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Analysis

Oil exporters run down reserves

by Nick Butler, Advisory Board

Oil exporters run down reserves

This year is shaping up to be a difficult one for oil producers and the sovereign wealth funds that have been built on oil revenues over the last decade.

Both of the world’s benchmark crudes – Brent and West Texas Intermediate – have been trading below $40 a barrel since the start of the year (Chart 1). Even the prospect of a production freeze by Saudi Arabia and Russia, announced in February, has not lifted prices significantly. The production cut needed to reset the market still seems a long way off.

For countries that predominantly rely on oil export revenues – meaning all the member states of the Organisation of the Petroleum Exporting Countries as well as non-Opec members such as Russia and Mexico – this is very bad news. In most cases, national budgets for 2016 were based on assumed oil prices of $100 a barrel or more.

Many governments have begun cutting back on spending. But with growing populations and no alternative sources of revenue, they face hard choices. None of the countries involved has produced a plan that balances the books at $40 a barrel or less. The result is either increased borrowing or a rundown of reserves – or both.

Oil -chart -1-Oil -prices -and -surplus -c -USE

Worldwide supply surplus

It seems clear that prices will remain low for the foreseeable future. The price decline has come despite conflicts across the Middle East and North Africa. Libya is in a state of civil war. Iran, despite last year’s agreement with China, France, the Russian Federation, the UK, the US and Germany over its nuclear programme, is still subject to US sanctions. Oil production and export levels are below historic levels in both countries.

But worldwide there is still a supply surplus of around 2m bpd. Stocks are growing, and the overhang they create will limit any upward price movement for several years to come.

There is no obvious sign that either the Saudis, who could cut production if they wished, or the US oil producers who have benefitted from the revolution in fracking technology, are ready to change course. Supply remains strong and demand, particularly in China, looks set to offer no more than moderate growth over the next year at least.

Sovereign fund reserves

The most affected governments are turning their attention to the reserves that they have – in most cases held through sovereign funds.

The level of reserves varies, but anything is better than nothing. The expectation for the rest of 2016 must be that most, if not all, exporting countries will draw down their reserves. The rainy day has come and, given the choice, governments will raid reserves before imposing austerity.

The effect on the global asset market could be substantial. Sovereign wealth funds are now significant investors which for years have put money into a range of key asset classes, including equities, bonds and property.

Now this is being reversed, with some reports suggesting that sovereign funds recouped a net $46bn from asset managers last year, with around $58bn expected this year (Chart 2). With few funds in a position to invest more, the obvious question is who will buy. Asset prices could fall substantially.

The traditional economic view is that falling energy prices benefit the global economy by giving consumers more money to spend. But that is too simplistic.

Significant parts of the economy, well beyond the energy sector itself, have come to depend on sovereign funds, which themselves are sustained by high oil prices. If prices remain low, the wider economic damage could be substantial.

Oil -chart -2-SWF-outflows

Prof. Nick Butler is a Visiting Fellow and Chair of the King’s Policy Institute at Kings College London.

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