Monday, 27 March 2017

Chronicles of an Omani devaluation unforetold

What does a devaluation in 1986 tell us about the likelihood of another devaluation today?

Of all countries in the Gulf, Oman carries the highest risk of devaluing its currency. Last year, it ran a large current account deficit (roughly trade deficit plus remittances) of around 21% of GDP, a large budget deficit worth 12% of GDP, and it has the lowest reserves among its neighbours. History shows that devaluation is not impossible: Oman devalued its currency by 10% in 1986 when oil prices collapsed. Why did Oman devalue its currency then? And what does that tells us about the likelihood of devaluation today?

The fundamental reason behind the 1986 devaluation was that Oman’s foreign currency reserves were not sufficient. At the very least, a country should be able to back every unit of currency in circulation with US dollars to maintain the peg, similar to the gold standard. In 1985, just before the devaluation, Oman had $441 million dollars of reserves. And although there is no official money supply data going back to the 1980s, I estimate currency in circulation to have been also around $400 million in 1985. With the decline in oil prices in 1986, Oman had to use its reserves to finance its deficit, which meant that it was no longer able to provide dollar coverage for its currency in circulation and was therefore forced to devalue.

Does Oman have sufficient means today to avoid a similar devaluation?

·      Oman’s reserves today are enough to last the country for two years. Oman has $38 billion of reserves, which is more than enough to back the $13 billion of Omani Rial currency and deposits. Moreover, the remainder $25 billion of reserves could be used to finance two years of external deficits (trade plus remittances), estimated to have reached $13 billion in 2016.

·   Oman could also safely borrow from international markets to finance the deficit for an additional year given its low public debt ratio. Oman could still borrow around $13 billion while keeping its public debt ratio relatively moderate at 30-40% of GDP. The additional borrowing could finance its needs for one more year.

·    The recovery in oil prices and support from other Gulf countries could double the survival time of Oman. The recovery in oil prices, which have bottomed out in 2016, will shrink Oman’s deficits and financing needs. This means that the same amount of reserves and debt would last the country longer. More importantly, other Gulf countries are likely to step in to support Oman when needed to avoid the risk of contagion on their own currencies. Indeed, recent reports suggest that Oman was in talks with Kuwait, Qatar and Saudi Arabia to receive a multi-billion dollar deposit. And although Omani authorities subsequently denied the report, other Gulf authorities have not. Interestingly, Oman joined the Islamic Military Alliance, led by Saudi Arabia, around the same time of the alleged talks.

Reserves, the ability to raise debt, the expected recovery in oil prices and support from the rest of the Gulf mean Oman could maintain the value of its currency for the next 5-6 years. There might be issues such as questions about the illiquidity of reserves, the impact of a potential credit rating downgrade on Oman’s ability to raise debt or concerns about political transition (although these have abated lately). But all in all, a devaluation in Oman is unlikely in the medium term.

Friday, 17 March 2017

US rate hike highlights the region’s policy limitations

The unintended fiscal consequences of higher US interest rates.

The US central bank raised interest rates on Wednesday. The US economy is recovering: growth is picking up, unemployment is falling, inflation is rising and the long overhang from the 2008 crisis may well be behind us. This forced the central bank to raise rates to prevent the economy from overheating and inflation from rising to uncomfortable levels.

Many central banks in the region followed the US and raised rates. As their currencies are pegged to the US dollar, many countries in the region were forced to follow the US by raising rates. Absent this rate increase, capital would have flown out of these countries into the US to benefit from higher rates, creating pressure on the currencies and the peg.

Higher interest rates would lead to slower growth in the region. Higher interest rates reduce investments by increasing borrowing costs. Higher rates also lower consumption by making saving become more attractive. Both of these factors should lead to lower economic activity.

The fiscal position could exacerbate the slowdown from higher interest rates. Due to lower oil prices, many of the region’s governments are reliant on borrowing to finance their deficits. But if borrowing costs rise, some governments may decide to borrow less and cut their spending instead. Therefore, the fiscal response could propagate the slowdown interest rate increases.

Despite the recent pickup in interest rate, appetite for borrowing has not diminished. For example, Oman borrowed $5 billion from international markets on 8 March, followed by Kuwait borrowing $8 billion on 13 March.

But the situation highlights the region’s policy limitations. While the currency peg to the US dollar makes sense from an economic view, it leaves government spending as the main tool to manage the economy as interest rates are tied to their counterparts in the US. But if government spending becomes responsive to interest rates, then the region has no truly independent policy options to manage the business cycle. This unfortunate situation came about because the decline in oil prices coincided with higher growth and interest rates in the US.

Sunday, 5 March 2017

OPEC and oil: Out of ammo?

There is little more OPEC could do to increase its revenue.

The OPEC agreement to cut production has shifted oil prices to a higher level, around $55 now compared to $45 prior to the deal. But there are signs that higher oil prices are leading to a revival in US shale production. Most energy market forecasters expect increased US production in 2017 after a decline in 2016. Could OPEC do anything to fend off the re-emergence of US shale? The short answer is probably no. If OPEC decides to cut its production further, this will lead to a loss in market share without any significant gain in prices. Conversely, the benefits from flooding the market to increase OPEC’s market share are only marginal and uncertain. 

1. Further production cuts by OPEC would be counterproductive. Further cuts would only lead to temporary improvement in prices, as more and more shale companies would become profitable leading to higher US production and a return of prices to pre-cut levels. This means that OPEC would end up with lower oil revenues as it loses market share without any gains in prices.

2. Despite increasing its production aggressively in 2014-16, OPEC allowed shale an escape route. OPEC’s actions reduced spot prices (the price at which oil is traded for immediate delivery), but it did not reduce futures prices (the price at which oil is traded for delivery in the future) below shale’s cost of production. The chart below shows that a shale company with production cost of $50 per barrel was still able to make profits in 2o15 by selling its output for delivery in 12 months’ time at the price of $55 in January 2015 and $51 in October 2015. Selling oil using futures contracts allowed many shale firms to survive during the oil slump.

3. If OPEC floods the market to reduce the spot as well futures prices of oil below the cost of US shale, then the gains would be small. Although the gain in market share could more than compensate OPEC for lower prices, the benefits are likely to be marginal. Even if we assume that the new more aggressive market share strategy would be twice as painful for shale as the one pursued in 2014-16, the overall increase in OPEC’s revenues would be small, estimated to be around $12bn per year or less than 0.5% of the cartel’s GDP. Furthermore, these gains would be quite uncertain given the uncertainty about the reaction of shale and how their production costs would evolve over time.

To summarise, OPEC’s November cuts were successful because there was room for prices to rise before hitting the cost of production of US shale, estimated to be around $50-55. Now that prices are at that level, further cuts have little more to achieve. Flooding the market on the other hand might seem more sensible, but back of the envelope calculations suggest the benefits to OPEC are small and highly uncertain.

Sunday, 19 February 2017

OPEC cuts - a short-term gain for a long-term pain?

OPEC’s strategy has worked so far, but could end up being self-defeating.

OPEC surprised markets on 30 November 2016 by agreeing to cut oil production in an attempt to support prices. The cuts were meant to reduce OPEC’s production by roughly one million barrels per day (mb/d), effective from 1 January 2017. Data released in the last few days provide the first test about whether the cuts have been successfully implemented. The bottom line is that: compliance has been high helping prices to move up; the overall movement was beneficial for the finances of OPEC members; but could prove to be short lived as it gives a lifeline to US shale producers, who are likely to ramp up production and depress prices. Below I elaborate on these points.

1. OPEC members have complied with the agreed cuts. The latest data show that production fell to 32.1 mb/d, lower than the 32.5 mb/d ceiling that had been agreed on. Every single country reduced its production compared to October 2016 levels (see chart). Some have made substantial reductions as in the case of Saudi Arabia, which lowered its production by 598 kb/d.

2. The cuts have moved oil prices to a new and higher range. While oil prices hovered around $45 per barrel before the cuts, they have been fluctuating around $55 per barrel since the agreement. This represents an increase of about 22%.

3. The cuts have so far benefited OPEC finances as the gain in prices more than offset lower production. The rise in prices has far exceeded the cuts in production. For example, Saudi oil output has fallen by 6% since last October, while prices have risen by 22%. If current prices and production were to be sustained for the whole year, Saudi oil revenues would be higher by around $27bn compared to what would have happened without the deal.

4. But higher oil prices may not be sustained as US shale oil could make a comeback. Higher oil prices are making US shale oil profitable again. US production rose in December after several months of continuous decline. The International Energy Agency is reporting increased investment in US shale oil, implying more supply to come in 2017. Higher US supply would lead to lower prices, reversing the gains made by OPEC cuts.

In conclusion, OPEC successful implementation of production cuts has pushed prices higher and benefited the revenues of its members. But the strategy could be self-defeating as it is giving US shale oil producers a lifeline to increase their production and depress prices again. If this does happen, then OPEC would either be required to support prices by making further cuts or make a U-turn on its strategy.