Blinking!!

By: Dr. M. Ray Perryman
Published in syndication October 26, 2016

On October 19, Saudi Arabia held its first international bond sale - EVER! The sale, which received orders of $67 billion for the $17.5 billion in bonds offered, is the largest to date from an emerging market economy. Investors eagerly welcomed the offering as a way to achieve further exposure in the Middle East given recent expectations that the price of oil will rebound next year. The kingdom offered dollar-denominated bonds with yields slightly higher than US Treasuries with similar maturities. In total, Saudi Arabia raised $5.5 billion of both 5- and 10-year bonds and another $6.5 billion in 30-year bonds.

This initial sale is expected to be only a beginning of multiple offerings which could total more than $100 billion through 2020. Saudi Arabia has traditionally seen about three-quarters of its revenue come from oil, and experienced a $100 billion deficit last year alone after years of surpluses and accumulating cash reserves.

In addition to raising revenue through bond sales, the country is taking other steps to deal with the budget crisis. The kingdom slashed public spending to meet revenue shortfalls, also decreasing government worker pay and subsidies. Capital expenditures are down by more than 70% this year, and infrastructure investments have dropped from a third of government spending in 2011 to only a tenth presently.

Since many of these actions have hurt the private sector and are harmful to the long-term growth of the country (not to mention threatening the power base of the royal family), Saudi Arabia has also adopted an economic reform program named "Vision 2030" looking to achieve a more balanced budget, diversify the economy away from oil, and lead to the creation of millions of non-oil jobs. Major parts of this plan include reforming the Saudi stock market in order to attract more foreign investors and accessing different sources of financing through bond issues. The kingdom has already issued over 190 billion riyals (around $51 billion) worth of domestic bonds since last year and recently borrowed $10 billion from international banks to meet budget shortfalls. Public debt is expected to increase from less than 8% to 30% of economic output by 2020.

Another part of Vision 2030 is privatizing state assets, including the state-owned Saudi Arabia Oil Company, better known as Aramco. The company will have an initial public offering (IPO) for less than 5% of the company. Proceeds from the IPO will help in part to establish a $2 trillion sovereign wealth fund for the kingdom.

Saudi Arabia is not alone in struggling with budget deficits due to the long-standing low oil prices. The Gulf region has been particularly hard hit and the IMF has estimated that these countries will experience a combined budget deficit of $765 billion over the next five years. Many other Gulf nations have already issued international bonds, including the emirate of Abu Dhabi which raised $5 billion in April, Oman which sold $2.5 billion worth of bonds in June, and Qatar which raised $9 billion in May. The success of the Saudi Arabian offering has also opened up the door for other nations who are looking to issue bonds in the future, including Jordan.

OPEC Members have been following a market share strategy, led by Saudi Arabia, to increase production in order to lower the oil price and shut down higher-cost oil producers such as the US shale segment. However, the burden on Gulf nations is large and growing, and there is more incentive every day to abandon the market share strategy and cut production. Preliminary agreements have been reached and while some are optimistic about the OPEC meeting at the end of November, others are concerned over the current flooding of the crude market. Production has recently increased in some nations, such as Nigeria and Libya that have recovered from production disruptions and Kazakhstan which just finished drilling in its new Kashagan oilfield. Russia has been experiencing record output and while the nation has pledged to cooperate with OPEC, its exact level of commitment has been vague.

Since many of the largest oil exporters are keenly feeling the effects of low oil prices on their budgets, the likelihood that OPEC members will agree to some sort of production cut is growing. Many analysts expect oil prices to rebound sometime next year to the $60 range, though the recent oversupply will take some time to resolve. While this would be a good sign for the oil industry and would add to the modest resurgence we have seen in drilling after projects bottomed out early this summer, an oil surge of the magnitude we saw a few years ago is unlikely for the foreseeable future. Nonetheless, OPEC in general and Saudi Arabia in particular have now blinked, which is the first step toward a more orderly market and more normal levels of activity in the United States.