Arab oil faces higher ‘break-even’ price

May 29, 2011, 6:01 p.m. EDT

Arab oil faces higher ‘break-even’ price

Surge in domestic spending strains a fragile energy market

By V. Phani Kumar, MarketWatch




HONG KONG (MarketWatch) — A sharp rise in domestic government spending by Saudi Arabia and other key Arab oil exporters threatens to upset the mutually beneficial relationship they’ve kept for decades with energy consumers worldwide.

A wave of popular protests sweeping the Middle East and North Africa has toppled regimes in Tunisia and Egypt and led to civil war in Libya. It has also forced the region’s rulers to launch programs worth tens of billions of dollars in attempts to redress public grievances.

The spending spree is likely to be felt far beyond their borders. To cover the cost, energy producers have to squeeze more money from their oil fields. That means raising their “break-even” price — the amount of money they must make from each barrel of oil — to avoid fiscal deficits.

Failure to fund these new commitments could lead to domestic spending cuts, which could stoke social and political unrest, or jeopardize their fiscal soundness by requiring they take on more national debt or draw down sovereign wealth funds accumulated over the years.

Producers’ rising break-even points also have profound implications for consumers, and the interests of both groups depend on finding an oil price they can live with.

“A major implication of this higher break-even price of oil is that it is unlikely that we will see oil prices below $70 to $80 [a barrel] in coming years. The period of low oil prices that we had, particularly in the 1990s, is gone,” said Garbis Iradian, a deputy director in the Africa and Middle East Department at the Institute of International Finance, in a telephone interview from Washington.
$100 a barrel

Iradian said the global economy could cope with oil prices in the $80 to $100-a-barrel range, but would be hurt if prices held at $130 to $140 “for a long period of time.”

He’s not the only person with the view that $100 a barrel is something consumers can handle.

Charles Seville, a director in the sovereign debt team of Fitch Ratings, wrote in emailed comments that the world economy is adjusting to higher oil prices, and that $100 oil is “less of a shock second time around than it was in 2008,” when Nymex crude-oil prices peaked at $146 a barrel.

Seville said, however, that the Organization of Petroleum Exporting Countries, a 12-member cartel of oil exporters that claims to own nearly 80% of the world’s proven oil reserves, will not “seek oil prices so high that they tip the global economy into recession.”

But there are divergent views on the economic impact of higher oil prices.

Andrew Kenningham, senior international economist at Capital Economics, said higher prices is already causing a widespread economic slowdown, as is evident in weakening global purchasing managers’ indexes data for March and April.

“We estimate that a $30 rise in the oil price knocks around 1% off U.S. household consumption. There will be similar effects elsewhere in the West,” he said.

Last week, the International Energy Agency’s Governing Board expressed “serious concern” that the rise in oil prices since September threatens economic recovery by “widening global imbalances, reducing household and business income and placing upward pressure on inflation and interest rates.”

The IEA is an independent organization of 28 industrialized nations founded in response fuel shortages created by the 1973 Arab oil embargo. None of its members is part of OPEC.

The IEA said oil importing developing countries were “most likely to be seriously affected by high oil prices, undermining their economic and social well-being,” and called on producers to “help avoid the negative global economic consequences.”

The price of oil carries enormous weight in the global economy. Oil supplies a third of the world’s total energy needs, versus 28% for coal and 23% for natural gas, according to the International Monetary Fund.

To avoid jeopardizing market share, analysts point out that producers share consumers’ fear of prohibitively high prices.

“Neither oil exporters nor importers want an oil price well over $100 per barrel, as it will prompt demand destruction for oil (and other goods) and weaken the still-fragile global economy,” said Rachel Ziemba, head of Middle East Research at Roubini Global Economics in London.

But net oil exporters’ domestic spending needs, especially after the turmoil of the Arab Spring, have left them less room to maneuver, driving break-even costs even for OPEC members “scarily high,” she said.
Break-even prices

For Saudi Arabia, the world’s biggest oil exporter and owner of the largest proven reserves, the fiscal break-even price is estimated to have jumped to $85 a barrel in 2011, up 25% from last year. It’s expected to rise further to $110 by 2015, according to the IIF.

The kingdom’s break-even price was just a little over $30 in 2003.

The fiscal break-even level is different from straightforward oil production costs, a number not publicly available from the state-owned oil company Saudi Aramco.

Fiscal break-even prices for other members of the six-nation Cooperation Council for the Arab States of the Gulf, or GCC, are also rising rapidly. According to IIF data and forecasts, the 2011 break-even for Bahrain, Oman, U.A.E, Qatar and Kuwait is also forecast to have more than doubled, on average, from 2003 levels.

Though break-even prices for other producers are also rising, the trend in Saudi Arabia is seen by some analysts as particularly worrisome since it is currently the only OPEC member with significant spare production capacity.

Overall spare output capacity among all Arab OPEC members is estimated at 4.11 million barrels per day. Of this, Saudi Arabia alone accounts for more than 3.25 million bpd, according to the IIF.

The spare capacity matters because it allows the kingdom to cushion oil- price shocks by pumping more crude into the marketplace when output from other producers are disrupted.

“The rising break-even cost will reduce the willingness of oil exporters like Saudi Arabia to pump more oil, unless they see extensive demand. This could add to volatility of oil prices and is one of the several factors accounting for a high base price for oil,” said Roubini Global Economics’ Ziemba.

Another reason behind the rising break-even price level is that Saudi Arabia is now using more of its own oil at home.

Paul Gamble, head of research at Jadwa Investment in Jeddah, said the Saudis currently burn more than 2 million barrels a day, about a quarter of the 8.5-million-barrel daily output. Domestic consumption is rising at about 9% a year, outpacing both gains in domestic output and demand growth in the rest of the world.

“If you have domestic consumption going up, that reduces the amount you can export, which pushes up higher break-even oil prices in the future,” he said.
Spending spree

The surge in Saudi Arabia’s break-even price stems from its decision to boost spending by an estimated 500 billion Saudi riyals ($133 billion) through two supplementary fiscal packages announced in February and March. Attempts to provide affordable housing, a key public grievance, accounted for the bulk of those packages, with 250 billion riyals set aside to build 500,000 houses over the next few years.

Commitments were also made to support housing loans, social security and health care benefits. All public sector workers were given two months’ pay as bonus, in addition to generous salary raises.

Not all the money allocated will be spent or handed out at once, and some items are seen as one-off expenses. But a large part of the expenditure, especially salary increases and other administrative costs, are seen as difficult to reverse.

Jadwa’s Gamble estimates nearly 28% of Saudi Arabia’s total spending goes toward capital expenditure, which the kingdom could target if a fall in oil prices forced it to tighten its belt. The kingdom’s foreign exchange reserves, estimated at more than $450 billion at the end of 2010, also offer a cushion to fall back on if oil prices dip below its break-even, he said.

“Unlike other countries, Saudi Arabia’s reserves are not in a sovereign wealth fund. These are meant to meet local needs. The government is quite happy to draw down these reserves to meet spending commitments … It can run deficits for some time and easily finance them,” Gamble said.

Those foreign assets, which are rising rapidly as the kingdom’s oil revenues rise, and a consolidated national debt of less than 4% of gross domestic product, support Fitch’s AA- long-term local and foreign currency issuer default ratings, which were affirmed in April.

However, the same safety net aimed at averting social discontent is driving up expenditures.

“Spending has gone up steadily every year since 2004, and the Saudis have already gotten used to high oil prices,” said Roubini Global Economics’ Ziemba, adding that because of their “reliance of an ever-higher price of oil,” the oil price level that the country “might be implicitly targeting has also increased.”

“In the case of a severe financial crunch, they could cut back on that spending. But given that Saudi has a large amount of foreign assets, [even] if there was a significant fall in the price of oil, which has an effect on the Saudi economy, it would be more likely that they would increase spending,” Ziemba said.

Varahabhotla Phani Kumar is a reporter in MarketWatch's Hong Kong bureau.

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