Last week, OPEC+ ministers managed to come to a consensus after days of contentious discussions in Vienna, achieving the goal of formally keeping the OPEC+ alliance together, but failing to solve some of the thorny issues between key members including Saudi Arabia and Iran. The final agreement, which commits the group to reversing recent overcompliance to boost production, remains formally agnostic on who will contribute to that production increase. This post looks at the factors that will shape upcoming fundamental outlook and assesses the macro impact for some key producers.
This suggests the alliance has moved into a transition phase of exit and shift to a different and more contested data dependent mode. The time-buying (or can-kicking) deal allows for more time to assess several key supply and demand variables described below including the impact of sanctions, the politically driven pressures and the resilience of global consumers.
In the near-term, the results support higher prices, especially as the net addition of fuel will be modest, and the result of individual decisions not the collective. Meanwhile the looming implementation of Iran sanctions poses a risk. Additions from the countries which can add will likely to offset by continued Iranian export declines as businesses trim their imports ahead of key November sanctions dates. The uncertainty around supply and risk of unilateral action to make up the gap. increases the likelihood of volatility and production.
Overall the result mapped with my expectations of gradualism, a moderate increase now, with ongoing reassessment and eventual gains through the year. As noted in our coverage of the Iran deal exit, OPEC members were likely to add supplies slower and more modestly than some market actors expected, while bargaining and price discounting from the Iranians would complicate assessment of production. The political pressures and uncertainty on production outlook in several key countries (including Venezuela, Iran, Libya, Nigeria), make it hard to imagine a different outcome, but divides will build over time, as further outages build in countries like Iran and Venezuela and only a few countries can produce more in compensation.
Focus on the big alliance, not only the smaller ones within OPEC: The result highlights the importance for Saudi Arabia (and GCC allies) as well as Russia of retaining the alliance struck in 2016 on managing oil output. Remaining vague on the details of how the production will be re-allocated from Venezuela to the countries with spare capacity, avoids a political decision that will eventually need to be addressed, since its hard to see any meaningful increases from that country. In fact, output is likely to fall further due to strikes, job cuts and equipment seizures.
Gradualism allows for more information gathering: By later in the fall, there should be more clarity on the following relevant fundamental issues that make it currently difficult to plan.
Exit from easing needs new forward guidance. 2018 was always going to be the year when the alliance shifted to a new phase. Like global central banks moving to quantitative tightening, the alliance (which was in a formal tightening phase), will employ new forward guidance for easing. The Joint monitoring committee (and a range of private monitoring bodies, are likely to take on a bigger role with focus moving beyond 5 year inventories as their main fundamental metric. It remains unclear what the new metrics, and forward guidance will look like. Saudi Arabian officials have already gone on the record to highlight the need for well over 1 million barrels a day in increase by the end of the year. Doing so, while absorbing Iranian output is likely to be difficult.
What might the impacts be on oil producers?
The decision brings increased breathing space to most oil producers, especially Saudi Arabia, most of the rest of the GCC and Russia, which account for the bulk of global spare capacity. While prices might soften from their recent levels, the increase in output, even if moderate should keep oil revenues elevated compared to 2017 levels and increase the energy contribution to growth. This should modestly reduce oil fiscal breakevens, though we assume that most countries will take the opportunity to spend a little more given that non-oil growth has been sluggish especially in MENA and SSA.
Our analysis suggests more GCC countries will use this space to become a little more expansive on the fiscal side, offsetting for what continues to be sluggish private sector growth, credit and sentiment. We have already seen stimulus rolled out in Abu Dhabi and Qatar, and spending outpace plans in Saudi Arabia, though some of these look temporary. We assume that fiscal breakeven price in Saudi Arabia may fall slightly to the low/mid 80s from the current $89/barrel, suggesting slightly less draw on debt. This implies that there will be more final demand rather than petrodollar savings. Countries in a position to save more include UAE (Abu Dhabi), Kuwait, Qatar, Russia, Kazakhstan, and possibly Nigeria. The chart below highlights likely shift in the current account surplus (flow of savings net of imports of goods and capital).
Other countries including Oman, Saudi Arabia, Iraq will likely tend to borrow less or draw down fewer reserves. Saudi Arabia likely will have more pump priming space to support the private sector.
We see a modest increase in Russian output, but limited impact on growth. In Russia, the flexibility of the exchange rate remains a key adjustment tool and increase in output is an offset to the financial cost of sanctions.
Those most vulnerable remain Venezuela, where local mismanagement, asset seizures and the exacerbating impact of sanctions suggest significant further outages. While politically OPEC could not formally reallocate its target, its hard to see any reversal of outages, especially as recent legal cases and strikes undermine its capacity further.
Iran, too will start to feel the pinch from the drop in oil prices, with the full impact dependent on sanctions implementation. For more on the scenarios, please see here. Decisions on adjusting to Iranian outages are more likely to be bilateral (between buyers and sellers) than within the alliance, but its hard to see if able to sell its current targets.
This post shares a few takeaways from my discussions last week in London with policymakers, investors and analysts on MENA and energy. Overall, sentiment was upbeat.There were two big elephants in the room: Saudi Arabia economic and foreign policy activism and the Iran nuclear deal. There remains significant uncertainty around the implementation around those issues, which offsets what is generally a more upbeat outlook in the face of $65-70/barrel crude.
One broader question pervaded my discussions. How much do higher oil prices help? Brent around $70 (or even in the mid 60s) gives significant more room for maneuver and likely will reinforce government driven growth across the GCC as it likely implies less fiscal austerity. It clearly buys time and room for maneuver and spread compression. However, we see only Kuwait and possibly the UAE having scope to resume saving, meaning that regional sovereign funds are likely to receive little new capital as more of the funds are used to support domestic spending. These trends will reinforce the ongoing acceleration of local growth from the 2016-17 pace, much private sector is likely to drag behind as the desire for quick growth brings government actors more into play.
Institutional investors remain constructive on GCC bonds on valuation grounds especially vs Asian alternates and even some of the more liquid CEEMEA names in the USD space. Oman and Egypt seemed to be top picks given that macro environment seemed to be better than feared, allowing some yield compression. $70 brent provides a lot of space for regional external balances and pegs, even if it won’t help fiscal balances much. Expect the GCC to continue to dominate global USD issuance among EM and Frontiers again in 2018, with Qatar joining peers. Going forward, concern may rise about Bahrain, and whether any regional support may not help bond investors.
Oil price and fundamentals: there’s a general consensus that the market is rebalancing and the OPEC + (Vienna agreement) has “worked” and the excess inventories in the U.S. will continue to be drawn down this year, but there is less consensus about the price forecast, which has a wide band around 55-80 this year. This reflects a difference of opinion about the growth in global demand (between 1.1 and 1.7mbd) and the persistence of the production freeze if prices remain high and incentive to cheat rises. On the demand side a key question is whether rising costs will dampen consumption growth (MENA oil producers are one place to watch, as is U.S. and Asian consumers) while shale production is a key place to watch on the supply side.
Global oil majors and many in GCC seem to be looking for $65 Brent this year, seeing some increase in shale output, some drawdown in inventories and the risk of a speculative correction. Others especially on the sellside seem to be sharply scaling up their forecasts, with Goldman Sachs pointing to the possibility of $85 by mid-year. In this price environment, expect oil companies revenues to move up but new investment is unlikely to outstrip plans.
Saudi Policy consternation: The Saudi anti-corruption detentions seem to be coming to an end, with reports that $100 billion in assets have been raised, likely a combination of stakes in companies and cash. This turns attention to the many key questions about the new anti-corruption regime, new institutions and the broader economic reform. Will Saudi authorities continue to hike public wages, even if that places a greater burden on the public sector? What will the new legal process be for corruption cases? Where will the new funds be managed? Will these funds be incorporated into the Public Investment Fund (PIF) which is already managing much domestic investment funds and waiting for new foreign issuance. Interest in the Aramco IPO seemed to have died down despite the improved oil valuation with many investors waiting to believe when they see terms. Meanwhile, the general view was that economic growth would accelerate and
The PIF itself is a matter of much interest, with many investors and regional watchers wondering how its asset allocation will evolve, how it will balance the foreign versus domestic investments and how it will balance competing mandates. It is rapidly staffing up and cares about a professional structure, but like many areas of Saudi policy, it is being asked to do a lot at once, with mixed goals.
Iran deal and economic policy: Coming only a few weeks after President Trump’s ultimatum on the nuclear deal and demand that European allies improve the deal, there was a lot of uncertainty on investment outlook. The view from Europe (especially France and Italy) is that the deal is working, and the burden high for changes, and the Iranians seem to be woking had to make sure that they are not blamed for the deal falling apart. This suggests major changes might be a hard task. Some European countries have already chosen to backstop local companies doing business in Iran, though oil companies concede that Iranian domestic policy uncertainty and term preferences pose as much concern as U.S. sanctions. Banks remain very concerned about sanctions and regulatory risk, which may explain the direct support of European firms. Meanwhile local macro issues including the vulnerabilities of the non-bank credit and the battle between government and IRGC suggest that Iran may struggle to benefit from some of the higher energy prices. The recent protests have triggered a less restrictive fiscal policy, with more subsidies remaining in place, and greater domestic leverage from the government.
Qatar: The general view is that the blockade is here to stay for some time and I've written extensively about Qatari resilience to the blockade due to its deployment of past savings. The economy has bounced back, the continued energy trade has provided solace to investors, and support from the U.S. and EU has limited the approach to secondary sanctions by the Saudis/Emiratis. Indeed, the new supply chains with Iran and Turkey look likely to stay. The recent U.S.-Qatar meeting likely increases Qatari leverage. Still, there are losers at home and the public sector is driving economic activity and absorbing more of the loans. These trends are likely to continue, as local rates remain high. The broader costs to GCC coordination and institutional strength are significant. Regional competition is likely to outstrip coordination resulting in lower domestic liquidity.
Finally, natural gas: If anything there was an even wider divide on natural gas fundamentals and price, with energy market representatives differing on whether there is an LNG supply glut, whether new entrants are taking advantage of cheap supplies sufficiently, and whether new supplies will offset. Policy mandates from China and other growing demand suggest that supply may be absorbed, and the market is gradually becoming less regional. I did field a lot of questions about U.S. energy policy and in particular support/demand for coal, which had some gas producers concerned. The pressure on higher cost natural gas producers is likely to remain.
Saudi Arabia released its 2018 budget with great fanfare today, including a meaningful increase in spending directly and via off-balance sheet funds such the public investment fund (PIF). With the oil sector no longer a drag and the non-oil sector benefiting from government pump-priming, economic growth should accelerate, from near-recessionary levels, part of a broader trend among oil producing nations. Still, private sector contribution is likely to lag as credit demand struggles, government funds dominate and questions remain about the rules of the game after the anti-corruption crackdown. Changes to energy policy are unlikely.
The budget included the largest planned spending (figure 1) of any budget, 978 billion riyal ($260 billion) and an additional 150 billion riyal in spending from various development funds. It comes close to the actual spending peaks of the early 2010s boom years. Given the spending increase in Q4, and a tendency to overspend budgets, actual spending in 2018 may again outstretch plans and in the longer 5 year plan. Adding in the spending from the PIF, there's likely to top that. This will reinforce the bounceback in growth after several years of moderate recession and austerity. It may be less effective in generating private sector activity, which is likely to lag consumption and government investment.
Figure 1: Actual and Government Spending (USD billion)
Source: Saudi Arabian Ministry of finance, Author's Calculations
The more expansive stance is not unique to Saudi Arabia. Most of its GCC and energy producing peers will also have more expansive or at least less austere budgets in 2018, helped by stronger oil and gas prices and still relatively easy global credit conditions that make it easier to issue debt. In Nigeria and Russia as well as Bahrain and Oman, less austerity is likely rather than stimulus. Still these decisions reinforce several trends for 2018 including a belated recovery for many commodity producing nations (catching up to the broader expansion seen in 2017), a bottoming out/improvement in EM investment and some pickup in inflation. All of these generally support EM and local equity over bonds.
With OPEC members and friends (and the ever growing energy journalist cohort) meeting in Vienna, it seems apt to look at the economic adjustment of some of the participating oil producers. While most would gain from rising prices. Russia, and Iran, smaller GCC countries (Kuwait, UAE and even Qatar) as well as some U.S. producers would look to be the relative winners. The slowbleed of capital outflows, external and fiscal deficits are likely to moderate across most of the other producers including Saudi Arabia, Oman, let along more vulnerable countries like Nigeria, Angola which are still struggling with the aftermath of their FX policies. With U.S. and global interest rates edging up, expect continued rate and sovereign risk divergence.
Rachel's musings on macroeconomic issues, policy and more.