Iran News ...


05/27/10

A Warning to Oil Producing Countries

By: Amir Naghshineh-Pour


Oil Exports by country (source: CIA factbook)

Oil prices and the world economy have broadly been correlated for the past few years. When worldwide economic growth accelerates, it is often coupled with higher oil prices and vice versa. The recent financial crisis threw oil prices on a rollercoaster ride. The prices ended their nine year rally in July of 2008 when they peaked near $150 a barrel. Then, they began to decline until December of 2008 when the prices bottomed out at around $34 a barrel. The prices resumed their advance since then. However, a new fundamental and speculative analysis points to a fresh weakening due to the sovereign debt crisis in Europe and overheating of China's economy. If these events become more acute, they will enforce a major burden to the global economic recovery at best or a worldwide double-dip recession at worst. For crude, the outlook for economic activity has long run below the premium that current price would suggest. This is something that oil producing countries need to be worried; in particular those with budgets that closely depend on oil revenues.

The recent looming European debt crisis has sent shivers to equity and commodity markets around the globe. The crisis in Portugal, Ireland, Italy, Greece and Spain (PIIGS) has severed confidence in the euro and the economic position of many European countries. It is highly probable that some of these European economies stumble into a double-dip recession. Even a global double-dip recession cannot be ruled out. Overall, there is no doubt that the European debt crisis will weight on the world economic recovery due to the globalized nature of world economies and a serious structural problem in Euro zone's economy. Many experts are growingly becoming concerned with the outlook for the Euro zone, and broader global macro economy. The general consensus is that the crisis in the private sector has now only swung to a government debt crisis, with government bond purchases and fiscal spending reductions only seen exacerbating the situation. ECB President Trichet just recently mentioned that the markets are in the worst predicament since WWI, and has appealed for a "quantum leap" of fiscal governance.

The debt crisis in Europe has reminded heads of states that governments will need to make deep cuts in expenditure in order to counterbalance budget deficits that were incurred to rescue their economies from the credit crisis. Investors remain worried that Greece, Portugal and Spain among others will need to ratify painful budget cuts to reduce their debts. These budget cuts, which may also include those of healthier European economies, will certainly delay worldwide growth. Furthermore, a comprehensive structural reform is urgently needed for Euro zone's economy; otherwise any aid packages will not be effective. The root cause of this structural problem can be sought in the fact that with a single monetary policy a broad spectrum of weak to strong economies cannot be managed at the same time. The present uncertainty towards the future of the European Union has made the future of the global economic recovery questionable.

In a parallel development, it seems that China's economy is overheating. This could be a sign of mandatory slowdown. Its equity market has already lost more than 20% of its value from its peak.1 As equity markets are usually a leading indicator of economic growth, the decline in the Chinese equity market points to a slower expansion in the near future. In addition, recent inflation data depicted that inflation is on the rise, which implies future interest rate hikes. Any rate hike is a break on economic growth. Just recently, China's economic planning agency predicted, due to higher inflation, the central bank will lift interest rates for the first time since 2007.

Furthermore, China strategist David Roche said China's economy is teetering on the edge of a major slowdown, though it's not a shakeout in the property market that's about the spark in the distress. Roche, an economic and political analyst, says the world's third-largest economy is now on the brink, faced with the inevitable reckoning that follows an extended bank-lending binge. "We've got the beginnings of a credit-bubble collapse in China" said Roche, predicting the economy will likely cool from its stellar double-digit growth rate to a 6% annual expansion as a result.2

The recent China's shift towards further dependence upon Europe as an export market is another area of concern for China's economy due the recent debt crisis in Europe. Other regional economies were paring back shipments to the EU as an overall percentage of global trade. Of China's global exports, the EU accounts for 21% stake today, up from 16.5% in 1999.3 Therefore, China is heavily exposed to any further slowdowns in the European economy amid a spreading debt crisis. In addition, considering the yuan/US dollar peg, the plummeting of the euro against the US dollar, and higher dependence of China's economy on Europe will certainly lower China's positive trade balance. Furthermore, if China goes ahead with appreciating its currency against the US dollar, the situation will become even worse for China's trade balance and hence for its economy.

Another subject that is worth noticing is the potential real estate bubble in some of China's major metropolitan areas.4 The popping of current real estate bubble could also send jitters to the global economy, since China is one of the major leaders of global growth. In the midst of the financial crisis, the Chinese government injected a massive amount of liquidity to prop up real estate lending and development to promote economic growth. No doubt that the stimulus package encouraged tremendous construction, lending, and speculative buying. Hence, if at some point China's real estate sector runs out of steam, the worldwide growth may be seriously threatened.

Since Greece's troubles seem to be turned into a European Union crisis (which may further be developing global implications), the crude prices have fallen as much as 20 percent from the 18-month highs set earlier this year. There is conviction in winding down risky positions across all the major asset classes. The pressing concern now is that the EU situation is deteriorating to an inexorable position that could tip the world's financial and credit markets back into turmoil.

Many economists are even more pessimistic. They have begun to lose confidence in European leaders' ability to contain the debt chaos. Their greater concern is that the Economic Union and its single currency could break apart has started to accelerate losses. The likelihood for the issues to develop into a wider contamination has started to generate discomfort among investors, which has begun to drag equity and commodity markets lower. Although there are some strong fundamentals in the overall European economy such as Germany for faster recovery, this issue has been overlooked with the developments in Greece dominating headlines. However, the debt crisis poses a threat to world economies as trade shrinks and banks may incur losses on European investments. Practically, all governments of advanced economies have to curb spending and raise taxes to reduce their budget deficits that will effectively dampen global economic growth.

Overall, the current situation could be an alarm ring for oil producing countries. The global financial slowdown will depress oil producing economies. Falling oil prices will be an unwelcoming event for them. With the exception of a handful of oil producing countries, the rest are heavily dependent on their oil revenues to finance their fiscal budgets. For the ones with large currency reserves in their sovereign wealth funds, bypassing lower revenues can be offset by using the cash they have accumulated in their funds. But for the ones with low cash reserves the situation can become very grim. Rising oil supplies and the prospect of slower growth as governments reign in spending may send crude prices further down.

Iran and Venezuela, among the major oil producing countries, have a unique situation. Both countries have squandered the windfall oil revenues they earned when crude prices soared in the first half of 2008, leaving them more vulnerable to lower prices. Both countries went on a massive spending spree. The substantial inflow of petrodollars into their accounts coupled with the faulty assumption that the oil prices would continue to rise triggered both countries to infuse billions of dollars into their economies. Both governments have frantically been openhanded in exhausting petro earnings and lowering interest rates that led to higher inflation and asset prices. And now both states need higher crude prices than in the past in order to break even as spending at home rises.

Neither country has substantial room for using the surpluses accumulated during the oil boom to support economic activity in the event of continued weakness. The majority of oil revenues have been spent on subsidized lending, massive bank credits, imprudent social spending, substantial imports, aids to other countries, and huge energy and food subsidies. Both countries need oil prices about $80 to $90 per barrel to fiscally break even. Knowing that the average petro price is less than $80 per barrel in 2010 so far, both countries are dealing with large budget shortages. In average, oil revenues are 80% to 90% of both countries' export earnings and about 50% of their federal budgets. As two of the biggest oil producing countries, Iran and Venezuela have become growingly dependent on oil earnings since the inaugurations of Ahmadinejad in Iran and Chaves in Venezuela. Therefore, if the existing condition persists, it is broadly expected that both governments will face serious economic challenges in the future.

The government of Iran has already moved on to reduce massive subsidies amid the ongoing political turmoil of the last year. There could only be one reason for doing so in this critical situation. Simply the government cannot afford to be as generous as before anymore. These subsidies have already crippled economic growth and made the economy very ill and vulnerable. Even though cutting these subsidies is a right pace in the right direction, considering its huge amount, which is close to $80 billion per fiscal year, may trigger temporarily high inflation and price instability. This is an extraordinary risk that the government has to take. Perhaps it has no choice. This is the price that the government and unfortunately the people have to pay for not paying attention to many warnings the government received from economic pundits.

Venezuela is not in better shape either. The inflation rate has already surged to more than 30% due to a surge in government spending, minimum wage hikes and easy access to credit.5 Any decline in oil income in the future will further undermine the government's ability to continue its lavish spending. Chavez has continued his efforts to tighten his grip on the economy by nationalizing many industries. He also just announced a dual exchange rate and started to crack down on brokerage houses for breaching the fixed exchange rates he established. In his latest move he announced that he would increase oil production at the end of 2010 perhaps because of fiscal shortages. These are all signs of desperation. This is a clear indication of future economic trouble for this socialist government. It seems that all of his economic policies have failed.

Considering the unfolding worldwide economic events, a possible global economic weakness, and lower commodity prices, it remains to be seen how these countries will cope with their troubled economies.

References:

1. Bloomberg.com, http://www.bloomberg.com.

2. Market Watch, "China analyst sees beginnings of unfolding credit bust," May 11, 2010, .

3. Market Watch, "China reports surprise $1.68 billion trade surplus in April," May 10, 2010, .

4. Time, "China's Property: Bubble, Bubble, Toil and Trouble," March 22, 2010, .

5. Yahoo.com, "Venezuela currency crackdown may worsen economy: analysts," May 21, 2010, .


About the Author: Amir Naghshineh-Pour (MBA) is the founder of Vesta Capital, LLC, a boutique capital management firm, in San Diego, CA USA. He can be reached via abibis@msn.com.

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