Middle East set for uphill battle in 2021 as oil volatility dominates

The coronavirus crisis has done more than wreak havoc on the world’s communities and infect millions of people — it has also sent global commodity markets into unknown territory.

In April, the price of West Texas Intermediate oil futures turned negative for the first time in history, while Brent Crude dropped below $20 a barrel for the first time in decades, as the global wave of coronavirus lockdowns deflated demand.

Despite oil experiencing a modest recovery since then, most experts predict the price of Brent Crude in 2021 will be between $30/bbl and $45/bbl. But that number pales in comparison to where it started 2020 — at around $66. As of October 9, Brent Crude was trading at $42.78. Experts say the earliest oil markets could return to pre-crisis demand levels is 2022-2023, following the deployment of a coronavirus vaccine.

While the fall in oil prices directly affected the Gulf region’s hydrocarbon-dependent sovereigns, it also indirectly impacted other Middle Eastern countries, in the form of lower remittance volumes, lower foreign direct investment and less generous financial support.

The double impact of coronavirus-related spending costs and declines in oil prices has left economic activity and growth tumbling across the Middle East.

“With the exception of Egypt, which is forecast to slow down to a modest 2.5% GDP growth for 2020, all other MENA countries are expected to experience a GDP contraction in 2020,” says Leila Benali, chief economist at Arab Petroleum Investments Corporation (Apicorp). “All are facing, at best, difficult trade-offs, or worse, daunting choices between reining in generous social support programmes or borrowing and over-spending, risking the currency crashing and soaring interest rates.”

Fiscal deficits across the region stand far above next year’s expected oil prices. Saudi Arabia’s fiscal breakeven price, for example, is thought to be about $63/bbl, while Oman’s is $72/bbl, according to the Institute of International Finance (IIF).

“Recovery in 2021 will be modest — in addition to the uncertainty surrounding Covid-19, we expect Brent to average $47/bbl in 2021, which is still far below pre-Covid levels in the $65 range. The major risk is if oil prices drop below $40 for a long time, in which case sovereigns will seriously struggle to finance their deficits,” says Garbis Iradian, chief economist MENA at the IIF.

The probability that oil prices will not recover to pre-pandemic levels puts sovereigns across the globe — in particular, those in the Middle East, a region replete with governments dependent on oil revenue — in critical positions.

Some governments have been pushed towards fiscal consolidation, while being forced to extend stimulus packages through tapping existing reserves and international debt markets, or accessing multilateral or foreign aid.

Those measures will continue to intensify in 2021 as sovereigns across the Middle East (and the whole world) come to grips with a new way of spending and living.

Some sovereigns in the Gulf that were hit particularly hard by the double-whammy of Covid-19 and low oil prices have been forced to reduce spending — such as Saudi Arabia, which has cut spending this year by about 10%.

However, ex-GCC countries in the Middle East, such as Jordan and Lebanon, and some North African countries, including Egypt, have had to sharply increase government spending, although their access to emergency IMF funding has helped. According to the IMF, $13.9bn has been dispersed across the Middle East and central Asia since the pandemic began.

“Only a few countries have the ingredients in place, in terms of governance, policy credibility, public finances management and a strong and sustainable economic basis, to be able to translate stimulus packages into productive debt and sustainable recovery,” says Apicorp’s Benali.

But one of the most important aspects of governance in the Middle East next year will be fiscal consolidation, in the form of taxation.

Experts say a tax revolution will need to take place across the region, especially in the Gulf.

Fiscal consolidation in the form of tax increases is likely to happen across the Middle East over the next year as governments scramble for income. It has already begun, as in July Saudi Arabia tripled VAT to 15% — a move that elicited a harsh reaction from many of its citizens. 

“The GCC still has a more generous tax system compared with the rest of the world, though taxation will have to adjust to become less dependent on oil while sustaining a wealthy average level of living,” says Gustavo Medeiros, deputy head of research at Ashmore Group.

The Gulf region in particular has a reputation for having generous welfare systems and providing large subsidies to their citizens, but that must change if these sovereigns want to favour economic growth amid a declining oil market.

“There is no choice but for GCC countries to increase non-oil revenue and restrain government spending, given the era of prolonged low oil prices,” says Iradian at the IIF. “It is likely that Bahrain and the UAE will follow Saudi Arabia and raise their VAT rates. Qatar, Kuwait and Oman have still not introduced VAT, but they eventually will. Kuwait is facing major problems in financing its deficit, so it could initiate major fiscal consolidation next year, following the parliamentary elections, by introducing VAT and cutting current spending.”

Many sovereigns have turned to international debt capital markets to fill their fiscal deficits this year, leading to what some are describing as a record year for bond issuance. That, they say, is set to continue in 2021 when corporates are expected to start funnelling into a market that dominated by sovereign issuance in 2020.

“So far this year, $102bn has been issued in the region, which is already substantially higher than last year’s figures and approaching an all-time record,” says Salman Ansari, managing director, head of capital markets, West, at Standard Chartered in Dubai.

According to Dealogic, $124bn has been signed across the entire Middle East since the start of the year.

Despite the inflated levels of uncertainty around commodities and Covid-19 in 2021, bankers say the Middle East will remain insulated from the worst of the shocks, as investor appetite appears insatiable.

“The GCC has shown itself to be exceptionally resilient to external shocks and the 2020 markets have proved this very well,” says Ansari at Standard Chartered. “While geopolitical risk may exist, secondary valuations across the region keep getting tighter, with 2020 seeing the lowest cost of funding, particularly across investment grade issuers in the region. As a result, for investors in 2020, GCC debt has proved itself to be tremendously insulated to external shocks.”

Issuers have exceeded expectations in recent months, raising record tenors at cheap levels.

Abu Dhabi, for example, raised the longest-ever bond in the region — a $5bn triple-trancher that included a $1.5bn 50-year tranche. Others also extended their curves.

“The kingdom has extended its dollar curve twice in 2020 — from 30 years to 35 years in its January issuance, and to 40 years in April, marking the largest EM order book in 2020, which is a testament for KSA’s balance sheet strength and transparency with global investors,” says Hani Almedaini, head of portfolio management at Saudi Arabia’s debt management office, the National Debt Management Centre.

Even sub-investment grade credits such as Bahrain, rated B2/B+/B+, managed to raise billions of dollars in multiple transactions, pointing to investors’ confidence in even the region’s weakest credits during a turbulent year.

However, the Middle East is split between countries that can easily absorb more debt and those that are at risk.

While increasing debt-to-GDP levels may be more damning for the Levantine Middle East countries, such as Jordan and Lebanon, those in the Gulf will be able to cope.

“A number of sovereigns have also successfully issued local currency debt this year, which was met with a lot of successes. Sovereigns in the Gulf are maturing and now have multiple avenues of fundraising available to them,” says Hussain Zaidi, managing director of EMEA and Americas syndicate at Standard Chartered in London. “We are not concerned about the implications of high levels of debt raising, because the debt-to-GDP ratios of the Gulf countries remain very manageable compared with emerging market peers.”

For some governments, the volatility in the oil market has reinforced the need for sovereigns to diversify away from hydrocarbon revenue. Sovereign wealth funds will play a critical role in doing that. The Middle East is home to some of the world’s largest, such as the Abu Dhabi Investment Authority which is estimated to have $580bn of assets.

“Sovereign wealth funds are helping to diversify oil-dependent economies and to achieve a surplus of capital. For example, Qatar’s income from investments has allowed it to achieve diversification, whereas other sovereigns in the region are still heavily focused on oil,” says Ashmore’s Medeiros.

Some sovereigns have begun to diversify using capital markets. In July, Saudi Arabia raised a green loan backed by Germany’s export credit agency — the first such loan signed in the region. Such financings facilitate transitions towards more environmentally conscious ways of spending, which most experts say the Middle East will need to embrace to prevent being badly affected by future commodity shocks.

Though some of the stronger sovereigns in the Middle East may be insulated from the worst impacts, the sub-investment grade credits of Bahrain and Oman are causing market watchers concern. Neither has a sufficient financial buffer, in the form of adequate public foreign assets that could be used to finance deficits.

“Bahrain and Oman are very concerning cases — debt-to-GDP levels and fiscal account dynamics have reached unsustainable levels and fiscal consolidation efforts have failed,” says Medeiros.

“At Ashmore, we have become more cautious on Bahrain, as we do not think its fiscal adjustments were effective enough. However, we had been overweight on Bahrain in 2018 and 2019.”