EFFECTS OF DECREASING IN OIL PRICES ON GLOBAL AND SAUDIA

ARAB ECONOMY:
During the past decade, the price of oil has traveled from $60 per barrel to a peak of $146 in
2009 and subsequently descended again to below $50 in 2015. While oil is sold in a global
market, the effect of rising or falling prices can be very different for importing and exporting
countries. Global Network Perspectives asked experts across the Global Network for
Advanced Management how the changing price of oil impacts their economies.

Brazil
The oil price matters in Brazil for various reasons. First of all, Petrobras based its pre-salt
investment projects on the projections of higher oil prices. Calculations state the cost of
producing pre-salt oil between US$41 and US$57 per barrel. Last Friday, the price of Brent
approached the grim US$41 floor.
Petrobras, being the largest indebted oil company in the world, already had to revise
significantly its investment plans, not only due to the declining oil price, but also due to the
ongoing corruption scandal (estimated US$2 billion), which triggered Petrobras rating
downgrade.
This significant slowdown in its investment strategy (plans were basically sliced by half) will not
only harm future output of Brazils oil production and consequently reduce world production
significantly 10 to 15 years onwards, but it will also decelerate sharply growth in industries and
the construction sector, linked to the Brazilian oil production. With the current recession
(expected minus 2% to 2.5% for 2015) this loss of potential employments comes really at a
bad time. Besides, lets not forget Petrobras foregone receipts earmarked for Brazilian
education system that needs urgently substantial and effective investment in order to raise
significantly Brazils low productivity level.
On the other hand, since 2006 the Brazilian government has subsidized petrol prices to curtail
inflation. In 2011-13 the subsidy cost amounted to an estimated 48 billion Reals. So, falling oil
prices help the troubled company to recover its losses accumulated over the past and allow
the government to cut subsidies at times where it has to generate a primary fiscal surplus.
However, the depreciating Real might become the counterproductive factor in this equation, as
import prices are rising in terms of domestic currency.

China
Since China replaced the United States as the world's largest net oil importer two years ago,
the recent falling oil price may affect the China economy in various different ways, in particular
when China is undergoing a period of rapid economic slowdown now. First, as the worlds
second largest economy, the strong Chinese economic growth has been a major driving force
for the global economy for many years. While the major indicators of the second quarter in
2015 show that Chinas economic growth has stabilized, a wide agreement is that China is
going through a slowing of growth and is flirting with recession. The falling oil price may help
stimulate growth in China and bolster economic growth especially in the industrial investment
field. Second, if the declining trend in oil prices continues, since more than half of domestic oil
supply depends on imports, the falling oil prices will translate into huge foreign exchange
savings for China. Moreover, at the industrial level, low oil prices may not only bring down
business expenditures for downstream industries, such as logistic companies and airline
industries, but also affect prices on agricultural products as well. This will in turn benefit the
consumer sectors as lower inflation raises consumption through higher disposable incomes.

Germany
The German economy heavily depends on car manufacturing, so the oil price may be
considered a crucial determinant in Germanys wealth.
A lower oil price accelerates car purchases of the emerging global middle class. The BP
Energy Outlook 2035 predicts that the global vehicle fleet will more than double from today
until 2035. According to the OECD, the Asian middle class will have risen from around 600
million today to 3 billion by 2035-45. Hence, there is a massive upside potential for German
car makers to sell their products in Asia and other regions, especially Latin America, and
eventually Africa.
A higher oil price favors fuel-efficient cars. In this field the German car industry is at the
forefront of innovation. In particular, the premium car manufacturers invest heavily in new
technologies because of the European Unions binding emission targets for new cars.
In the longer term, the oil price will become less relevant, because the global vehicle fleet will
increasingly switch from combustion engine vehicles to cars with electric drivetrains, fueled by

cheap solar and wind energy. Most German car makers have realized this fundamental
technological shift and taken action to enter this nascent market.

Mexico
The collapse of oil prices (to levels below $50 per barrel) since late last year has logically
benefited countries that consume oil, oil products, gasoline, and other derivatives, and has hurt
oil-producing countries by reducing their income from sales. In the case of Mexico, this
situation is exacerbated by the continuing decline in oil production by Pemex, the state-owned
oil company that has held a more-than-seven-decade monopoly (in 2014 Pemex reached its
lowest extraction volume since 1986).
The negative impact from the collapse in oil prices will be greater in Mexico than in other
exporting countries because lower oil revenues decisively affect Mexican public finances (more
than 30% of which depend on oil income). The inevitable cut in federal and sub-federal public
spending may affect Mexican business due to a lowering of the number of public contracts
available, as well as the impact from delays in payments to government suppliers, among
other negative effects. Many analysts estimate that GDP growth in Mexico could decrease by
half a point this year due to the drop in oil prices.
The good news is that the foundation for change is already in place, with the Energy Reform
approved by the Mexican government last year, which opens the state monopoly to private
investment and competition, making Mexico attractive to investors in energy sector industries
and sub-industries. Although Mexico is arriving 20 years late to this growing and increasingly
competitive market, the benefits of this paradigm shift will be evident. The Energy Reform
means foreign direct investment, technology, and advanced practices not previously available
to Mexico, along with final pricing that reflects the true cost of production. It will also allow for
the modernization of Pemex and the entire oil and oil derivatives production chain.
However, it is necessary to ensure proper implementation of the Energy Reform to achieve the
expected results, especially in the case of oil, where the drop in prices is acting as a
disincentive in the process. One example is the recent auction of oil plays in risk-sharing
production projects, from which 28 bids yielded just a single company being awarded two oil
fields. Despite these disappointing results, both the Mexican government and the business
community have high expectations that improved incentives aligned with international best
practices will enhance the attractiveness of the next rounds.

Rules and regulations can always be improved upon and adapted to the reality of the
marketplace. So far, the efforts made by the Mexican government to successfully implement
the reform seem to be going in the right direction, and the stakeholders involved in the process
expect that these efforts will contribute to triggering the energy potential of Mexico and its
competitiveness in the international arena.

Nigeria

The changing price of oil has caused Nigerias current account balance to fall by 69.3% (from
N$3.14 trillion in 2013 to N$964.6bn in 2014). In Q1 2015, Nigeria recorded a current account
deficit of N$723.8 billion, down by 212% from surplus of N$641.39 billion in Q1 2014. The CBN
hs devalued the currency twice in the space of one year as a result of falling oil prices. Oil
revenue, which accounted for 67% of the gross federal revenue in Q1 2015 (compared to
72.5% in Q1 2014) has also been on the decline. Earnings from oil is the major source of
foreign reserve in Nigeria. The foreign reserve was $29.01 billion at the end of H1 2015. So far,
it has fallen by 22.3% since H1 2014$37.3 billion when oil prices started falling. If the
economy is not well diversified, Nigerias economy will continue to be affected by the changing
price of oil in the future as the future of oil prices gloom.

Canada
What explains the discrepancies between predicted and observed gasoline prices in
Vancouver? Markets for crude oil and gasoline are closely connected but do not follow each
other precisely. Gasoline is a refined product, and thus bottlenecks at refineries and existing
gasoline inventories are crucial factors determining the price at the pump. Local demand and
supply factors can lead to local deviations that are different from those in other regions of the
country. Seasonal factors may also come into play. During September, after the end of the
driving season, refining capacity is often taken offline for repair and maintenance (so-called
"turnarounds"). Inventory levels can also be different regionally. In Western Canada, refineries
tend to have a much lower level of crude oil inventories (about 5-7 days) than refineries in
Eastern Canada (about 15-20 days). Similarly, inventory levels of refined gasoline differ. In
anticipation of planned maintenance shutdowns, refineries build up inventory. Larger
inventories put further downward pressure on crude oil prices. The bottom line: reduced
refining capacity is currently responsible for unusually high gasoline prices, combined with

strong demand from motorists.... Rest assured, though, that eventually prices at the pump will
fall into line with crude prices again.

Saudi Arabia's refusal to reduce oil output shows no sign of abating, but its
determination to drive out US shale producers is taking a toll on the kingdom's
economy, recent data suggests. And with the expectation of Iran's return to
global oil markets already undermining fragile prices, Riyadh's strategy looks
increasingly like it might be a gamble with declining odds.
Although the kingdom has substantial reserves, it appears to be burning
through its financial war chest at an alarming rate. According to the Saudi
Arabian Monetary Agency, foreign exchange reserves fell to $648bn at the
end of October from $742bn a year earlier.
Oil prices and OPEC
If OPEC does not compensate for the increase in Iran's oil exports by cutting
oil production, the International Monetary Fund says oil prices could fall
between five and 10 percent in the medium term. Energy giant BP estimates
that Iran has the fourth-largest proven oil reserves in the world after
Venezuela, Saudi Arabia and Canada, as well as the second-largest gas
reserves, according to the IMF.
How quickly Iran can ramp up production is up for debate, but a consensus
appears to be emerging. Jaap Kalkman, managing partner of Arthur D Little's
global energy and utilities practice, believes that Iran will add between 0.5 to
one million barrels a day within a year, while the IMF forecasts an increase of
around 0.6 million barrels a day in 2016.
Bijan Zangeneh, Iran's oil minister, is considerably more bullish about the
country's ability to bolster output but, whatever the figure, it is expected to

increase pressure on Saudi's economy, in which about 90 percent of

government revenues are derived from hydrocarbons.
Khalid al-Dakhil, an assistant professor of political sociology at King Saud
University, told Al Jazeera that he did not expect Iran's output to have a
dramatic effect.
"Politically, I do not see any impact of Iran's return to the oil market on Saudi
Arabia," he said. "This return could [cause] oil prices to go further down - but
remember, Iran is much more than Saudi Arabia in dire need to improve
prices, because it is coming out of political and economic isolation."
At the same time, there are signs that the Saudi campaign against US shale is
having an impact. There is mounting evidence that shale production in the
United States is beginning to wane, while energy consumption in advanced
economies is rising. Elsewhere in the world, major energy companies have
shelved a number of projects - a move that will support of prices in the
medium term.
Saudi economy
Even so, the IMF predicts that the gross domestic product in Saudi Arabia will
grow by only 2.2 percent in 2016, compared with 4.4 percent in Iran.
Eduard Gracia, a principal at the AT Kearney consulting firm, says Saudi
Arabia's decision not to cut production is due in part to the supply-demand
dynamics of the global market.
"It only makes sense to cut production if the supply situation is such that a
small output reduction results in a substantial price increase," Gracia told Al
Jazeera. "In a situation of global oversupply this may not be the case, so the
appeal of a production-cutting strategy is not clear."

By the end of this year, Saudi Arabia's budget deficit will reach 20 percent of
GDP, according to a December report from Capital Economics. The situation
has prompted the IMF to warn that Saudi could exhaust its reserves within
five years if policies remain unchanged. Riyadh has responded with cutbacks
in spending, and is under intense pressure to reduce expensive energy
subsidies.
The IMF estimates that these implicit subsidies cost the government $83bn in
2014, one of the highest totals in the Gulf Cooperation Council countries,
second only to Bahrain. Attention is now turning to Saudi's 2016 budget. It is
expected to be one of mostly heavily scrutinised budgets in years, as investors
seek reassurance that the kingdom's finances are under control.
According to press reports, leaked memos from King Salman to the Ministry
of Finance in October ordered government entities to stop new infrastructure
projects and to postpone purchases of new cars and furniture. Mounting
economic uncertainty led Standard & Poor's to downgrade Saudi's rating from
AA-/A-1+ to A /A-1 in October, with a warning of a possible further
downgrades.
The downgrade pushes up the costs of borrowing at a time when government
revenues have fallen sharply. There has also been speculation in financial
markets about how this could affect the Saudi riyal, with the spread between
forward and spot rates recently widening to the highest level since 2003.
However, according to Capital Economics, that scenario would be the last
resort, and Saudi has other options that could include tapping into the
international bond markets early in 2016 - something it has never done before.
Authorities are currently issuing around SAR 20bn ($5bn) of debt per month
to local banks, reducing the amount local banks have left to lend to the private
sector, according to an estimate from Capital Economics.

Saudi Arabias 2016 Fiscal Budget

The governments budget for the 2016 fiscal year (31 December 2015 to 30
December 2016) was endorsed by the Council of Ministers on 28th December.
It points to a sustained commitment in maintaining a high level of spending
despite the continued environment of lower oil prices (Figure 1). Despite
being reduced slightly, budgeted spending is set to play a vital role in
supporting the economy in 2016. The highlights include:

The government has reaffirmed its commitment to support the economy

by budgeting for a SR326 billion deficit in nominal terms, based on
revenues of SR514 billion and expenditures of SR840 billion. The deficit
will continue to be financed using a combination of Saudi Arabian
Monetary Agencys (SAMA) huge stock of net foreign assets, and domestic
debt. SAMA net foreign assets totaled $628 billion at the end of November,
while public debt rose from a long-term low of SR44.3 billion in 2014 to
reach SR142 billion in 2015, yet still low relative to GDP at 5.8 percent.

Despite the global environment of lower oil prices, the Kingdom has
maintained a high level of spending in the 2016 fiscal budget. Education
and healthcare remain the focus of government spending, accounting for 35
percent of total spending. Whilst spending on military and security services
constitutes the largest single share at 25 percent. A new allocation
accounting for 22 percent has been introduced to support the budget and
help address shortages in revenue. We estimate that budgeted investment
spending has been reduced to SR204 billion in 2016, with spending on key
social infrastructure projects maintained. This points to a gradual
consolidation in the fiscal stance but also shows the governments sustained
commitment on maintaining a high level of spending on human capital and
social infrastructure.

The budgetary performance in 2015 came close to our forecasts with a

deficit of SR367 billion, or 15 percent of GDP (Jadwa Investment forecast:
SR403 billion, 16.4 percent of GDP). Despite the deficit being the largest
on record, reduced spending has meant a much smaller than anticipated
deficit. This is the second consecutive fiscal deficit, and was mainly due to
both a steep fall in revenues and a rise in one off expenditures associated
with the royal succession. Total revenue fell by 41.5 percent compared to
the previous year, reaching its lowest level since 2009 at SR608 billion. We
estimate oil revenue to have fallen by 51 percent despite record production
(10.2 mbpd year-to -November). Fiscal expenditure was reduced for the
first time since 2002 to reach SR975 billion, SR136 billion lower than
2014.

In line with our expectations, preliminary economic data shows that the
economy continued to slow in 2015 with real GDP growth of 3.4 percent
(Jadwa Investment forecast: 3.2 percent). Non-oil private sector slowed to
3.5 percent year-on-year (Jadwa Investment forecast: 3.8 percent), with the
highest growth in the transport, construction, and wholesale and retail

sectors. Lower oil export revenues meant a first current account deficit
since 1998, at 6.3 percent of GDP or minus $41.3 billion.

Looking ahead, a National Transformation Program (NTP) will likely be

announced by the government in January, providing a roadmap for major
social and economic initiatives to be undertaken in the next five years. We
have already seen some elements of these major initiatives announced
today along the budget such as domestic energy price reform which should
have a positive impact on non-oil revenue while, at the same, curbing
growth in energy consumption.

We estimate a price of $40.3 pb for Saudi export crude (around $42.8 pb for
Brent) and production of 10.2 million barrels per day (mbpd) are consistent
with the revenue projections contained in the budget. We expect both revenues
and expenditures in 2016 to be above the budgeted level, but the differential
will be smaller as the government becomes more prudent in its spending
procedure. We forecast a budget deficit of SR313 billion (12.6 percent of
GDP) based on oil price of $47 pb for Brent in 2016.
The 2016 Budget
The 2016 budget outlines a small reduction in the level of spending compared
to 2015, down by SR20 billion to SR840 billion, underscoring the
governments determination and ability to support economic activity despite
the prevailing subdued oil pricing environment. It further highlights the strong
focus on economic diversification as spending on physical and social
infrastructure has likely been kept at elevated levels. We also believe the 2016
budget numbers are more conservative than previous years, judging by the
underlying assumptions on oil prices and historical patterns of government
overspending.

As highlighted in our 2015 budget report last year, we expect the government
to demonstrate an increasing tendency to monitor capital spending. Initiatives
for tighter control over capital spending include the order by the Council of
Ministers, back in April, requiring the kings approval for any project in
excess of SR100 million. We also anticipate the NTP to be announced in
January. One objective of this plan is likely to focus on speeding up the
diversification process, including government income and the role of the
private sector. We also expect this plan to be carried out through a number of
ambitious targets and key performance indicators which increase the
efficiency of public sector spending.
That being said, the Kingdom has budgeted for a second consecutive fiscal
deficit, amounting to SR326 billion in 2016, compared with SR145 in 2015.
With uncertainty still clouding the outlook for global oil market, the budget
foresees a further contraction in revenues by 28.1 percent and negative growth
of 2.3 percent in expenditure compared to last years budget.
At least in the short term we think that financing this deficit is straightforward,
as it can be done by drawing down the stock of foreign assets built up in
recent years and the financial capacity to issue debt. According to the latest
data available, at the end of November net foreign assets at SAMA stood at
$628 billion (SR 2,356 billion). The huge stock of assets that the government
can call on gives the Kingdom an advantage over most other countries in
alleviating the impact of lower oil prices. Also, the series of sovereign bond
issuance (around SR20 billion per month since June) provides the government
with more room to continue financing strategic projects, such as key
infrastructure developments including transport, housing, power and water,
and to support the private sector where necessary. We think the government
will increasingly rely on bonds to finance its future spending, which will
result in less FX reserves drawdowns. That said, the budget announcement
explicitly states that the government will utilize a financing plan that observes

the best financing options available. This includes both domestic and foreign
borrowing in order to avoid crowding out credit to the private sector.
Expenditure
Total expenditure is budgeted at SR840 billion in 2016 (Figure 2). This is
lower than the amount budgeted for 2015 (Figure 3). While there was a small
decline in budgeted spending, this spending is very high and reflects the
governments willingness to support the economy despite the fall in revenues.
We believe that this sends an important message to the private sector that the
fall in oil prices will not prevent the government from fulfilling its investment
plans. High fiscal spending remains psychologically important for the private
sector, in our view.
When compared to actual spending, the budgeted amount shows a declining
trend from actual levels in both 2014 and 2015, which totaled SR1,111 billion,
and SR975 billion respectively. We view this as a determined effort to curtail
actual spending, given that the government has consistently overrun its
budgeted spending by an average of 24 percent over the past decade (Figure
4).The last time that budgeted spending exceeded actual spending compared
to the previous year was in 2000. Budgeted spending as a share of non-oil
GDP is in line with historical levels, at an average of 50 percent in the last ten
years. Furthermore, we think that the government will target total spending to
be fixed at a certain proportion of non-oil GDP. This approach will likely be
highlighted in the 2020 NTP, thereby improving the confidence related to
budget announcements as well as reducing the chance for unnecessary
spending.
The 2016 budget announcement did not show a breakdown by type of
expenditure. We estimate a rise in budgeted current spending (the more rigid
part of expenditure), while we expect a reduction in budgeted investment
spending. Budgeted current spending has likely been raised to SR618 billion

or by 5.6 percent compared to the level budgeted for last year, this is half the
10 percent average annual growth in budgeted current spending over the last
ten years, and consistent with slowing growth in current spending over the last
two years. We think that budget commitments, spending packages, and very
high public sector employment had accelerated current spending during the
previous years. Wages and salaries are the largest component of this and are
certain to continue being a major contributor to growth. However, the budget
statement included a list of measures to be implemented which will reduce the
growth in this type of spending, specially since spending on wages and
salaries accounted for 50 percent of actual spending in 2015. Operations and
maintenance costs are also likely to be a growing source of current spending
in future years as major projects become operational.
At the same time, we believe that the government has budgeted a cut to
investment spending by 19.3 percent to SR222 billion in 2016. Budgeted
capital spending has already been cut by 3.4 percent for 2015, and we expect
the government to have budgeted for an even larger cut in this type of
spending in 2016. That said, we expect the 2016 budgeted investment
spending is 21.3 percent higher than its level five years ago.
While budgeted expenditure in 2016 spans all sectors, the priorities are
consistent with recent years (Figure 5). Military and security services has been
allocated 25 percent of the budget, the largest among all allocations.
Education is allocated the second biggest share, at 23 percent of total
spending, followed by the health and social affairs with 13 percent.
Spending plans for key public sector areas outlined in the budget include:
2016
(SR billion)

Budget

Allocation

Box 1: Budget Allocation 2016

The 2016 budget made a break with the reporting format of last few years and
introduced four new line items. The most significant was Military and
Security Services item, which had not previously been disclosed, and
represented a total budget allocation of 25 percent at SR213 billion. Education
and Training, the second largest budget item, was allocated SR192 billion in
2016, representing a decline of 12 percent year-on-year from SR217 billion in
2015. Health and Social Development dropped by a sizable 34 percent yearon-year to SR105 billion. Whilst Education and Training and Health and
Social Development budgets are down year-on-year, as the budget report
highlights, there are a number of projects which are being funded from
previous budgets surpluses, indicating that both these sectors will continue to
benefit from investment. Municipality Services, which made up 3 percent of
the total allocation, declined by 46 percent or SR19 billion. Economic
Resources is a new line and will be disclosed in the budget statement,
representing 9 percent or SR78 billion of budgeted expenditure in 2016.
Notably it includes an allocation for the King Abdullah City for Atomic and
Renewable Energy (KA-CARE) reaffirming that the government is keen on
developing a plan on renewable energy, which fits in with the proposal to
conserve natural resources outlined in the budget report. Public
Administration is another new item representing SR24 billion. A Budget
Support Provision line item has also been added representing a back-up fund

in case of shortages in revenue due to volatility of oil prices to the tune of

SR183 billion or 22 percent of the total budget. This is welcome addition to
the allocation and represents a clear sign that the government is pursuing a
more serious risk management approach to government finances. That being
said, it is conceivable that this provision remains untouched during 2016 due
to better-than-expected government revenue.
Economic, Fiscal and Structural Reform
This years Saudi budget spelled out clear objectives to consolidate
expenditure over the next three to five years. We anticipate more detail will be
disclosed in the NTP, but three key points stand out from the budget report
which the government has outlined it will tackle. Firstly, better management
of expenditure, secondly, improving revenue sources and debt capacity,
thirdly, limiting growth in bloated expenditure whilst channeling resources to
key sectors to ensure economic growth.
Better management of expenditure:
The implementation of a public finance unit in the Ministry of Finance and the
setting up of the National Project Management Agency are two initiatives
which are designed to ensure that expenditure is kept in check. Two further
reforms, the improvement of budgetary policies and procedures and reviewing
existing government projects, will aim to reassess existing practices and
projects to ensure they bring greater value to governments development
objectives.
Improving revenue sources and debt capacity:
The implementation of a GCC wide value added tax is a major development
that will add to government revenues. It will also be supplemented by
additional fees on goods deemed as undesirable, such as tobacco and soft

drinks. The budget report also cites privatizing a range of sectors and
economic activities, whilst an improvement in the management of the states
assets will also generate more revenue.
Since mid-2015 the government has been issuing bonds mainly to the
domestic banking sector. This is expected to continue during 2016, but with
the help of a debt management unit within the Ministry of Finance, the
government will be able to improve its financing strategy so allow continued
borrowing from both domestic and international sources.
Limiting expenditure and channeling resources:
Two majors sources of expenditure are earmarked for limited growth. One of
these relates to government support to energy and utilities. A royal decree
announced that petrol prices would go up by 50 percent, up from 16 cents (0.6
riyals) to 0.24 cents (0.90 riyals) for a liter of high grade gasoline. However,
the budget report states that more price rises should be expected as energy,
water, and electricity prices will be increased gradually over the next five
years. This is a welcome move since, according to Jadwas estimates, the
government spent $61 billion on energy subsidies in 2015 with almost $9.5
billion of that on gasoline alone (Box 2).
The other area will be related to recurring expenditures, especially wages,
salaries, allowances which amounted to SR450 billion in 2015. This would
imply that the public sector is likely to see slower growth in salaries or slower
growth in headcount, or perhaps both. In light of this, to ensure that the
private sector can create a larger share of jobs, the government plans to
improve the investment environment related to the private sector, which will
include overcoming legislative, regulatory and bureaucratic obstacles.
Investment will also be central to ensuring that the welfare of citizens is not
compromised with the budget specifically citing education, health, security,

social and municipal services, water and sanitation, electricity, roads,

electronic transactions, scientific research as a benefactor regardless of the
more disciplined expenditure approach going forward.
Box 2: Cost of energy subsidies
When looking at the price of various energy products globally and then
comparing those to the prices paid by end users in Saudi Arabia, Jadwa
estimates that energy subsidies cost the Saudi government around $61 billion
dollars in 2015 (9.3 percent of GDP). Although the opportunity cost of
subsidies to government decreased by 39 percent year-on-year, as
international crude and crude-related product prices dropped, the total still
represents a significant loss. The largest item cost was in the provision of
diesel, costing $23 billion (3.5 percent of GDP) to the government in 2015,
since it makes up a significant portion of total Saudi energy demand. Diesel
consumption totaled an expected 800 thousand barrels per day (tbpd) in 2015
(28 percent of total domestic consumption), through its varied use in
electricity generation, desalination and transportation. At 16 US cent per liter
(rising to 24 cent per liter in 2016) at the pump, the provision of gasoline also
represented another major cost to the Saudi government, at around $9.5 billion
in 2015 (1.4 percent of GDP), when compared to prevailing international
gasoline prices. Electricity generation represent a significant cost to the
Kingdom with around 1.6 million barrels of oil and refined products per day
are consumed to meet domestic demand. Domestic users pay as low as 3 US
cent per for each kilowatt hour of electricity, a significant discount of 60
percent when compared to international prices. We estimate that the
opportunity cost for the government keeping prices at such low levels was
equal $23 billion in 2015. The Electricity Co- Generation Regulatory
Authority (ECRA) forecasts peak electricity demand rising by 25 percent
between 2015-2020, so generation costs will rise too.

Revenue
Total revenue is budgeted at SR514 billion. We anticipate that around 73
percent of total revenue will come from oil; an official revenue breakdown
was not published. As is the norm, the oil price and production projections
used to derive the revenue figure were not disclosed. We calculate that oil
production of 10.2 mbpd at a price for Saudi export crude of $40.3 pb
(equivalent to around $42.8 pb for Brent) is consistent with the oil revenue
projection in the current budget. The government has consistently based its
previous budgets on conservative oil price assumptions. Over the last five
years, the actual oil price has averaged more than 50 percent higher than the
one used for the budget. In 2015, however, the oil price assumption used for
the budget was $64.8 pb, higher than the $49.6 pb year-to-date average price
for Saudi crude. Nevertheless, with Brent crude currently trading at $37 pb
(see box 3), we think that the oil price assumption was again reduced
significantly compared to the 2015 budget price of $64.8pb, meaning the
government is once again being cautious in its assumptions for 2016 oil
prices.
With these assumptions in the background, the announced revenues are
projected to decline by 28.1 percent compared with the previous years
budget. Even though we anticipate that prices will be lower than in 2015, we
think that revenues will be comfortably above the governments assumption.
Revenues generally provide the base from which expenditure is calculated;
conservative budgetary assumptions on oil prices and spending have
contributed to high levels of overspending in recent years. In 2016, however,
we think that the government will be more prudent in its spending, which will
likely mean lower levels of overspending compared to the budget.
Projections for non-oil revenues were not published. Fees and charges for
government services and customs tariffs are the main sources of non-oil
revenues. We anticipate receipts from both of these sources to increase
gradually in line with more careful monitoring of income receipts as well as

the higher demand on government services. The prospect of further increases

to interest rates in the US is likely to improve the return on government
foreign assets which account for around 96 percent of GDP, though we do not
anticipate a significant push here as the interest rate adjustment is likely to be
gradual.
Box 3: Jadwas oil market outlook for 2016
The current period of low prices is set to remain throughout 2016, pulled
down primarily as a result of persistently high oil supply. All- out competition
between members of OPEC will be the main reason for continued
oversupplied markets. In OPECs recent meeting the notional idea of
production quotas was dropped, paving the way for even more intense
competition in an already heavily-oversupplied market. Even as non-OPEC
supply begins to slow during 2016 the additional supply coming on-line from
Iran will mean global oil markets will be looking at demand to lift prices out
of the doldrums. With global economic activity not picking up significantly in
the year ahead, this will translate to moderate yearly growth in oil demand.
OPEC data shows that non-OPEC supply will decrease by 0.2 million barrels
per day (mbpd), year-on-year, in 2016. Amongst the largest non-OPEC
players, both the US and Russia will see year-on-year declines in production.
For Russia, the combination of international sanctions preventing Russian oil
companies access to international finance and government proposals for
higher crude taxes to boost state revenue will mean crude production, which
reached record post -soviet levels in 2015, is expected to slow slightly in
2016. According to latest Energy Information Agency (EIA) data, total US oil
production will decline by 6 percent or 600 thousand barrels per day (tbpd),
year-on-year, in 2016.
We forecast OPEC supplies rising by around 600 tbpd year-on-year to average
of 32.1 mbpd in 2016. Most of the OPEC rises are expected to come from

increased Iranian supply when nuclear- related sanctions are lifted at some
point in Q1 2016. Although Iraq saw an estimated 11 percent increase in
production year-on-year in 2015, this has been attributed to investment in the
upstream sector since 2009. Further substantial increases in Iraqi production
will be more difficult due to the countrys deteriorating fiscal situation as a
result of lower oil prices, higher military spending, and costs associated with
civil conflict.
Saudi Arabian crude production is expected to average 10.2 mbpd in 2015,
slightly above our forecasted 10.1 mbpd (Figure 6). We do not see Saudi
Arabian policy cutting production in order to support upward movement in
prices. So far Saudi policy of gaining market share has worked with lower
prices undercutting both OPEC and non -OPEC competitors in key markets
and we expect Saudi production to be unchanged, year-on-year, at 10.2 mbpd
in 2016 .
According to OPEC data, global demand will rise by 1.25 mbpd in 2016, yearon-year, in line with the average of the last four years, supported almost
entirely by non-OECD countries. Weak oil demand growth in the EU and
Japan will keep rises amongst OECD countries to a bare minimum. Amongst
the non-OECD, year-on-year growth in 2016 demand will be mainly driven by
India (up 3.5 percent), China (up 3 percent) and the Middle East (up 2.5
percent).
Moderate oil demand and a glut in oil supply will result in a continued build
in OECD commercial crude stocks during most of 2016 (Figure 7). In fact,
even with a currently high level of geopolitical tension there is no risk
premium attached to oil prices since commercial stocks are more than capable
of handling any adverse supply shocks in the short term. Even as global oil
markets tighten toward the second half of 2016 (Figure 8) commercial crude
stocks will have peaked in excess of their 15 year average. As a result we see

limited upside to Brent prices during the year with our revised forecast at $47
pb, down from $61 pb previously, for 2016
Jadwa Investments 2016 budget forecast
We forecast a budget deficit of SR313.4 billion in 2016, equivalent to 12.6
percent of estimated GDP. On the revenue front, we expect oil prices to be
higher than that used in the budget (see Box 3) and therefore oil revenues will
exceed the budgeted total. We forecast total oil revenues contributing SR609
billion to the budget and non-oil revenues contributing SR168 billion.
Actual spending will be above the budgeted level. Over the last ten years
actual government spending has averaged 24 percent higher than the budgeted
amount. However, in 2015, the overspending ratio came out lower at 13.4
percent. We expect another decline in the overspending ratio in 2016 to 9.8
percent. We think such a trend will be further enforced given the expected
pressure on oil revenues and the more prudent expenditure control, together
with the lower level of budgeted spending for 2016. We forecast total
expenditure of SR922.4 billion.
The oil price level necessary for revenues to balance our forecast level of
government spending, known as the fiscal breakeven oil price, is $88.4 pb for
Saudi export crude (equivalent to around $90.9 pb for Brent). This is based on
our production assumption of 10.2 mbpd and an oil export/revenue transfer
ratio of 85 percent. We also assume a 1 percent growth in domestic oil
consumption to 2.9 mbpd in 2016. We think that forthcoming increases in
domestic gas production should take some of the burden from oil as the fuel
for domestic energy consumption next year. The main growth in gas output
will come from the Hasbah and Arabiyah fields in the east of Saudi Arabia and
from Shaybah field in the Empty Quarter. Both Hasbah and Arabiyah are
expected to produce non-associated gas which will be processed by the Wasit

processing plant. These projects were supposed to come on-line in 2015 but
faced technical delays and should be operational in early 2016.
Budgetary performance in 2015
The recent announcement by the Ministry of Finance also reveals that the
preliminary 2015 fiscal outturns were significantly different than the 2015
budgets projections, and at line with our projections. For the first time, actual
oil revenues have come out lower than budgeted; the result of falling oil prices
($52.2 pb for Brent in 2015, down from $99.4 pb in 2014). Total spending was
again in excess of the budgeted projection, leading to a deficit of SR367
billion, the largest deficit on record, equivalent of 15 percent of GDP (Jadwa
Investment: SR403 billion, 16.4 percent of GDP).
Revenue totaled SR608 billion (Jadwa Investment: SR679. billion). It was 15
percent lower than the budgeted level, and 41.5 percent lower than its 2014
level. We estimated that the 2015 budget was based on a price for Saudi oil of
$64.8 pb and production of 9.6 mbpd. Actual price of Saudi oil averaged $49
pb in 2015, 48 percent lower than its level in 2014, and 11.2 percent lower
than that used in the budget. The actual level of oil production was above our
forecasts. Non-oil revenues were SR163.5 billion, up by 28.9 percent on the
2014 total, the fastest year-on-year growth on record. This is a direct result of
the governments efforts during the year in improving the collection of fees
and taxes. For example, taxes on petroleum products have increased by 7
percent, year-on-year despite the large drop in oil export revenues. Another
source of growth came from foreign investment returns by SAMA and the
Public Investment Fund (PIF), which rose from a total of SR21.9 billion in
2014 to reach SR 37 billion in 2015.
2015 Budget Data
(SR Billion)

Expenditure amounted to SR975 billion (Jadwa Investment: SR1,082 billion),

13.4 percent above the budgeted level but 12.2 percent lower than in 2014.
This was the first year-on-year decline in actual spending since 2002. In
nominal terms, the decline was SR136 billion, while the overspending stood at
SR115 billion. The official announcement attributes the current overspending
to additional spending from the royal decrees announced in January, which
totaled SR115 billion . We have highlighted the impact of this extra spending
in previous publications as a downside risk factor to our earlier deficit
forecast. While a breakdown of spending into capital and current expenditure
was not disclosed, we maintain our view that public sector pay rises and
greater employment in government accounted for a large share of current
spending. This highlights the increased rigidity in the Kingdoms budget,
though this includes one off spending associated with the royal decrees.
Further, the government noted that its efforts to rationalize current spending
will continue. It is important to note that the initial estimates of government
spending and revenues contained in the budget statement tend to be revised. In
general, both are higher, with the rise in spending usually larger than that for
revenue.
We believe that despite the budget being in deficit, capital spending remained
an important element of expenditure. While the government reduced its
investment spending towards the end of 2015, we think it will continue to
engage in this type of spending in the short-to-medium term, as it still remains
affordable to do so. The government will, as a result, be able to continue
spending on key social and infrastructure projects, and at a level high enough

to support growth in the private sector. That being said, we estimate that
capital spending accounted for 31 percent of total spending in 2015, still high
compared to an average of 28 percent between 2004 and 2014. This type of
spending is critical to sustain robust growth in the non-oil sector and help to
lessen the dependence on the oil sector as the main source of income.
Diversification of sources of fiscal income rather than fiscal deficits should be
the focus of policymakers in the Kingdom.
As a result of the budget being in deficit, the government has started a series
of monthly sovereign bond issuance, all of which is domestic, to cover part of
the shortfall. The public debt increased by a net of SR97.7 billion to SR142
billion by the end of 2015, equivalent to just 5.8 percent of GDP (Figure 12).
We think that autonomous government institutions were the main subscribers
to these debt issuances. Commercial bank holdings of government bonds, the
closest proxy to their holdings of government debt, have only risen by SR27
billion over the eleven months of the year to SR80 billion. Among the
autonomous government institutions, we believe the largest two subscribers
were the General Organization for Social Insurance (GOSI) and the Public
Pension Agency (PPA). As mentioned earlier, we think the government will
continue with issuing more bonds to banks and other autonomous government
agencies to finance its spending. Looking ahead, there is a downside risk that
liquidity could shrink from further government bond issuance, which could
result in a crowding out effect on credit to the private sector. While this is not
our baseline scenario, if such an event does happen, we expect the government
to allow other financial and non-financial institutions (i.e. insurance
companies, investment firms, and family offices) to participate in purchasing
public debt.
Economic performance in 2015

The Ministry of Finance budget announcement included preliminary

macroeconomic data, which provides some insight into the governments view
on economic performance this year and prospects for next year. Data showed
that overall economic growth fell to 3.4 percent year-on-year, slowing from
3.5 percent year-on- year in 2014. We had forecasted 3.2 percent GDP growth
in 2015. According to the budget statement, the oil sector grew by 3 percent
year-on-year in 2015, Jadwa had forecasted 3.4 percent. Stripping out the oil
and gas sector, non-oil economic growth was at 3.6 percent year-on-year with
the private sector expanding by 3.7 percent, compared to Jadwas forecast of
3.8 percent. Lower oil revenues contributed to the first current account deficit
since 1998. Inflation continued to decline.
Real GDP growth fell to 3.4 percent year-on-year, a trend which we had
anticipated (Figure 13). We anticipated lower economic growth compared to
last year because of weaker non-oil sector performance, while oil sector
growth accelerated. The oil sector grew by 3 percent year-on-year as the
Kingdom increased production. The latter grew by 5 percent year-on-year to
an average of 10.2 mbpd compared with 9.7 mbpd in 2014. Both higher crude
exports, from 7.1 mbpd in 2014 to an expected 7.4 mbpd in 2015, and
increased refinery output led to oil sector growth. As oil sector growth
accelerated, the pace of growth in the non-oil economy did not fare as well,
but nevertheless grew by 3.6 percent (Figure 14). Within the non-oil economy,
growth of government services slowed to 3.3 percent.
The non-oil private sector grew by 3.7 percent. We had anticipated a slowing
performance in 2015 as negative sentiment associated with lower oil prices
and reduced government spending impacted business and consumer
confidence and banks discomfort in the lending environment. The data
release showed that the transport sector would be the fastest growing sectors
in 2015 at 6.1 percent . Construction sector growth was robust at 5.6 percent
year-on-year. Non-oil manufacturing grew by 3.2 percent year-on-year,

supported mainly by improved overall capacity, up 2.5 percent year-on-year,

but specifically due to a rise in higher value adding specialty chemicals
capacity, up 35 percent year-on-year. The wholesale and retail sector also
recorded modest growth at 3.8 percent, reflecting weaker sentiment related to
lower oil prices. Growth in the finance sector was also in line with
expectations, at 2.6 percent.
Inflation was put at an average of 2.2 percent, compared to 2.7 percent in
2014. This is in line with inflation data produced on a monthly basis by CDSI
and is the lowest since 2006, when inflation reached 1.9 percent. Inflation has
remained subdued relative to previous years, but a recent acceleration to rental
inflation and the newly announced revision to domestic energy prices all point
to a likely upward trend next year (Figure 15).
The current account recorded its first deficit since 1998 at $41.3 billion (6.2
percent of GDP), down from a surplus of $76.9 billion in 2014 (Figure 16).
Although a detailed breakdown of the current account is not published, it is
clear that the reversal in the current account balance is mostly due to the drop
in oil revenues (oil revenues account for around 83 percent of total current
account receipts). The fall in Saudi oil export price from $95.8 pb in 2014 to
$49 in 2015 pushed the oil export revenues to $157 billion, down from $285
billion in 2014. Non-oil exports also fell by 18.8 percent year-on-year,
compared to 6 percent growth in 2014 (Figure 17). The fall in non-oil exports
was mostly due to a decline in plastic and rubber, and chemical product
exports. We see that the decline in oil prices has increased pressure on Saudi
petrochemicals due to lower oil prices having reduced the competitive
advantage of Saudi petrochemical companies relative to their international
competitors. Petrochemicals and plastics account for more than 60 percent of
the Kingdoms non-oil exports. Imports were also down by 10.5 percent yearon-year, more than the monthly trade data. Latest available data for the first
ten months of 2015 showed that imports were 5 percent down from the same

period in 2014. Data on the other components of the current account were not
published.
The economic outlook for 2016
We expect that the economy will continue to decelerate in 2016, dragged
down by slower growth in both the oil and non-oil sectors. Annual growth in
the oil sector will remain positive in 2016 as gas production should support
growth in the sector. The non-oil private sector will continue to grow albeit at
a slower pace, as reduced government spending should continue to have a
negative impact on business activity. However, we think that government will
maintain a level of spending high enough to continue supporting positive
growth in the non-oil private sector. While we expect the NTP announcement
in early 2016 to include major initiatives and reforms to stimulate private
sector activity, we believe that the impact of these initiatives will only start be
felt towards the end of the year. These initiatives are expected to include
investment and non-oil export promotion, as well as regulatory,
administrative, and financial reform.
Economic growth in Saudi Arabia is forecast to slow to 1.9 percent in 2016,
owing to a slower growth in both the oil and non-oil sectors. Based on the
available data, we expect oil sector growth to reach 0.9 percent despite a
marginal decline in oil production. We think that forthcoming increases in
domestic gas production will support the growth in the sector during 2016.
Within the non-oil sector, we expect the governments real GDP to expand 2.5
percent year-on-year due to our expectation of continued spending to meet
demand on government services, while the non-oil private sector is expected
to expand by 2.8 percent, slowing down from 3.7 percent in 2015. We believe
that the private sector will continue to feel the sentimental impact of lower oil
prices, while lower government spending will limit any potential for an
acceleration in growth for some businesses. From a sectorial point of view, we

expect transportation and utilities, the main beneficiaries of government

spending on key social infrastructure, as well as the service based wholesale
and retail sector, to be the fastest growing sectors of the economy in 2016.

Inflation is expected to record an acceleration in 2016, but remain relatively

low compared to previous years. We think that reform to energy prices will be
a major driver for inflation in the short-term. In addition, the housing segment
has been the largest contributor towards headline inflation throughout 2015.
more home-seekers will continue to rent property in 2016 in anticipation that
affordable housing may be available soon for purchase. This should push up
demand for rental units and put further pressure on the rentals for housing
segment. We also maintain our view that there will be some local inflationary
pressure as a result of the high level of consumer spending. Pressure on
domestic foodstuffs will likely remain subdued as international food prices
continue their deflationary trend. Despite the heightened speculative trading
against the Saudi Riyal in the forward market, we do not foresee any changes
to the Riyals peg to the Dollar. The stronger outlook for the US Dollar and
the prospect of higher interest rates may also put further downward pressure
on prices of imports. Oil exports are forecast to fall slightly, while imports
will remain unchanged from their 2015 level. Investment income will rise,
benefiting from the higher interest rate environment. This will cause the
current account to record a smaller deficit at 6.3 percent of GDP.

Global oil prices have fallen sharply over the past seven months, leading
to significant revenue shortfalls in many energy exporting nations, while
consumers in many importing countries are likely to have to pay less to
heat their homes or drive their cars.
From 2010 until mid-2014, world oil prices had been fairly stable, at around
$110 a barrel. But since June prices have more than halved. Brent crude
oil has now dipped below $50 a barrel for the first time since May 2009
and US crude is down to below $48 a barrel.
The reasons for this change are twofold - weak demand in many countries due
to insipid economic growth, coupled with surging US production.
Added to this is the fact that the oil cartel Opec is determined not to cut
production as a way to prop up prices.
So who are some of the winners and losers?

Russia: Propping up the rouble

Russia is one of the world's largest oil producers, and its dramatic interest
rate hike to 17% in support of its troubled rouble underscores how heavily
its economy depends on energy revenues, with oil and gas accounting for 70%
of export incomes.
Russia loses about $2bn in revenues for every dollar fall in the oil price, and
the World Bank has warned that Russia's economy would shrink by at least
0.7% in 2015 if oil prices do not recover.
Despite this, Russia has confirmed it will not cut production to shore up oil
prices.

"If we cut, the importer countries will increase their production and this will
mean a loss of our niche market," said Energy Minister Alexander Novak.
Falling oil prices, coupled with western sanctions over Russia's support for
separatists in eastern Ukraine have hit the country hard.
The government has cut its growth forecast for 2015, predicting that the
economy will sink into recession.
Former finance minister, Alexei Kudrin, said the currency's fall was not just a
reaction to lower oil prices and western sanctions, "but also [a show of]
distrust to the economic policies of the government".
Given the pressures facing Moscow now, some economists expect further
measures to shore up the currency.
"We think capital controls as a policy measure cannot be off the table now,"
said Luis Costa, a senior analyst at Citi.
While President Putin is not using the word "crisis", Prime Minister Dmitry
Medvedev has been more forthright on Russia's economic problems.
"Frankly, we, strictly speaking, have not fully recovered from the crisis of
2008," he said in a recent interview.
Because of the twin impact of falling oil prices and sanctions, he said the
government had had to cut spending. "We had to abandon a number of
programmes and make certain sacrifices."
Russia's interest rate rise may also bring its own problems, as high rates can
choke economic growth by making it harder for businesses to borrow and
spend.

Venezuela is one of the world's largest oil exporters, but thanks to economic
mismanagement it was already finding it difficult to pay its way even before
the oil price started falling.
Inflation is running at about 60% and the economy is teetering on the brink of
recession. The need for spending cuts is clear, but the government faces
difficult choices.
The country already has some of the world's cheapest petrol prices - fuel
subsidies cost Caracas about $12.5bn a year - but President Maduro has ruled
out subsidy cuts and higher petrol prices.
"I've considered as head of state, that the moment has not arrived," he said.
"There's no rush, we're not going to throw more gasoline on the fire that
already exists with speculation and induced inflation."
The government's caution is understandable. A petrol price rise in 1989 saw
widespread riots that left hundreds dead.

Saudi Arabia: Price versus market share

Saudi Arabia, the world's largest oil exporter and Opec's most influential
member, could support global oil prices by cutting back its own production,
but there is little sign it wants to do this.
There could be two reasons - to try to instil some discipline among fellow
Opec oil producers, and perhaps to put the US's burgeoning shale oil and gas
industry under pressure.
Although Saudi Arabia needs oil prices to be around $85 in the longer term, it
has deep pockets with a reserve fund of some $700bn - so can withstand lower
prices for some time.

"In terms of production and pricing of oil by Middle East producers, they are
beginning to recognise the challenge of US production," says Robin Mills,
Manaar Energy's head of consulting.
If a period of lower prices were to force some higher cost producers to shut
down, then Riyadh might hope to pick up market share in the longer run.
However, there is also recent history behind Riyadh's unwillingness to cut
production. In the 1980s the country did cut production significantly in a bid
to boost prices, but it had little effect and it also badly affected the Saudi
economy.

Opec: Not all are equal

Alongside Saudi Arabia, Gulf producers such as the United Arab Emirates and
Kuwait have also amassed considerable foreign currency reserves, which
means that they could run deficits for several years if necessary.
Other Opec members such as Iran, Iraq and Nigeria, with greater domestic
budgetary demands because of their large population sizes in relation to their
oil revenues, have less room for manoeuvre.

They have combined foreign currency reserves of less than $200bn, and are
already under pressure from increased US competition.
Nigeria, which is Africa's biggest oil producer, has seen growth in the rest of
its economy but despite this it remains heavily oil-dependent. Energy sales
account for up to 80% of all government revenue and more than 90% of the
country's exports.
The war in Syria and Iraq has also seen Isis, or Islamic State, capturing oil
wells. It is estimated it is making about $3m a day through black market sales
- and undercutting market prices by selling at a significant discount - around
$30-60 a barrel.

United States: Fracking boom

"The growth of oil production in North America, particularly in the US, has
been staggering," says Columbia University's Jason Bordoff.
Speaking to BBC World Service's World Business Report, he said that US oil
production levels were at their highest in almost 30 years.
It has been this growth in US energy production, where gas and oil is
extracted from shale formations using hydraulic fracturing or fracking, that
has been one of the main drivers of lower oil prices.
"Shale has essentially severed the linkage between geopolitical turmoil in the
Middle East, and oil price and equities," says Seth Kleinman, head of energy
strategy at Citi.
Even though many US shale oil producers have far higher costs than
conventional rivals, many need to carry on pumping to generate at least some
revenue stream to pay off debts and other costs.

Europe and Asia: Mixed blessings

With Europe's flagging economies characterised by low inflation and weak
growth, any benefits of lower prices would be welcomed by beleaguered
governments.
A 10% fall in oil prices should lead to a 0.1% increase in economic output,
say some. In general consumers benefit through lower energy prices, but
eventually low oil prices do erode the conditions that brought them about.

China, which is set to become the largest net importer of oil, should gain from
falling prices. However, lower oil prices won't fully offset the far wider effects
of a slowing economy.
Japan imports nearly all of the oil it uses. But lower prices are a mixed
blessing because high energy prices had helped to push inflation higher, which
has been a key part of Japanese Prime Minister Shinzo Abe's growth strategy
to combat deflation.
India imports 75% of its oil, and analysts say falling oil prices will ease its
current account deficit. At the same time, the cost of India's fuel subsidies
could fall by $2.5bn this year - but only if oil prices stay low.

How Saudi Arabia Benefits From Low Oil Prices

On June 19, 2014 Brent oil futures closed at $115.06, its highest level for the
year. After that, oil prices started to free fall and as of March 12, 2015 oil was
trading around $58 per barrel. Experts have two main reasons for this
dramatic decline: the increase of US shale production and an economic
slowdown in Europe and Asian giants China and India, some of the biggest oil
importers. The former doesn't seem like a strong argument because US shale
production is only a tiny fraction of total daily oil production worldwide,
around 90 million barrels, and therefore less likely to have a significant effect
on prices (source: www.eia.gov). So low demand is more likely the primary
reason that drives the oil price down. (For more, see: Oil Price Analysis: The
Impact Of Supply & Demand).
Figure 1: Oil price needed to balance the budgets.

The dramatic decrease in oil prices have mostly hurt oil exporting countries'
economies in the following ways:
1. Oil revenue is an important part of financing government expenditure.
Therefore, low oil prices result in budget deficits, forcing governments to seek
other sources to finance the deficit or reduce spending. (The above figure
shows the oil price needed to balance the oil exporters budget).
2. Lower oil prices also mean lower foreign currency inflows, leading to a
decrease in the countries foreign currency reserves. Almost all oil exporting
countries economies depend on the import of goods or services and currency
reserves finance this foreign trade. Decreasing currency reserves would lead
to devaluation of local currencies against major international currencies such
as the dollar and the euro.

OPEC, a consortium of oil-exporting nations, decided to maintain the current

production level at a meeting in November 2014 despite expectations of a
production cut. Saudi Arabia - the biggest oil producer with around 30 percent
quota of the organization's total production (See Figure 2 below) - blocked
calls for a production decrease from poorer countries in the organization.

Why did the country opt not to cut production? Saudi Arabia is one of the
main players in the oil market, supplying 12-13 percent of the total daily oil
output worldwide. As the second biggest oil producer after the US, it wants to
preserve its share in the market and a cut in production would threaten this
share, which takes a long time to regain.
Together, OPEC countries contribute about 40 percent of total daily oil supply
worldwide, leaving 60 percent of the market share uncontrolled and making
Russia and the US (Saudi Arabia's biggest competitors) dominant in the
market. There is also no guarantee that a price increase resulting from a

production cut would be enough to justify the decrease in supply and bring in
the oil revenue that is crucial to balancing the budget.
Another possible reason behind the decision to maintain the production level
is that Saudi Arabia wants to kick the smaller oil exporters - who would not be
able to manage low oil prices for too long - out of the game and thereby
increase market share by a couple of percentage points. In the short run, all oil
exporting countries including Saudi Arabia are affected by the low oil prices.
But Saudi Arabia benefits in the long run with estimated currency reserves of
about $700 billion, allowing it to bear current low oil prices for a few more
years.
Low oil prices also give Saudi Arabia political power over other oil exporting
countries that are its political rivals. For example, Saudi Arabia clashed with
Russia and Iran over the Syrian conflict when the latter kept supporting
Bashar al-Assad's regime against Saudi Arabia and its western coalition.
The Bottom Line
Saudi Arabia's large currency reserves and dominant position in the oil market
allows it to manipulate the current scenario to its favor. The country's ability
to tolerate low oil prices for much longer than its competitors helps it squeeze
weaker competitors out of the market and strengthen its political position
against countries like Russia and Iran.
THE gold price, which hit a five-year low on July 20th, reflects supply and
demand right now, and also expectations about the future. The yellow metal
serves two purposes: it is a commodity (used in electronics, jewellery and
dentistry, for example) and a store of valueespecially as an insurance policy
against political upheavals. But gold is unlike other assets: it brings no
income, and it costs money to store it. For now the shiny metal, and the hardbitten investors who favour it, are in trouble. Gold rallied strongly after the

financial crisis, but the price peaked in 2011 and has been falling ever since
(see chart). Some believe it could go below $1,000 an ounce this year.

The most immediate reason for golds woes is the strong dollar. Gold is priced
in dollars, so if the American currency goes up, investors mark down the
yellow metal accordingly. An added factor is that the dollar is rising because
of the revival of the American economy, which is bringing the prospect of
higher interest rates. That is bad news for gold. Higher interest rates increase
the opportunity cost of holding zero-yield assets: the money tied up uselessly

in bullion could be earning a return if invested in treasury bills or other debt.

Strong corporate earnings have a similar effect: when dividends are generous,
it hurts more to miss out on them.
The big hope for gold fans was that China, which aims to make the yuan into
a reserve currency, would boost its gold stocks to the hefty levels held by
Western central banks, in order to make it credible in international eyes. But
this does not seem to be happening. China has raised its gold reserves a bit.
But its bullion hoard is still puny, and as a share of total reserves, Chinas gold
holdings are falling.
Gold is also suffering because of a spate of unusually good political news. The
euro zones deal on Greece has reduced the chance of a messy default, and of
the break-up of the single currency. The nuclear deal with Iran reduces the risk
of war (which tends to boost gold). It also raises the chances of a broader
agreement on other Middle East issues such as Syria. That leaves pessimism
as the main reason for holding gold. Some gold bugs believe that the scale on
which central banks are creating money out of thin air (quantitative easing
in the jargon of monetary policy) will eventually doom the whole edifice of
international finance. But for now public confidence in fiat money (that is:
currency backed by promises, not precious metal) is undimmed. And, wags
say, if the world economy does indeed collapse completely, lead (in the form
of bullets) may be more useful than gold.
Worldwide: How Has The Drop In Oil Prices Affected Other Commodities?
The effects of the dramatic drop in the price of both Ice March Brent, the
international oil marker, and its US counterpart Nymex March West Texas
Intermediate, have been widespread. This is impacting not only the oil
services industry, where many firms have cut their capital budgets as well as
jobs, but also a number of markets across the world. The commodities market,
in particular, has been widely affected with the prices of metals such as

copper, lead and nickel dropping, albeit not as dramatically as oil, and the
price of gold increasing.

In passing, it is worth noting that the death of King Abdullah in January 2015
prompted some investors to bet on a change in strategy as a result of the
change in the leadership of Saudi Arabia, OPEC's largest producer and de
facto leader, with Crown Prince Salman succeeding King Abdullah. However,
many analysts expect King Salman and Ali al-Naimi, Saudi Arabia's oil
minister, to stand by the existing Saudi oil policy, at least in the near term.
That is, to allow market forces to determine the oil price and press ahead with
unrestrained production of crude in order to eclipse more marginal producers
and to not risk losing market share, despite the effects that this has had on the
price of oil.

How has the drop in oil prices affected other commodities?

With oil prices down more than 50% since June its worth looking at what
commodities are likely to be most affected by the slump and whats happened
so far. The relationship is complex though and it may be too early to draw any
firm conclusions. Given that energy accounts for up to 50% of the production
cost of many commodities, a drop in the oil price reduces the price floor. In
the longer term though all commodities could see higher demand (and prices)
if the drop in the oil price eventually stimulates an increase in economic
growth

In terms of agricultural commodities corn is most directly affected by lower

oil prices as lower energy costs reduce the cost of production, increase
margins and encouraging more planting. Corn is also used in bio-ethanol and
so lower corn prices could see higher demand.

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However, cotton has the largest per-acre energy costs of all agricultural
commodities so it is likely to see the steepest falls. According to a recent
report from Societe Generale the historical correlation between cotton and
crude is the highest across all commodities at 0.45:1.

The impact on metals is more complex. According to Macquarie aluminum

production has the highest energy-related costs at around 40%, copper the
lowest at 18% with gold coming in second last with 22% of production costs
related to energy prices.

While electricity accounts for 40% of the production costs of aluminum, the
most energy intensive of the base metals, thermal coal is the predominant
power-source rather than crude. However, during periods when crude prices
are driven to extreme highs or lows the relationship between crude and
thermal coal become much closer potentially leading to a higher correlation
between crude and aluminium prices.

Gold also has a complex relationship with crude. Lower oil prices, if reflected
in a decline in fuel prices could increase consumer spending on gold jewelry,
particularly in countries like India who stand to benefit greatly from lower
crude prices. However investment demand for gold could decline if lower oil
prices lead to lower inflation.

Macquarie note that in in recent years platinum, silver and aluminum have had
the highest correlation with oil prices but over the longer term platinum,
copper and tin had the highest correlation with oil prices with palladium the
weakest correlation.

Finally, the effect on natural gas prices is more direct, at least in the short
term. With gas contracts linked to oil (particularly in Europe and Asia) a
decline in the oil price will feed directly into gas prices. In the U.S. the decline
in oil price could encourage shale drillers to use more gas rigs in preference
over oil, increasing gas supplies and leading to a further drop in gas prices.

Of these commodities heres what happened since crude began its plunge in
mid-June corn (down 12%), cotton (21%), aluminium (unchanged), copper
(down 7%), gold (down 8%) and US natural gas (down 37%). This would
tend to support the previous analysis, particularly suggesting natural gas and
cotton are the most vulnerable to the fall in crude prices. However, it will be
sometime before the full effect is felt, particularly the timing and scale of any
demand side impact.
Strong supply growth and the strength of the US dollar are two important
factors in the fall in commodity prices. One other is the impact of lower oil
prices. Given that energy accounts for up to 50% of the production cost of
many commodities, a drop in the oil price reduces the cost of production for
many other commodities.

In terms of agricultural commodities corn is most directly affected by lower

oil prices as lower energy costs reduce the cost of production, increase
margins and encouraging more planting. Corn is also used in bio-ethanol and
so lower corn prices could see higher demand.

However, cotton has the largest per-acre energy costs of all agricultural
commodities so it is likely to see the steepest falls. According to a recent
report from Societe Generale the historical correlation between cotton and
crude is the highest across all commodities at 0.45:1.

The impact on metals is more complex. According to Macquarie aluminum

production has the highest energy-related costs at around 40%, copper the
lowest at 18% with gold coming in second last with 22% of production costs
related to energy prices.

While electricity accounts for 40% of the production costs of aluminum, the
most energy intensive of the base metals, thermal coal is the predominant
power-source rather than crude. However, during periods when crude prices
are driven to extreme highs or lows the relationship between crude and
thermal coal become much closer potentially leading to a higher correlation
between crude and aluminium prices.

Gold also has a complex relationship with crude. Lower oil prices, if reflected
in a decline in fuel prices could increase consumer spending on gold jewelry,
particularly in countries like India who stand to benefit greatly from lower
crude prices. However investment demand for gold could decline if lower oil
prices lead to lower inflation.

Macquarie note that in in recent years platinum, silver and aluminum have
had the highest correlation with oil prices but over the longer term platinum,

copper and tin had the highest correlation with oil prices with palladium the
weakest correlation.

The sharp fall in oil prices amid deteriorating sentiment over the global
economy has made investors weary of investing in other commodities.

Copper, in particular, has been hit very hard, slumping to its lowest price
levels in nearly six years. This was triggered by aggressive selling by Chinese
hedge funds earlier this month when the market was on the edge because of
the collapse in the oil price and when physical demand in China was weak
because of the approaching lunar New Year holiday. Other metals have also
taken a hit, with nickel and lead experiencing recent sharp decreases.

As the price of oil has dropped, gold, on the other hand, has experienced its
highest price level since August 2014 as many investors have sought to invest
in the market to park their capital. With the Euro falling to an 11 year low as a
result of a number of factors including the Swiss National Bank's decision to
decouple from the Euro and the European Central Bank's quantitative easing
measures, gold has risen very quickly.

On top of a growing trend for banks to dispose of their commodities

businesses, there is a debate whether banks will continue to finance trading in
commodities. Oil, at least in the near future, is likely to provide a low return
with most commentators thinking that the price will not rise substantially for
the foreseeable future, with some even going so as far as stating that the price
will fall as low as USD20 per barrel. Therefore, the incentive for banks to
finance this particular commodity would appear to have fallen away. This

could see a space open for non-bank lenders to come into the market and play
a much more active role in the financing of commodities. These entities are
generally subject to less regulation and have access to a more diverse set of
methods to inject capital into financings.

Impact on existing contracts

In the oil market, many, if not most participants will enter into hedging
contracts against a price fluctuation. However, this is often a hedge against a
rise in the oil price and some participants will, as a result of the current
conditions, have found that they have been asked to make margin payments to
hedge counterparties as they are 'out of the money' on the hedging contract.

Exit options?

Parties may find it difficult to remove themselves from their existing

commodities contracts.

Force Majeure: A force majeure clause allows one party who has been subject
to a pre-defined event to suspend performance under the contract, or , in a
worst case scenario, allow one or both parties to terminate the contract. The
key point to note is that performance by the affected party should be rendered
impossible to perform (sometimes being severely hindered is also considered
to constitute force majeure). Some parties may look to rely on this provision,
however it is unlikely that the fall in oil prices will constitute a force majeure
event under contracts.

Material Adverse Change clauses: There is a possibility that parties could look
to material adverse change clauses in their agreements as a way of terminating
their contracts. However, these clauses are usually drafted to concern the state
of the individual contract participants (e.g. a party's credit rating) rather than
market realities. These provisions are also notoriously difficult to rely on in
the event of a termination. Of course, if a party's credit rating, for example,
were to be affected because of the fall in oil prices, then this could provide an
option for the other party to terminate under this type of provision.

What can parties do to counter the drop in oil prices?

It may be possible for parties to include, in future contracts, a clause which is

effectively a 'hedge' to be triggered by a pre-determined event (for instance a
defined rise or fall in the oil price, e.g. if oil drops below USDX per barrel).
This could give parties the ability to re-price the contract in this event, to
ensure the contract remains economically viable, or at least to be obliged to
enter into good faith negotiations around re-pricing. Depending on the level of
bargaining power between the parties, it may even be possible to incorporate
such a fluctuation as a termination event.

Existing contracts could also be reviewed to see if there is the possibility of

amending them to include such a clause, but re-negotiating an existing
contract which does not have a contractual mechanism for this already built in
would seem unlikely.

The full impact and the duration of the drop in oil prices remains to be seen;
but what is certain is that this is a worrying time for the commodities market.
Parties will have to consider the terms of their existing contracts as well as
continuing to consider ways to mitigate risk when embarking on transactions
in the future. This could include a renewed reliance upon derivatives as a way
of protecting against price and foreign exchange risk.

REFERENCE:
https://www.rt.com/business/327324-saudi-arabia-budget-oil/
http://susris.com/2015/12/29/saudi-arabias-2016-fiscal-budget-jadwa/
http://susris.com/2015/12/28/royal-decrees-on-states-budget-for-fiscal-year-2016/
http://www.bbc.com/news/business-29643612
http://www.investopedia.com/articles/investing/031715/how-saudi-arabia-benefits-low-oilprices.asp
http://www.economist.com/blogs/economist-explains/2015/07/economist-explains-17
http://www.mondaq.com/x/396914/Oil+Gas+Electricity/How+Has+The+Drop+In+Oil+Pric
es+Affected+Other+Commodities