INSIGHT 17 May 2016

Twilight of the Petrostate

The age of oil rents is over. A political and geopolitical revolution is on its way.

About twenty countries around the world are dependent on a single number: the price of oil. Some, primarily Persian Gulf states, live entirely off their oil and gas wealth. They rely on crude oil, natural gas and petroleum products for 50 percent of their Gross Domestic Product and for 70-plus percent of their budget revenue. Some 15 countries generate more than 50 percent of their export earnings from oil, gas and petroleum product sales.

Oil-producing countries have been living a dream. In recent decades, most oil-producing countries saw their per-capita GDP not only expand but show a rate of growth above the global average. In other words, they were getting rich faster than the rest of the world. In terms of dollar-denominated GDP per capita, as crude prices peaked in 2011 Russia and Kazakhstan outstripped Malaysia and Turkey; Saudi Arabia and Equatorial Guinea nearly overtook South Korea; Kuwait shot ahead of Great Britain, while Qatar rose to rank as one of the three richest nations. The new generation of the petrostates' political elite has come to look on oil rent as a means to achieve all its goals. And yet, many experts will call the oil windfall a curse, not a blessing. A prosperity that is due to the sheer accident of owning large mineral resources rather than to technological prowess, investment and hard work has its downsides, including the degradation of political systems, the throttling of competition and the proliferation of populist fiscal policies.

An awakening from this dream is now inevitable. The future holds challenges for those countries that have cast their lot with the global oil market. There is little doubt that oil's transformation into an ordinary, non-rent-generating commodity is going to change the world.

The Invisible Hand against the Petroleum Leviathan

Over the course of human history many rent-generating commodities capable of enriching their owners have turned into ordinary products. Pricing becomes determined by production costs rather than scarcity value. The readiest example is land, which has seen the rent component of its price steadily decline over millennia and has thus gradually ceased to be the main cause of armed conflicts. Other cases include furs, which generated rent for Russia into the eighteenth century, and natural rubber, which fed the Amazon boom in the early 1900s.

Inevitably, technological progress reduced the scarcity value for many commodities. A rent-generating commodity could also suffer a fall in demand when a less expensive substitute of similar quality comes to the market. The story of natural and synthetic rubber is a prime example.

Another common scenario was when supply increased, such as when previously inaccessible deposits were brought on line or new resource-rich areas were discovered. This was how the exploration and settlement of North America decimated Russia's rent from the fur trade.

Oil is now subject to just such pressures from both demand and supply.

The weakening in oil demand has more to do with technological progress than with the slowdown in China’s economy, which has been the main growth driver for the world economy and oil consumption in the recent decades.

Indeed, economic growth and oil consumption have become more and more disconnected. Over the last fifteen years, average oil-consumption-to-GDP elasticity has been about 0.7 for China and even less for developed countries. A striking example is the U.S. where from 1980-2014 real GDP grew by 150 percent and oil consumption edged up only 11 percent. This is because modern economic growth is increasingly driven by more energy-efficient sectors. Even lower prices fail to boost oil's appeal to consumers who stand to gain more from improving energy efficiency than from saving on oil costs.

Moreover, huge investment has been made in alternative energy, natural gas and electric vehicle R&D. While not all this investment is viable at low crude prices, nonoil solutions in transport, energy and petrochemistry are sufficient to rein in oil-demand growth. These solutions are constantly becoming more efficient and competitive. This means that a business that only yesterday relied on government subsidies to survive will need no state money to make a profit tomorrow, even in a cheap-oil environment.

The supply side has changed even more dramatically. Although much more oil was pumped in 2014 than in 2007, the proven-reserves-to-production ratio increased from forty-nine to fifty-five years over that period. The advent of accessible shale oil alone added 50 percent to proven U.S. reserves. And this was not all “tough oil,” which can be economically recovered only at very high prices. At the start of the current oil market downturn, Moody's estimated that more than half of U.S. shale oil producers would stay profitable at $51/bbl. In the last year, this figure has become much lower. Unremitting competition-induced innovation has enhanced productivity and reduced costs. In fact, production costs at most shale oil wells eventually are likely to decline to $10–12/bbl (in current prices) due to technological breakthroughs.

Possible coordinated action by producers to curb supply and a ramp-up in Iranian production (which we are hearing so much about) could become important near-term factors. They are not, however, the drivers shaping new environmental and long-term trends. Technological innovation is chiefly responsible for the buyers’ market that will stay with us for years to come. This is making the development of a growing number of oil deposits economically viable at lower prices. And no analysis would be complete without a reference to the colossal $3.2 trillion poured into the oil industry in 2005-2014, nearly three times the amount invested over the previous decade (1995-2004). This investment should keep production going strong even at low prices. Private investment and innovation, as opposed to policies in big-oil producing countries, is increasingly determining supply. Thus, the influence of the Petroleum Leviathan—the handful of producing countries with the ability to exercise a heavy influence on the price of oil—will fall victim to the invisible hand of the market, which increasingly is armed with new oil extraction, energy-saving technologies and nonpetroleum solutions in transport, power generation and petrochemistry.

Who Stands to Lose Most

History shows that large oil and gas reserves do not necessarily secure happiness or success. In fact, oil riches may, in fact, be an obstacle to both. The vast majority of oil-producing states have paid for their windfalls with the entrenchment of authoritarian or populist left-wing regimes, repression of civil society and infringement of women's rights.

Only a third of oil-producing nations enjoy GDP per capita in excess of $10,000, while five (Angola, Iraq, Nigeria, Venezuela and Algeria) have failed to reach the $5,000 mark. In other words, although the petrostates as a group have outperformed the rest of the world in recent years, some of them have missed out on their chance. Abundant oil and gas, while always a good thing for the ruling elite, often fail to benefit the common people. And, of course, the less well-off will suffer most from a long-term decline in oil prices.

Theoretically, a government can make up for lower oil revenue by deploying the reserves accumulated in a sovereign wealth fund or by raising debt. About half of the oil-producing countries have built substantial reserves. Moreover, Norway (which learned the lesson of the 1986 oil slump and the subsequent banking crisis in the aftermath of which its reserve fund was set up), Kuwait and the UAE have all put aside enough money to tide them over a fairly long period of low oil prices or even nonexistent oil revenue. On the other hand, countries like Angola, Nigeria, Iraq, Venezuela, Mexico and Ecuador have too tiny a piggy-bank to compensate for revenue shortfalls in even the near term, while Russia and Algeria are vulnerable over the medium term. The least wealthy nations (by GDP per capita) have the smallest reserves, a result of the imprudent economic policies of their governments.

International borrowing is, as usual, easiest for countries that need it least. Saudi Arabia is a top example of this. The country should be able to raise cheap debt on the back of its strong credit rating. Mexico and Kazakhstan have some spare borrowing capacity, as does Azerbaijan. That country, however, is crippled by a colossal capital outflow (10 percent of GDP in 2014). Iran and Russia are prevented from tapping global markets by sanctions, while the other petroleum producers are hampered by low credit ratings and a lack of creditor and investor confidence.

Strong oil and gas earnings have fostered an illusion of omnipotence among the ruling regimes, prompting them to increase the government share of their economies. The government share has remained relatively small in only four petroleum states (Nigeria, Iran, Kazakhstan and Mexico) where the enlarged government budget stands at less than 30 percent of GDP. Elsewhere in the petrostate universe the figure is higher. This represents a hindrance to economic growth in medium-developed countries. The more oversized the budget, the greater the amount of commitments including social spending that is bundled into it and, consequently the more painful is an oil-induced decline in revenue.

The worst placed are those countries whose budgets are not only oversized but also unbalanced. Borrowing from their own central banks would spur inflation, while putting a heavier tax burden on an increasingly impoverished population would not be easy. The only way out of the squeeze is to cut spending, starting with capital expenditures. However, phasing out infrastructure and other mammoth projects that governments use to create jobs could cause mass unemployment and social unrest. Shrinking capital spending may also trigger infighting among the corrupt elite, as its major source of illicit enrichment dwindles.

The threats to social peace from a reduction in current spending are too obvious to merit discussion.

An oversized, unbalanced budget, especially in a relatively poor country, is a clear sign of irresponsible populism. Norway, which ended 2015 with a 6 percent budget surplus, stands out as a rare example of an oil-rich country that has pursued prudent economic policies. By contrast, a clear majority of petrostates are running a budget deficit, as the oil windfall has encouraged their populist leaders to forego sound fiscal constraints. The deficit is biggest in Venezuela (24.4 percent of GDP in 2015), Algeria (13.7 percent), Azerbaijan (7.6 percent), Russia (5.7 percent) and Ecuador (5.1 percent), all of which are already feeling the pinch. But even the affluent Persian Gulf states, particularly Saudi Arabia where government spending exceeded 50 percent of GDP and the budget deficit hit 21.6 percent of GDP in 2015, will have to radically revise their fiscal policies in the coming years. This revision will have far-reaching consequences not only for their own peoples but for the whole world.

What Oil Did to the Soviet Union

The last thirty years of the Soviet Union's existence are an excellent case study in how oil and gas dependence can shape the destiny of a country and the world.

In the early 1960s, the Soviet Union was not yet a petrostate, selling less than $1 billion in oil to capitalist countries and earning just above a fourth of its export revenue from commodities.

The country was then in the catch-up growth stage. In fact, "catch up and overtake capitalists" was a slogan that formed a lynchpin of Soviet ideology. This goal was starting to look elusive by the 1960s. The economies of leading Western nations, especially war-ravaged Western Germany and Japan, had been expanding at a tremendous rate since the end of World War II. What’s more, growth had been steadily accelerating in the U.S., which doubled its growth rate between the mid-50s and the mid-60s. The Soviet economy, on the other hand, was slowing down.

Estimates of Soviet growth rates provided by official government statistics, Soviet economists and their Western counterparts vary widely, but they all point to deceleration setting in around the mid-1950s. By that time industrialization had nearly run its course and the central planning system, which had been reasonably well suited to industrialization needs, was beginning to show its inability to cope with an increasingly complex, postindustrial economy. Urbanization, too, had already occurred, with urban population exceeding 50 percent in 1962. A cheap rural workforce could no longer be counted on as a source of rent.

Disappointed by the failure to catch up with the West, the Soviet elite was also frustrated by the inability to materially to improve its own living standards. The country simply lacked the resources. Change, therefore, was imperative. Nikita Khrushchev was removed from power and a radical reform program was drafted. It became known as the Kosygin reform, after the country's long-serving prime minister.

Had the reform been implemented, it might have set the Soviet Union on a path of gradual change, roughly along the lines that China experienced. Deng Xiaoping's China and the USSR of the initial Brezhnev years differed greatly, however, first and foremost in urbanization levels. Once oil was found in West Siberia in the early 1960s, opening up a new source of revenue, the reform was shunted aside. The last hope of change vanished with the Prague Spring of 1968, which taught the Soviet leadership one thing: even a small concession to liberalism could have tremendous, unpredictable consequences.

Major oil discoveries in West Siberia continued through the 1960s. As crude production in the region rocketed from 1 million tonnes per year in 1965 to 365 million tonnes per year in 1985, Soviet oil exports jumped from 75 million to 193 million tonnes per year. This came against the backdrop of a sustained rally in oil prices, which saw the year-average Brent price climb from $7.7/bbl in 1971 to $66.3/bbl in 1980 (in 2000 dollar terms).

As a result, Soviet oil-export earnings quadrupled between 1975 and 1985. The government no longer had to worry where to find food for its people or machinery for industrial modernization. Living standards rose, as did the wherewithal to support both friendly socialist regimes around the world and the Warsaw Pact member states' armed forces.

But prosperity came at a price. With the share of oil, gas and petroleum products in export revenue topping 50 percent by the 1980s, the Soviet Union developed a strong dependence on crude prices. When prices dropped in 1986, the government was caught unprepared.

It reacted by scrapping a few megaprojects that could no longer be financed. Fortunately, one of the first to go was the one that involved diverting part of the flow of Russia's northern rivers (the Ob and the Yenisei) to arid lands in Central Asia. However, while the obviously unsustainable expenditure was abandoned, the government was making little progress on general fiscal consolidation.

This was due to the opposition from several political and industry interest groups that had sprung up during the fat years. They had come to expect their share of the oil rent and had learned to fight for it. The most powerful of these lobbies represented water utilities and agriculture, the military and defense industry and the apparatchiks responsible for supporting the ”international socialist system”.

Mikhail Gorbachev's cautious attempts to reduce funding to these groups met fierce resistance. Cuts had to be spread across the board and were clearly inadequate. Beginning in 1985, the country started running a budget deficit which widened to 10 percent of GDP in 1990. The gap in the balance of payments increased fivefold in just eight years. Ramping up exports to capitalist countries brought little relief. The only way out appeared to be foreign borrowing, which was made quite easy at first by the Soviet Union's traditionally high credit rating.

But as foreign debt surged from $28 billion in 1988 to about $100 billion in 1992 while government finances unraveled, borrowing grew increasingly difficult and costly. Politically motivated credits were raised but could not ultimately save the country..

By autumn 1991 the Soviet Union was going bankrupt, with no international reserves to speak of, no means to avert default and no money to buy vital imports, let alone support “friendly” regimes. The living standards of a population that depended on government aid plummeted. The end of 1991 marked the end of the USSR.

To be sure, the Soviet Union's main economic problem was not oil dependence. Oil or no oil, the Soviet planning system was doomed to collapse one day. But it was oil price swings that determined the timing of its demise. Expensive crude stalled economic reform and then a sharp drop in oil prices exacerbated the pain of the country's transition to democracy and a free market. But for this drop, the Soviet Union could have survived for another couple of decades.

Low Oil Prices: What is in Store?

The effect of a long-term slump in oil prices on any given country is difficult to forecast. Too much depends on the state of the country's economy and its future economic policies. But some of the global consequences can be guessed.

First, the populist regimes in Venezuela, Ecuador and Algeria, which are the most financially vulnerable today, are going to be hit hard. Indeed, Latin America as a whole is certain to veer to the right. The rulers in Ecuador and Venezuela, as well as in Venezuela-sponsored Cuba, have already been scared by the triumph of right-wing forces in Argentina. While liberal reforms will hardly bring about an immediate improvement in people's lives, left-wing populism is certain to start losing its grip on the continent.

Second, the post-Soviet space is in for a major shift in the balance of power. Until now, economic integration within it has been underpinned by Russia's oil and gas revenues, the trade breaks that Russia offered and its vast labor market where millions of Central Asian migrants could earn enough money to support their families back home. This cooperation model is on the way out. A new one must be established if Russia doesn’t want to lose its regional leadership once again. Unless much-needed domestic reform occurs in Russia, Azerbaijan and Kazakhstan (which is the only one of the three to have made half-hearted reform noises), the countries that depend on their own or Russian oil revenues will face social and economic upheaval. The repercussions may transcend borders, as hundreds of thousands, if not millions, of people flee their homes.

Third, the Middle East will see its balance of power recast. Iran, Turkey and Israel are well placed to increase their influence as Saudi Arabia's dominance wanes due to its declining oil wealth. There is a chance of political liberalization in Iran. Falling oil prices may also serve as a trigger for a major redrawing of borders and the emergence of monoethnic or monoreligious states. In this context, a break-up of Syria and Iraq appears probable. Violent conflicts are most likely in the near term, as regional governments seek to divert popular attention from domestic problems and to solve them by getting their hands on their neighbors' resources. It is hardly a coincidence that the last time Iraq's oil revenue shrank the country invaded Kuwait. In the longer term, however, violence will subside if prices stay low. The belligerents will run out of the funds necessary to finance war efforts.

So far, enormous oil wealth has been encouraging petrostates to maintain their military spending at much higher levels than those of non-oil-producing countries. This trend is most conspicuous in the Middle East, where military spending in 2014 hit 11.7 percent of GDP in Oman, 10.8 percent in Saudi Arabia and 5.7 percent in the UAE. In the two latter countries, it accounted for about 25 percent of the budget.

Increasing U.S. isolationism will be another consequence. This is due less to lower crude prices than the country's diminishing dependence on oil, both as a revenue source and as a growth driver. Once isolationists in the U.S. have the upper hand in their long-running argument with interventionists, albeit temporarily,China—and later, perhaps, one or two other aspirants—will pick up the mantle of global leadership. A major rearrangement of regional balances of power will follow.

But most importantly, cheap oil will change the way that globalization plays out in oil-producing countries and their regions.

High oil prices have boosted the quantitative dimension of globalization by increasing trade, investment and tourist flows, but have greatly impaired its quality. Russians travelled all over the world, Arabs snapped up London properties and Venezuelans gorged on imported goods. Meanwhile, the petrostates’ elites were busy perpetuating their countries' institutional backwardness. In this topsy-turvy world, greater prosperity and closer integration with developed countries on a purely material level was accompanied by the elites' and populations' growing rejection of market democracy values and, as often as not, by political confrontation with the West. Globalism thrived in body, but its spirit flagged.

Lower oil prices are working to reset the balance. As trade, investment and migrant flows between oil-producing countries and the rest of the world decline, the body of globalism will certainly grow leaner. Its spirit, however, will revive. The full enjoyment of Western comforts and technologies will no longer be compatible with a negation of its values and institutes. Only those countries that embrace modernization and carry it further than they did in the previous oil downcycle can hope not be relegated to a historical footnote. The rest will be condemned to economic enclavization centered on a resource that is steadily losing value.

Now is the time for petrostates to awaken from their long oil dream and choose between the first and the third worlds.

 

Authors: 

Petr Aven - Chairman of ABH Holdings S.A. and board member of Alfa-Bank (Russia), served as Minister of Foreign Economic Relations during Yeltsin government.

Vladimir Nazarov - Director of the Finance Research Institute of the Ministry of Finance of the Russian Federation.

Samvel Lazaryan - Adviser to Director of the Finance Research Institute of the Ministry of Finance of the Russian Federation.