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Slipping Oil Prices:
Is the Oil Rich Middle East
Prepared?
The Brookings
Institution
Middle East, Persian Gulf, Global Economics, Energy Security, Labor
Markets
Djavad Salehi-Isfahani,
Visiting Fellow, Global Economy and Development, Wolfensohn Center for
Development, Middle East Youth Initiative
Editor's Note: This is
the first in a series of analyses, "Food, Fuel, and Finance: How
Will the Middle East Weather the Global Economic Crisis?", by the
Middle East Youth Initiative on the impact of the global economic
slowdown on Middle Eastern countries. While the Middle East is
expected to maintain strong economic growth, we will explore the
impact of the adjustments in commodity prices and the financial
crunch on oil and non-oil exporting countries. Will long-term
reforms enable the Middle East and its millions of young citizens to
compete in a global economy which is now more uncertain and
volatile?
Recent
turmoil in the world financial markets has spilled into oil and other
commodity markets. Oil prices have fallen by nearly one-half from their
peak in July 2007 and may fall further as the financial crisis drives
the economies of the major Western countries into recession. Judging by
the large drops in the region’s key stock markets—they have fallen from
30 to 50 percent this year—the recent economic boom is already over. If
the price of oil slides to below $50 per barrel, it will cause a broader
economic crisis with rising unemployment, threatening the fragile
political balance in the region today.
The last time a
high price gave way in 1986, it was for the same reason: a recession in
the Western economies. In August 1986, prices plunged to about $10 per
barrel and sent the economies of the oil rich countries of the Middle
East into a long recession, raising levels of popular resentment against
the region’s governments. Reversals of fortune in oil exporting
countries tend to be more politically charged than elsewhere because
they raise questions about the management of the large inflow of wealth
that precedes retrenchment. What are the lessons from the oil price
collapse of the 1980s for governments in the region today?
Is the global
slowdown causing the price of oil to collapse?
Is a large price
collapse even possible, given all of the talk about global energy
shortages? The basic economics of the oil market indicate that it is not
only possible but in fact quite likely. With inelastic demand and
supply, large price changes can result from even small changes in the
balance of supply and demand. Recession in the Western economies coupled
with several years’ worth of investment in energy-saving equipment
worldwide will continue to lower demand for oil in the coming months,
despite falling prices and continued growth in India and China.
To prevent a
glut in the global market and to shore up the price of oil, OPEC will
step in to administer output cuts. Their emergency meeting later this
month may well draw up a new, lower set of quotas but, if the past is
any guide, setting quotas is one thing and enforcing them another. As
demand shrinks, all oil producers are tempted to compensate for the
lower price by increasing output. OPEC’s pleas to its members to abide
by quotas will fall on deaf ears and prices will stay on a downward
spiral amid blame and finger pointing. In a normal market, the price
drop by itself would rejuvenate demand, reduce supply, and eliminate the
glut. But the market for oil is no ordinary market: demand is
unresponsive in the short run because it is tied to fixed investment in
equipment, and supply is not only inelastic it may be backward bending.
If these events
were to unfold according to the scenario that played out in the 1980s,
Saudi Arabia would soon be expected to step in and take unilateral cuts
in production. It would seem reasonable for them to do so because, by
now, they are supposedly exhausted from pumping too much oil to keep
prices from rising too much, and this would be a good time to step back.
But, their experience in the 1980s tells them otherwise. Then, small
cuts turned into larger cuts as other OPEC members offered discounts,
cutting expensive Saudi oil exports by half and turning their current
account from a surplus of 25% of GDP in 1980 into a deficit of 15% in
1984. After repeated threats, in August 1986 Saudi Arabia resorted to
“netback pricing,” offering buyers the lowest price. Within a week, the
world price for oil fell to $10 per barrel. This was a hard lesson for
the Middle East to learn. This time Saudi Arabia may not wait as long to
defend their market share, which means that, barring unexpected
disruptions in supply, prices may fall sooner rather than later.
Managing the
reversals in oil prices and in expectations:
There is little
indication that policy makers in the oil rich nations of the Persian
Gulf have made plans for a return of oil prices to levels below $50 per
barrel. They are not alone in thinking that “cheap oil” is a bygone era.
Government expenditures in Iran, Kuwait, Saudi Arabia, and UAE increased
on average by 15-20% per year in real terms in recent years.
However, despite
rising expenditures and expectations of lasting high prices for oil, the
sheer size of the increase in oil revenues enabled these countries to
enjoy large trade surpluses and to accumulate large savings. These
savings will cushion the fall in oil prices but will not be enough to
prevent an economic downturn. Saudi Arabia has enjoyed a trade surplus
of about 25% of GDP in the last four years, which it has used to build a
significant sovereign fund. Iran’s more modest surplus of about 10% of
GDP has helped build up the Oil Stabilization Fund, but it is too small
(equivalent to less than six months of imports) to smooth expenditures
over the medium term. Last year the combined surplus of Kuwait, Saudi
Arabia, and the UAE was over $200 billion but, at the rate expenditures
have been rising, these surpluses will disappear within a year or two.
For these
governments, the pressure to cut back on expenditures is already being
felt, so their external savings are unlikely to stave off economic
slowdown or even recession. In the 1980s, financial surpluses of the
same order of magnitude gave way to deficits in just a few years. Once
the oil market began to slide in 1983, Saudi Arabia ran a current
account deficit every year for the next 12 years. The decline in the oil
market brought economic stagnation not just in the oil rich countries,
but in the region as a whole. Between 1983 and 1987, GDP per capita (in
2000 PPP dollars) was down by 20% in Saudi Arabia, 17% in Iran, and 32%
in the UAE. Only Kuwait managed to keep the decline to less than 2
percent.
For these
countries, bringing their economies to a soft landing may prove much
easier than managing the downsizing of expectations without a political
backlash. Leaders in the region have offered scant warning to their
citizens regarding the end of the petro-boom. Even after the global
financial crisis had begun, mega projects were being announced in the
GCC as if to defy the reality of what the global downturn will do the
region’s economies. In Iran, where populist politics has been riding the
oil boom in recent years, the appetite of the Ahmadinejad government for
social spending has doubled the rate of inflation in just one year, and
has raised expectations to a point that even a stable level of
expenditures is bound to disappoint. In 2008, when the government should
have been adding to the Stabilization Fund, it made its largest
withdrawal. Recently, Iran’s Central Bank governor warned that if oil
prices do not recover, oil revenues will fall by $54 billion, which is
more than half of their current level.
Private
investors and ordinary citizens in the region are still hanging on to
unrealistic expectations about the future of their economies.
Unfortunately for the region’s political leaders, no one will blame the
private sector for failing to predict the downturn when these
expectations fail to materialize: citizens will blame the government for
mismanaging the economy.
The challenges
that governments face now are more difficult than those they faced after
the end of the oil boom in the 1980s, and the region seems politically
more volatile. While recent economic growth has created vast
improvements in the standard of living and in infrastructure, it has not
generated enough good jobs, especially for youth. In the GCC, dual labor
markets have created millions of jobs for immigrant workers, but large
sections of national youth remain unemployed, many spend years waiting
for high paying government or private sector jobs. With cutbacks in
government expenditures, their waits will likely be longer than they had
anticipated. In the countries with the largest youth populations—Saudi
Arabia and Iran—youth unemployment is in excess of 25%. The challenge is
particularly daunting for Saudi Arabia: While Iran’s youth bulge is
shrinking, Saudi Arabia’s is growing.
The one bright
spot in all of this is that hard times make the case for policy reform
more persuasive. The oil rich countries have a list of policy options
before them, including reorienting education away from mere seeking of
formal degrees toward acquisition of skills, transforming the search for
government jobs into a search for careers in the public or private
sector, and giving the youth a greater voice in shaping their own
destiny. With the oil feast all but over, the time has come to set the
incentives for the region’s youth to become tomorrow’s productive middle
class.
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