April 18, 2016
- An uncertain road ahead for oil prices out of the Doha talks
- Expecting a tailwind from lower oil, emerging economies get an unpleasant surprise
The meeting in Doha over the weekend was anticipated to be the beginning of the end of the oil glut to continue to support prices in the oil market. With a failure to freeze production even at today’s high levels, it will return the strain on oil exporters like the UAE. Oil importing emerging markets may have expected to get a boost from lower prices but have seen currency devaluation and financial market instability lead to problems that offset a lot of their gain. In our second article, we focus on the paradox of the negative impact of lower oil price on oil importers.
Background on prospects for an oil price freeze
Some of the world’s biggest crude oil producers from both OPEC and non-OPEC countries were close to reaching a major agreement to freeze oil production in a bid to support oil prices in Doha yesterday. In February, Saudi Arabia, Russia, Qatar and Venezuela all agreed to freeze production at January levels if other large oil producers followed suit. This interim agreement on a production freeze led to a recovery of oil price to $42 per barrel from a level bottomed at below $30 per barrel.
This agreement on production cuts was a reversal on earlier talk. Russia and Saudi Arabia had each refused to cut or freeze their production levels in late 2014 and last fall 2015, respectively, in order to maintain market share. However, the prolonged price slump down to the mid-$26s per barrel led these countries to come to table and take a unified action to counteract the price slump through a production freeze at January 2016 levels.
The assembly of OPEC and non-OPEC countries meeting in Doha ahead of the official meeting of OPEC in June ran aground on one big challenge in particular: getting a ‘yes’ vote from Iran on this issue. Iran, recently freed from many Western sanctions, refused to put a cap on production in order to gain its lost market share subsequent to its recent re-entry into the international oil markets. In return, Saudi Arabia refused to join an output freeze until Iran agreed to freeze its own oil output. Oil prices have plunged drastically ever since the major producers at Doha failed to reach an agreement to freeze output.
How has the UAE’s economy been affected by the oil plunge?
The UAE’s trade account balance is severely affected by a plunge in the oil prices. Given the uncertainty that came out of the Doha meetings that were expected to limit the oil supply glut, it could further hit the economies of oil exporters like the UAE. These countries will see the direct effect of lower oil continue and the compounding effect of fiscal tightening in response to low oil. During the past 18 months, oil has fallen by about 70% and the failure of measures to reduce the supply glut at Doha will continue to see supply increase even as demand growth remains slow. The purchasing managers index, which surveys businesses across the country, recorded a positive reading at 52.6 in January this year (anything over 50 indicates economic expansion), it is at the lowest point since March 2012.
The value of exports of hydrocarbons have dropped by 50% since 2013. This total accounted for 33% of the GDP in 2013 but has fallen to 17% as of the end of 2015. The most dramatic channel through which the impact is felt is the current account. Although the value of hydrocarbons exports has fallen by 50%, the effect on the current account balance is more severe, having fallen 70% to a level of 5.8%. The UAE economy will continue to see the effects of lower oil prices and increasingly a trickle-down effect to the non-oil economy as spending on capital projects are reduced and subsidies are scaled back.
The IMF’s World Economic Outlook, released last week, highlighted an issue that falls below the headlines like those around the Doha talks between oil-exporters but is of critical interest to emerging markets that import oil. Where has the benefit to consumers and aid to central banks in their fight against inflation gone?. The IMF explained:
Oil-importing emerging market economies are benefiting from terms-of-trade gains but in some instances are facing tighter financing conditions and weakness in external demand, which counter the positive terms-of-trade impact on domestic demand and growth.
One of the commonly assumed outcomes that will accompany low-priced oil is an equal rise in the fortunes of oil importing countries. Yet, this has not been the case during the 2014-2016 swoon in oil prices where countries like Turkey and Indonesia have seen significant disruption during a period when lower oil prices should have acted as a tailwind to their growth.
This challenges two key points of conventional wisdom in economic discourse. First, that the fall in oil will enable countries that do not depend on production as source of economic growth; second, that the detrimental impact of lower oil prices in exporters will be symmetric with the positive benefit to oil importers.
One explanation why the traditional relationship breaks down is that oil exporters have become more liquidity constrained than oil importers in the situation where oil prices drop significantly compared with smaller drops. This ‘non-linearity’ does seem to have affected the oil producers’ response to low prices relative to the impact on consumers in developed markets, but it doesn’t fully explain why oil-importing emerging markets would fail to benefit from oil price drops.
The liquidity constraints facing oil exporters may not show themselves immediately; oil prices fell significantly starting in 2014 but it was not until the second half of 2015 when the repatriation of assets held overseas began to intensify. However, the lack of new liquidity flowing to oil-exporters that would have been invested globally (including into markets like Indonesia and Turkey) did start to have an impact because it began to create financial market instability.
Although the dependence was particularly felt by countries like Turkey which have lower domestic savings rates and higher external funding needs, those like Indonesia where savings rates are higher were not immune either. The oil price drop pulled liquidity out of these markets to fill the liquidity needs of the oil exporting countries. Turkey had some precursor rumbles from its dependence on Middle Eastern investors for its early sukuk offerings. In 2012, a late upsizing of its debut sukuk which led to overallocation for Middle Eastern buyers led to small tremors in the secondary market.
Oil importers’ position is made even more difficult because their dependence on external capital meant that the benefit of lower oil prices for developed market consumers, as well as heightened risk aversion associated with financial market volatility, led to flows out of more risky markets like oil importers. These effects are not as large—the IMF noted that the impact of lower oil prices on developed market consumers was more muted than in past experience—but the volume of the capital flows from developed markets makes it just as important for oil importers.
In effect, oil-importing emerging economies were expecting to have lower oil flow through to savings for consumers (or governments if they significantly subsidize energy prices). However, in reality, most of the benefits they received in lower energy savings were offset by outflows of capital that raised borrowing costs and led to currency depreciation that offset the expected inflation benefit from lower oil. As with rising, falling or steady energy prices, the economies that develop the best sources of mobilizing domestic savings have come out in the best shape.
Note: The data presented are the Current Account Balance (% of GDP)