taken a significant step to an EM upgrade after the financial market regulator signalled it would open the Tadawul, the Kingdom’s $540bn stock market to Qualified Foreign Investors in the first half of 2015.

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Sources close to discussions between the IMF and Saudi officials earlier this year described them as “heated”. For some time the IMF has been advocating the Kingdom, along with other Gulf states, rein in expensive energy related subsidies.

For decades Saudi Arabia has maintained a social compact providing citizens a cradle-to-grave welfare safety net in exchange for loyalty and stability.

That contract has been under strain as substantial levels of youth unemployment and a bloated public sector wage bill increasingly take their toll on government finances.

The Ministry of Finance says salaries, wages and allowances will account for 50 percent of government expenditure in 2015 which, it says, it is attempting to “rationalise”.

Saudi Arabia’s decision to maintain production output irrespective of oil prices is viewed by some as a bold move to stare down the growing threat from US shale.

Others, however, think it is a huge gamble at a time of regional instability.

There is a lingering unanswered question over the extent the Kingdom is simply responding to supply and demand swings or using oil as a proxy for its geopolitical ambitions.

It is a point noted by Kristian Coates Ulrichsen, Fellow for the Middle East at Rice University’s Baker Institute; “Saudi officials wish to project an air of normality and avoid any form of concern lower oil prices might harm the economy in order to reassure both the international markets and domestic opinion that they remain in control despite the growing regional volatility all around them.”