Energy market turmoil deepens challenges for many major oil and gas exporters

Global oil and gas markets are facing an unprecedented situation: demand is collapsing because of the impact of the coronavirus (COVID-19) while supply, already overabundant, is significantly increasing.

In some countries, large-scale production and exports of oil and gas provide vital income to finance their national budgets, which means volatility in global energy markets can translate almost instantly into macroeconomic pressure. When prices fall, these “producer economies” have often responded by trimming their spending, cutting salaries for public sector employees, and axing or delaying large capital projects. These measures have previously contributed to slower economic growth – or even contraction.

This high dependence on external revenue has created conditions that have incentivised an economic structure that relies more on the distribution and allocation of rents than on the creation of the conditions for enterprise. This has typically left national economies narrow and undiversified.

The risks associated with undiversified economies that are reliant on volatile commodity prices have long been recognised. However, the track record of producer economies in general highlights that achieving this transformation is easier said than done. Today, many countries are as dependent on hydrocarbon revenues as they were several decades ago.

However, the case for change is increasingly difficult to sidestep. Factors on both the demand and supply side have suggested for years that we are entering a period of sustained pressure on development models that rely heavily on oil and gas revenues. On the supply side, the unprecedented growth in shale production was the primary driver of the significant price drop in 2014, and remains an integral consideration for today’s oversupplied market.

On the demand side, there are profound questions over the longer-term demand outlook as improvements in efficiency and the growing use of electric vehicles dovetail with intensified efforts from governments and consumers worldwide to respond to climate change.

Recognising these growing structural pressures, some producers have announced ambitious reform efforts aimed at diversifying their economies and promoting private sector growth. The implication of such efforts is that oil revenues can be channelled into making the investments necessary to diversify the economy.

The plunge in the oil price during 2014 and 2015 was a wake-up call for many producer governments. It underlined the need for change but simultaneously undercut the means of supporting it, as many public budgets were reduced sharply. This echoes the history of diversification efforts in recent decades: the incentive to enact difficult reforms is closely linked to the patterns of the commodity price cycle, rising when oil prices are low and states have fewer tools at their disposal to push through the reforms.

Today, we are witnessing another shock, this time from both the demand side (the coronavirus impact) and a surge in supply. In many producer economies, public finances are in worse shape today than they were five years ago, leaving them even less able to absorb the shock. And the coronavirus is set to provide a huge test for the countries’ social and health infrastructure.

In an updated analysis, we have modelled what impact the change in the market conditions over the past week could have on key producers. Using the IEA’s World Energy Model, we considered the combined impact of declining overall demand for oil in 2020 (based on the IEA’s latest Oil Market Report), a surge in supply by some low-cost producers, and a price assumption for the year that averages USD 30 a barrel.

The results are startling. Under these assumptions, oil and gas income for some key producers would fall between 50% and 85% in 2020, compared with 2019. This would represent these producers’ lowest income in over two decades.

In some cases, the price effect is somewhat mitigated by higher output. But in all cases, there is a sharp drop in income of at least 50% compared with 2019. Many producers face the dual impact of lower volumes and lower prices, with an even higher resulting year-on-year fall in income.

The impact of this drop in income will be felt across the board. Producer economies have not fully recovered from the previous price collapse in 2014. For example, per capita GDP in Nigeria in 2018 was one-third lower than it was in 2014, meaning that in many ways, Nigeria is less prepared to deal with a price shock than it was five years ago.

Lower oil prices are expected to put severe fiscal strain on a number of the most important producers. In Iraq, the current price would imply a monthly budget deficit of USD 4 billion simply in order for the country to meet existing obligations for salaries, pensions and other current spending. The country would have to go even deeper into the red if it wanted to proceed with any investments in much-needed capital projects such hospitals, schools, roads and power plants. This strain will exacerbate the pressures on Iraq’s health service, which is already underfunded by regional standards.

As well as the likely widening of fiscal deficits, the countries’ decreased export revenues will impact their overall trade balances, leading to downward pressure on their currencies. For a number of producers that have exchange rates pegged to other currencies, this would require a drawdown of crucial foreign exchange reserves to maintain currency stability. Oman, which runs one of the largest fiscal deficits in the world and has the highest current account deficit of all countries in the Gulf Cooperation Council, is particularly vulnerable in this regard.

The impacts would not be limited to the Middle East. For example, Ecuador’s oil and gas income is projected to fall by 85% compared with last year, compounding an already difficult situation for a government that only recently announced a USD 1.4 billion reduction in public spending.

The results of this new analysis underline once again the strategic importance of the broader reform initiatives that have been underway – albeit often in a halting manner – in many of these producer countries. Economic transformation and diversified growth are essential not only to deal with the changing dynamics of global energy, but also to generate opportunities for growing populations at a time when large numbers of young people are entering the workforces of countries such as Iraq and Nigeria.

Change in the energy sector is a fundamental part of the development of more productive, innovative and sustainable economies. The reform process will be complex and challenging, but the IEA’s special report from 2018, Outlook for Producer Economies, underlined that a well-functioning energy sector – based on a wider range of resources and technologies, including renewable energy – can be a durable asset for today’s producers, providing some of the capital and know-how that can support more diversified growth.