| || ||Glen Hodgson |
Senior Vice-President and Chief Economist
Forecasting and Analysis
Originally published in The Globe and Mail on June 1, 2016
The supply glut in global oil markets is shrinking and, not surprisingly, oil prices have recovered from their mid-February lows below $30 (U.S.). Global oil demand keeps rising, but a sustained adjustment to production will ultimately support higher prices.Oil production could be stabilized in two ways. First, exploration activity, notably in U.S. shale oil deposits, has pulled way back and U.S. oil production is tailing off—which is helping to reduce the supply glut.
Second, lower oil prices have slashed government revenue in oil-producing regions around the globe, leading to mounting fiscal pressure that could be relieved by moderating their own production levels. We will focus on the second element—the fiscal squeeze on oil-dependent governments—recognizing that U.S. (and Canadian) oil investment and production driven by market forces will also shape future oil supply and resulting prices.The budgets of oil-producing provinces—Alberta, Newfoundland and Labrador, and to a lesser extent, Saskatchewan—are being hit hard by the collapse in oil prices, as is the federal government. Oil sector royalties represented 22 per cent of government budgetary revenue in Alberta and over 30 per cent in Newfoundland and Labrador in 2014–15. The rapid shrinking in oil royalties, combined with lower personal and corporate income tax receipts, have pushed these two provinces deeply into deficit.
While Canada’s circumstances are tough, they pale in comparison to what is happening in a variety of other oil-producing regions—the Middle East, Russia and elsewhere. Government budgets in many of these countries are much more exposed to oil-based revenues than Canadian jurisdictions. As a consequence, nearly all oil-producing regions are now deeply in fiscal deficit and rapidly accumulating public debt.
Let’s do a quick scan of a few individual cases. Saudi Arabia had a fiscal deficit of about $90-billion in 2015 and is projected to have a comparable deficit in 2016. Oil represented a third of all Saudi government revenue in 2014 (similar to Newfoundland and Labrador), and the government plans to introduce a value-added tax to provide a more stable revenue source. Like Alberta, Saudi Arabia has very little public debt and therefore has significant borrowing capacity to finance fiscal deficits. If it has to, Saudi Arabia can outlast many other oil producers in the game of “fiscal chicken.”
The next group of large oil producers is more exposed to the oil price shock than Saudi Arabia. Oil represented half of Russia’s federal revenue in 2014, according to the International Monetary Fund. Russia experienced a recession, with GDP declining by 4 per cent in 2015, and had an overall budgetary deficit of nearly 5 per cent of GDP. Restrained spending and revenue diversification will be required (even as Russia is building up its military capacity), and economic growth is unlikely to be robust.
Iran faces many of the same fiscal and growth challenges as Russia, although the lifting of economic sanctions and a still-planned increase in oil production would improve Iranian economic prospects. Iran and Saudi Arabia remain at loggerheads politically and neither wants to cut production first. Nigeria managed to grow through 2015, but relying on oil for 60 per cent of its government revenue meant the fiscal deficit doubled to 3.3 per cent of GDP.
Other cases are more difficult. In Iraq, oil accounts for over 90 per cent of government revenue. Not surprisingly, the fiscal deficit ballooned to 18 per cent of GDP in 2015, although growing oil production helped to ward off an actual recession.
Venezuela is the worst case. The country has been economically mismanaged for a decade—even with oil at $100 a barrel, the budget was not balanced. The Venezuelan economy is now in virtual free-fall, contracting by around 10 per cent in 2015 and still shrinking. Store shelves and government coffers are empty, with rampant currency speculation and a growing possibility of default on its external debt. Venezuela’s fiscal deficits are at risk of being monetized (that is, funded by the central bank), adding to the potential for hyperinflation.
Social programs are being cut in all of these petro-states, and many are examining options for diversifying their economies—well after the horse has left the barn. Of course, deep cuts to public spending on social programs and consumer subsidies may place the legitimacy of the ruling regimes at risk.
In short, deep fiscal problems have created a strong financial incentive for oil-producing nations to consider a modest pullback in oil supply, to further reduce the market glut. North American producers have already responded to market signals by slashing new oil sector investment—but that action may not be enough. Other oil producers are feeling the fiscal cost of cheap oil; they may eventually have to engage in a sincere discussion and consider concerted action to reduce production and shore up prices, even if such action is tough to swallow.