Monday, 30 March 2015

Will the conflict in Yemen impact oil prices?

The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders.

Oil prices jumped by almost 5% when the Saudis launched air strikes against Yemen on 26 March. The strikes have raised questions on whether this could cause a significant supply disruption in the oil market. The answer depends on how the conflict unfolds and how widespread it becomes. For this, it is useful to consider three scenarios.

Scenario 1: The conflict stays within the Yemeni borders. This is the most likely scenario. The regional foes have tended to fight their wars through domestic proxies, as in the case of Syria. The scenario promises Yemen years of chaos and misery, but is likely to have little impact on oil prices. With a production of just 150 thousand barrels a day (b/d), Yemen is a small producer accounting for less than 0.2% of global oil supply. Any losses from the Yemeni oil production can be easily replaced with the Saudi excess capacity. And in any case, the oil market is ridiculously over-supplied, so a small loss will hardly be noticed. 

Scenario 2: The conflict spills over in a limited way. This could take the form of the closure of the Bab el-Mandeb Strait. The strait is an important trade route, where 3.8m b/d of crude oil and refined products passed through in 2013, mostly going from the Gulf to the Mediterranean. But the closure of the Bab el-Mandeb Strait does not take this supply out of the market; it just means that the oil tankers have to use an alternative route around Africa. This would add time and transit cost, but the impact on the oil market should still be contained.

In this regard, the strait of Bab el-Mandeb is far less important than that of Hormuz both in terms of oil flow (17m b/d in Hormuz versus 3.8m b/d in Bab el-Mandeb) but also in terms of the availability of alternative routes to bypass each strait (there is not enough pipeline capacity to bypass the strait of Hormuz, while alternative routes exist to bypass Bab el-Mandeb).

The closure of the Bab el-Mandeb Strait is unlikely. There is a heavy presence of international warships in nearby waters as well as an American military base in Djibouti. And if necessary, the Egyptian, Saudi or even the Israeli navy could be deployed to keep the strait open.
Source: Energy Information Administration

Scenario 3: A widespread regional war. This scenario is extremely unlikely. But if it did materialise, it would represent a major shock to the oil market. At risk would be a third of the world’s oil production. However, it is difficult to imagine how an outright war can come about. After all, the regional powers have shown a preference to fight their wars through local proxies and possibly by exporting fighters rather than engage in a direct conflict.

Conclusion. The impact of the conflict in Yemen on the oil market is likely to be limited, unless it spreads outside its borders. The prospect of a regional spillover currently looks unlikely. Perhaps realising this, oil prices declined sharply on the second day of the Saudi strikes, reversing all the gains made on the previous day. 

Monday, 9 March 2015

Are lower oil prices impacting the Iraqi dinar?

Lower oil prices and confusing policies are starting to cause a dollar crunch in Iraq.

1. Iraq gets almost all of its US dollars from the government’s sale of oil. To meet the private sector’s demand for dollars (to pay for imports, travel and medical expenses etc), the Central Bank of Iraq (CBI) holds daily auctions in which it sells dollars to the private sector at the official exchange rate (1,166 Iraqi dinar per 1 US dollar) as long as import receipts are provided.

2. The 2015 budget imposed a new restriction preventing the CBI from selling more than $75m a day in its currency auctions. The imposed limit reduces the volume of dollars available to the private sector by two thirds (daily volumes averaged $204m in 2014). The limit was not in the initial draft of the budget, but was later added by the parliament to prevent the depletion of international reserves as oil prices declined, reducing the availability of dollars in the economy.

3. The restriction on the currency auction brings back memories of the dollar crunch of 2013. Following the sacking of its governor, Sinan al-Shabibi, the CBI significantly reduced the volumes of dollars on offer at the auction. As a result, the market price of the dollar deviated from the official price. At its peak, the dollar was sold at 1,292 dinar in the market, almost 11% above the official price. But even during this episode, the volumes sold at the auction were about double the new $75m limit.

4. Following the approval of the budget, the CBI reduced the volume of the dollars sold in its daily auction to an average of $80m—above the ceiling imposed by the budget, but much lower than the $204m it sold daily in 2014. Unsurprisingly, the market price of the dollar began to deviate from the official price. It reached 1,237 dinar to the dollar on 19 February, 6.1% above the official price.

5. The CBI suspended the daily dollar auction after 19 February, leading to speculations that it would stop selling dollars altogether. The CBI denied these speculations, claiming that it has merely replaced the daily auction with a new mechanism based on direct bank transfers. Meanwhile, reports suggest that the government and the CBI are likely to appeal against the article restricting the CBI sales to $75m a day. Against this backdrop of policy uncertainty, the dinar has continued falling against the dollar. Anecdotes suggest the dollar was trading at 1,264 dinar a few days ago.

6. Why is the currency auction so controversial? Its controversy led to the sacking of a former CBI governor, the imposition of a limit on the auction’s daily sales and, ultimately, its outright suspension. Opponents claim that the CBI was lenient in selling dollars against fake import receipts. The dollars sold were then used for speculation and sometimes smuggled out of the country.

Are these claims right? Probably yes. My estimate of private sector imports of goods of services in 2013 is $41bn, which is below the $54bn sold in the CBI’s auctions in the same year. This suggests that some of the dollar purchases were indeed used for speculation and probably smuggled out of Iraq.

7. But is tightening the supply of dollars the correct response to this? Probably not. As in 2013, supply restrictions will only lead to a decoupling of the market price from the official price—a process that is ongoing now despite the CBI’s insistence that it is only temporary.

Monday, 2 March 2015

Egypt’s new growth strategy

Egypt’s new strategy of less government spending, more investment and higher growth is a little ambitious

The economy of Egypt has slowed down considerably since the 2011 revolution. Annual real GDP growth, the standard measure of economic activity, has averaged 2.1% in 2011-14 compared to 5.6% between 2004 and 2010.

Almost half of that growth differential was due to a slowdown in investment. It is hardly surprising that investors have been spooked by the political and legal uncertainty which have followed the revolution. In the chart below, the contribution of investment to real GDP growth over 2011-14 is reduced to a barely visible grey strip below zero. The other half of the growth differential was equally split between private consumption and net exports as the overall environment proved detrimental to consumer sentiment and competitiveness.

Faced with this, the government’s strategy was to increase public spending to shore up the economy. As a result, the government’s contribution to annual real GDP growth has increased a little in 2011-14 relative to 2004-10 unlike all the other components.

But this strategy is now reaching its limits. The government’s budget deficit in the fiscal year 2013/14 was 13.8% of GDP. Excluding grants from the Gulf, the deficit was a massive 17.6% of GDP. This is very large and not sustainable for two reasons. First, because domestic banks—which have lent out large sums to the government in recent years—will eventually run out of liquidity. And second, because Egypt’s Gulf backers are showing reluctance to continue writing blank cheques and are seeking a change in the direction of economic policy.

The Egyptian government is therefore moving to a new strategy, which is based on replacing government spending with investment. In its latest survey of the Egyptian economy (which is published for the first time after a five-year pause), the International Monetary Fund (IMF) predicts annual real GDP growth will average 4.5% over 2015-19 despite a significant tightening in government spending. This is because the IMF expects investments to grow at annual rate of 6.1% over the same period, which is high but still lags the 2004-10 rate.

To achieve this, the government has been designing and promoting large infrastructure projects. These include the Suez Canal Regional Development project as well as preliminary plans to build a large number of housing facilities and construct roads. The authorities also aim to attract foreign investment and the forthcoming economic conference on 13-15 March is one platform to advertise the new strategy.

The new strategy is sound in theory but has its risks. After all, the factors which have inhibited investment post-2011 are still largely in place. Egypt needs to attract enough investments not only to counteract the substantial cut in government spending, but also to raise growth from its current levels. This might be a little ambitious given its prevailing circumstances.