The Senate Foreign Relations Committee held a hearing on the economic and geopolitical implications of low oil and gas prices. Two witnesses testified on this topic, giving their perspective on how various geopolitical factors influence the price of oil and gas now and in the coming years. Below is a combined summary of the key points in both of their testimonies.
- Timothy Adams, President & CEO, Institute of International Finance (IIF)Written Testimony. Adams evaluated the extent of an economy’s oil dependence in terms of flow and the resources accumulated by a country from a stock perspective that would help cushion the impact of lower oil prices.
- Robert Kahn, Senior Fellow for International Economics, Council on Foreign Relations, Written Testimony. Kahn used the fiscal breakeven point as a starting point to assess the risk of oil exporting countries, and then looked at the willingness and ability of countries to adjust to these shortfalls.
Low Gas and Oil Prices Global Economy Overview
In less than two years, the price of crude oil has dropped from about $100 per barrel to about $30 today. Both supply and demand factors have contributed to this trend, over the course of which the price of natural gas, as well as for many other commodities, has also decreased sharply. Without a decrease in production, it is hard to imagine prices rising materially until 2018 at the earliest.
The oil price downturn creates an important windfall for consumers, and has boosted prospects for oil importing countries (OIC’s) through higher household disposable incomes and lower inflation. This has been the case for
countries in Emerging Asia and Emerging Europe. Lower oil prices have also helped reduce external vulnerabilities in oil‐importing countries with large current account deficits such as India, Indonesia, South Africa and Turkey. Policy makers in OIC’s have used this as an opportunity to maintain easy monetary policy to support growth and cut back spending on subsidies (India and Indonesia) to free up fiscal resources for capital expenditure, including infrastructure.
For oil exporting countries, low prices exert heavy financial and fiscal burdens. This comes at a time when the global economy already faces sluggish growth and significant downside risks from slowing Chinese growth, volatile exchange rates and capital flows, and high corporate debt.
The U.S. economy nonetheless has proven resilient. In 2015, the real GDP grew, and the unemployment rate is at the lowest level since 2008. However, lower oil prices appear to have been a small drag on growth last year. The increase in consumer spending as a result of low oil prices was cancelled out by a 40 percent drop in capital expenditures in the oil and gas sector.
One reason for the muted consumer response to date may be the desire to save and repair balance sheets after the damage caused by the Great Recession. While this is a healthy development, it is possible that consumers could become more willing to spend if oil prices remain low.
Most major forecasters expect similar levels of growth in the U.S. this year, which would place the U.S. above other advanced economies including the EU and Japan. Nevertheless, the U.S. economy is not immune to oil-related turbulence.
Many of the emerging markets in turmoil have close trade and financial links to the U.S. stock market turmoil in recent months has contributed to a tightening of financial conditions, while the appreciation of the dollar in addition to lower oil prices is imparting a deflationary impulse to the economy. All of this suggests that U.S. policymakers will need to continue to be alert to the risks emanating from abroad.
Risks emanating from low oil prices for oil exporters
During much of 2015, most OEC’s faced world oil prices that were below their breakeven price1 with oil at $50/ barrel. In 2016, it is likely the gap has only grown between current prices and prices that balance the books. These countries delayed adjustment in 2015, assuming that oil market prices would rebound, and only in late 2015 when prices had declined further did they begin to seriously consider the need of policy adjustments.
Although this suggests the potential for disruptive adjustment is higher in 2016, we are still seeing sizeable asset drawdowns – Russia, U.A.E., and Qatar are liquidating their investments – which could result in the withdrawal of $400 billion of equities later this year.
The lack of transparency in many sovereign wealth funds (SWFs) makes it difficult to estimate how long countries can continue to drain savings, but it is predicted that:
- Venezuela will possibly default before the end of 2016.
- Middle East would run out of fiscal buffers in less than five years.
Policy adjustments need to be made, ideally ahead of a crisis, and a failure to address these imbalances could translate into crises of much larger scale and spillover into the U.S. in unexpected ways. Where there is a willingness to take tough measures, there are important benefits to IMF-led international support in terms of policy advice, strong reform packages, and financial support where needed. Low energy prices are generating global risks, and U.S. policymakers need to be vigilant and ready to act.
Challenges faced by most vulnerable oil exporting countries & their policy adjustment options
The most vulnerable
Iraq & Middle East
Challenges – In Iraq, the drop in oil prices coupled with supply disruptions due to Islamic State (ISIS) attacks have had a profound effect on an economy that is heavily reliant on oil for government financing. ISIS attacks are also hindering the development of non-oil sectors by disrupting trade and destroying infrastructure.
Policy Adjustments – The government is attempting fiscal consolidation. Firm policy implementation will be required to sustain the adjustment effort and preserve domestic stability.
Challenges – Low energy prices, poor economic policies, and sanctions imposed by the U.S. and EU mean the recession in Russia is deepening. Nearly half of government revenue in Russia is from oil and gas prospects. Their 2016 budget assumes the price of oil is $50/ barrel, which would produce a fiscal deficit of 3% of GDP. With the current oil price and trajectory for this year, Russia could see a 7% deficit. Russia’s revenue shortfall exposes their difficulty in generating non-energy related income and subsequent structural weaknesses.
Policy Adjustments – The government’s current strategy has been to run down wealth and depreciate the Ruble. Though depreciation has raised the Ruble value of oil revenue, high inflation shifts the burden onto the broader population, especially those with fixed incomes. If Russia continues on this trajectory, the end of 2016 will exhaust its fiscal buffers. Poor policy is undermining the long-term health of the economy, and the risk of a crisis will rise over time if the government does not adopt fundamental reforms.
Challenges – Despite diversification efforts, oil revenues remain a significant part of the Nigerian economy, and the shortfall to the budget is causing stress. In 2015, GDP growth dropped and government deficit rose from 2014 levels. Foreign exchange restrictions introduced by the central bank have caused credit problems for the private sector and contributed to broader shortages in the economy.
Policy Adjustments – The country is seeking emergency loans of $3.5 billion from the World Bank and the African Development Bank (AfDB), which could help cover the government’s financing needs. But financing alone will not suffice. Low oil prices change the economic foundation, putting pressure on their fixed currency. The central bank has had to draw down from their foreign exchange reserves to defend their pegged exchange rate. Though reserves remain ample, Nigeria should devalue the naira and loosen capital controls as a part of a broader strategy to promote exports, continue to diversify from oil, and relieve external pressures.
Challenges – Continued delays in the exchange rate and spending adjustments prolong and deepen the recession, increase the risk of debt default, and threaten social order. Oil export revenues are a third of what they were in 2012, and will be inadequate to meet debt service. Reserves are small and it is unclear whether they are all useable.
It will take extraordinary measures to make it through the year without a default. And if the government responds by further compressing imports, popular support for the government could collapse. The government response to the economy’s continued decline from 2015 into 2016 was to devalue the primary official exchange rate and to adjust some domestic prices through mid-March 2016.
China has been the primary provider of finance to the Venezuelan government, and many of the contracts require payment in oil, so the decline in price of oil has increased the quantity that Venezuela needs to provide. Venezuela needs continuing relief from the required amount, but it is not in China’s interest to provide loans under the guise of commerce to extend the current government. China’s message needs to be that it will be a critical player in a rescue package, and to that end cannot be too closely associated with the current government or policies.
The current government is unlikely to seek help from the IMF and won’t cooperate with Western governments. However, change could come quickly as a result of domestic conditions, and a future government could be willing to take measures that warrant international support.
Policy Adjustments – When conditions warrant, international policy makers should institute a bold adjustment program:
- A rapid move to unify the exchange rate regime
- Move domestic energy prices to world levels
- A strengthened & targeted social safety net system that protects those most in need from the dislocations caused by adjustment effort
- Sustainable budget including a broadening of revenue base & well-anchored monetary policy
- A comprehensive program to recapitalize the banks
Short-term bridge financing, perhaps linked to oil, may be needed once agreement is reached on a comprehensive adjustment program. Any future IMF packages would need to include debt re-profiling (an extension of maturities with limited net present value loss).
Extraordinarily high debt as a share of exports suggests the need for deep restructuring, as would the ratio of debt to GDP if a unified exchange rate settles near the black market rate. China will need to contribute, through transparency about its claims on the government and a willingness to provide relief through a negotiation. This would diverge from how China has been operating in emerging markets but would go a long way toward becoming a responsible part of the global rescue architecture. The IMF is uniquely placed to develop a bold program that contains these elements and mobilize support to ensure adequate financing for the adjustment. U.S. government support will be essential in putting such a package together.
Countries with rising vulnerabilities – Saudi Arabia, Kuwait, Qatar, U.A.E.
Overall – most of these countries are in the Gulf, where vulnerabilities are contained for now but likely to rise as the price of oil continues to remain low. Less economically vulnerable to short term decline because:
- Strong national balance sheets – low government debt or high international reserves
- Substantial current account surpluses
- Low oil production costs protect market share
- Continued growth in non-hydrocarbon sector
- They have more time to adjust to lower oil prices as they can cushion the short‐term impact on their economies by running down accumulated assets and ramping up borrowing.
Challenges – If low oil prices persist over time, they will need major and sustained economic and fiscal adjustments, which are now starting to get underway. Examples include reducing oil subsidy bills and slashing investment projects, but cuts will need to go much deeper.
Least Vulnerable countries – Malaysia, Mexico, Colombia, Ecuador, Iran
Overall – combine significant oil exports with more diversified economies. Excluding Iran, these countries are less exposed to the negative impact of low oil prices on growth and balance of payments, as flexible exchange rates and track records of good policy management make them better equipped to withstand pressures through a combination of fiscal and/or monetary policy adjustment and exchange rate depreciation. In Iran, the lifting of sanctions is likely to boost oil exports and private investment, providing support for growth.
Committee member questions
Sen. Fluke (R-AZ) asked if the low prices delayed the impact Iran will have when they come back online. In response, one of the witnesses said low prices only delay their potential impact, but do not thwart it. There is strong European interest. There is foreseeable growth by 6 percent, and there will be massive investments into the hydrocarbon infrastructure, and in a matter of years Iran will be back to pre-sanction levels.
Sen. Robert Menendez (D-NJ) asked what a fiscal breakeven price would be where Russia is no longer able to sustain operations. A witness responded that an outcome like that would be a long way off. A more likely scenario is that the upcoming election will force Russia to rethink their cuts on social programs.
Sen. Corey Gardener (R-CO) asked about China. Specifically, he cited that Moody’s Investor Service lowered the outlook on China’s credit rating. He asked if there are layoffs in the industrial sector in China. A witness responded that there has been a structural shift in the nature of China’s growth, which is impacting the nature of what and how much it imports. On top of that, there is a cyclical component, which magnifies the structural shift. The witness noted that we are now seeing a substantial slowdown in China – about 6.5 – 7.5% – which is a good thing because previously China had been flooding the world market. A consumer as large as China in the global market is not economical in global competition.
Sen. Chris Murphy (D-CT) asked if the cancellation of the two pipeline projects show that Russia’s efforts to extend their energy reach have been curtailed. Khan agreed that Russian oil infrastructure is dated and needs investment in development projects.
Sen. Jeanne Shaheen (D-NH) asked about Russia’s influence in Europe, and what Europe can do to look at future sources of energy. A witness responded that the politics of diversification in Europe are fraught, but Europe cannot be dependent on a single pipeline that has the ability to be switched on and off.
Sen. Ben Cardin (D-MD) commented that sanctions could be a challenge going forward if Europe decides to continue doing business with Russia. A witness responded that while that is true, the U.S. would still have ability to continue financial sanctions without Europe.