The trouble still brewing

Yesterday’s discussion at SAIS of Learning to Live with Cheaper Oil : Policy Adjustment in MENA and CCA Oil-Exporting Countries raised serious issues. Oil prices are now expected to remain “lower longer,” as IMF deputy managing director Min Zhu put it. While contributing to global growth, the price decline is posing serious economic and governance challenges to the rentier states of the region and their relatively poor dependent cousins.

The 2014 oil price decline resulted from three main factors: increased production of tight oil and gas, slackening demand (especially due to economic slowdown in China and Russia) and increased efficiency. While prices have risen sharply from their lows early this year, the IMF expects them to remain well below their previous peak, with only gradual increases over the next five years or so to around $75 per barrel.

Some efficiency gains have already been erased, as oil prices have risen from their lows at the sharpest rate ever, even if they are still far off their peak. The shale revolution is not going away, even if many less productive wells have been shut. But larger ones are still producing. Much of the shut-in capacity will return as prices rise again.

This puts the oil producers in a difficult and long-lasting bind. The immediate impact was on their foreign exchange rate reserves, which are down dramatically. Growth is slowing.  Budgets are being cut. The oil producers cannot continue to subsidize food and energy prices as well as avoid taxing their populations.

Sharply cutting their budgets however will not be a sufficient policy response, especially as it will have growth-reducing effects like limiting bank credit. The oil producers will need to undertake structural reforms to generate private sector growth that has heretofore been lacking. This is basically a good thing. Low oil prices will force producers to do what they’ve known for a long time they should have been doing, including cutting government jobs, reorienting it towards revenue collection rather than distribution and privatizing bloated state-owned enterprises.

But it is still difficult to picture how the oil producers will generate sufficient jobs to meet the needs of their bulging youth populations. If they somehow manage it, the social contract that has enabled the often non-democratic regimes to claim legitimacy will need revision, with citizens receiving less and asked to provide much more. Governing institutions will be under enormous strain as they try t o learn to collect taxes even as they reduce public services. Legitimacy will be in question. This is a recipe for trouble.

The fiscal squeeze will affect not only the oil producers themselves but also the states of the region to which they provide support, either in the form of aid or remittances. The eventual political consequences could be dramatic not only for the Gulf but also for Egypt, Jordan, Morocco, Pakistan and others. We have not seen the end of consequences “longer lower” will generate.