The perils and blessings of low cost oil for growth markets

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The perils and blessings of low cost oil for growth markets
The perils and blessings
                 of low cost oil for
                 growth markets
PwC’s Growth
Markets Centre
February 2015

                 The end of an era                                  challenges for their continued growth, though
                                                                    all for differing reasons. Brazil and India went
                 Without a doubt, growth markets have presented     through elections last year and are in need of
                 a remarkable story during the past two decades.    significant reforms to revive their economies,
                 Specifically in the aftermath of the global        whilst Russia found itself entangled in a
                 financial crisis, all eyes were on those markets   geo-political conflict and is now dealing
                 that presented a promise of growth, with the       with the political and economic sanctions
                 U.S., Europe, Japan and most other developed       that resulted from it. China is in the midst of
                 economies stagnant or even in decline. Though      a major transformation of its economy, meant
                 many developing countries witnessed high-paced     to make it far less dependent on export and
                 growth, some of the most impressive growth and     investment-driven growth while increasing
                 development happened in the bigger emerging        its share of higher value-add activities. Parts
                 economies, most notably the ‘BRICs’. While at      of Africa, in the meantime, had to battle with
                 the same time, Africa emerged as one of the        the full magnitude of the deadly Ebola virus,
                 world’s new frontiers of growth.                   regional conflicts, and political change. A
                                                                    period of fast paced, ‘catch-up growth’ seemed
                 Recently, it is becoming more apparent that        to have ended, with an evident impact on the
                 economic growth rates in the growth markets        world economy.
                 have begun to slow down. Many of the major
                 developing economies are facing significant
Even though most growth markets were                        In a world still largely running on fossil fuels
facing stronger headwinds to their rates of                 and with so many developments and moving
development, it was at least in an environment              parts, the question quickly arises whether the
of steadily increasing or stable oil prices which           recent oil price development is a good thing or
provided some predictability. The recent                    not – especially for the growth markets.
dramatic drop in the oil price however, has
removed this pillar of stability and has placed
many growth markets back under a cloud of                   The impact of lower oil
uncertainty and unpredictability.                           prices on growth markets
                                                            Many of the immediate and medium term
The steep drop in oil prices                                effects on both developed and developing
                                                            markets have been well highlighted in recent
Since the middle of 2014, the oil price witnessed           months. It is mostly the longer term effects
an exceptional development and sharply dropped              that are leading to further debate. However,
by over 50%, to a level of around US$50 a barrel1           what is clear is that countries, governments,
today. The underlying factors of this ‘sudden’              companies and consumers alike are being
development are widely acknowledged and                     impacted, though in various ways.
reflect the rationale of the market. While
obviously the decline in economic growth in
                                                            Direct impacts
many of the growth markets, especially in China,
                                                            In the short term there are some obvious
diminished the demand for oil, it is a combination
                                                            ‘winners’ – big net importers such as India
of factors that started the sharp supply-driven
                                                            and China – and ‘losers’ – net exporters such
price decline we are witnessing today.
                                                            as Russia and Venezuela – from this drop in oil
                                                            prices. However, not all importers and exporters
With the global demand for oil already
                                                            will benefit or suffer to equal measure.
declining, a number of additional factors have
created an oil supply increase and build-up of
                                                            Those who lose – Net oil exporters, with
reserves that was not seen in this way before:
                                                            economies and national budgets that still very
a massive increase in oil extraction by the U.S.,
                                                            much depend on the export of oil and have
a limited impact of ongoing conflicts in the
                                                            built up few reserves, are the ones that feel the
Middle East on production (e.g. in Iraq), and
                                                            biggest pain. For example, Russia, Venezuela
more recently, the strategic decision of Saudi
                                                            and Malaysia all have been hard hit due to the
Arabia and other GCC OPEC members to not cut
                                                            proportion of oil revenues as a percentage of
back on oil production and putting the onus of
                                                            their overall economy. They – and others – are
marginal barrel pricing on non-OPEC members.
                                                            struggling with immediate consequences, such
                                                            as reduced government budgets, growing
The dynamics that led to the sudden drop in oil
                                                            deficits, and volatile exchange rates.
price had already been in the making for a
longer period. It is the U.S.’s rapid increase in
energy production that is the more surprising               The role of the oil majors
event and it has made the increase in supply                Not all oil exporting countries are affected
and resulting drop in oil price more dramatic               to the same extent, as the ‘oil majors’ are
than previous declines, and less likely to                  likely to look at the cost of production in
rebound in the short term.                                  these countries and refine their activities
                                                            accordingly, by reducing production from
By making use of new – and previously                       those now less profitable sites. Not only will
uncommercial – techniques such as horizontal                these countries be affected by the reduced
drilling and fracking, the U.S. has transformed             price per barrel, but also by the volumes now
from a net oil importer into one of the major               being produced in their countries. However,
producers in less than a decade. It has made                the case is even more dire for those countries
the U.S. one of the biggest oil and gas suppliers           which are in the ‘Exploration’ phase, (such as
in the world, ahead of Russia and with                      Uganda) as CAPEX is one of the first areas that
expectations that it will overtake Saudi Arabia             the oil majors will review and those sites which
in the coming years. Compounding all this, oil              are not yet producing oil or are in the early
production is also increasing in countries like             stages of exploration will most likely be either
Iraq, where daily production has even reached               put on hold or exploration activities reduced.
pre-conflict levels again.                                  This means that certain growth markets will
                                                            receive less revenue from exploration licenses
                                                            and will have to wait longer for revenues from
1 Both the European “Brent” and American “WTI” Price        near term oil production.
index are currently in the range of USD 50–60 per barrel,
as per February 2015
Those who gain – Growth markets which are             Oil and related commodity intensive
net importers of oil on the other hand, are the       industries such as Transport and Logistics,
countries that are experiencing the most              Agriculture, and Manufacturing will also
obvious immediate benefits. They are spending         benefit from these reduced costs, contributing
less on their oil imports and are able to use         as said to lower inflation and enhanced
these savings to reduce their trade deficit,          production and employment.
improve government budgets, reduce inflation
and redistribute money to infrastructure              Cheaper oil does not necessarily mean cheaper
projects. However, even here there are markets        electricity, as many growth markets are dependent
which are impacted more than others. China is         on coal for energy production. However, most
the world’s biggest importer of oil, but it also      of these markets do not have sufficient levels
has significant oil interests in supplying            of power available and are dependent upon
countries and some of its savings are offset by       large numbers of oil fuelled generators. It is
these devaluated interests. India, on the other       here that the financial benefits will be most
hand only has a nascent oil industry, but it is       felt by those reliant on back-up power.
the world’s third biggest oil importer and
hence arguably benefiting to a greater extent.        These benefits are not a given and growth
                                                      markets’ governments who are fortunate to
Indirect impacts                                      fall into the ‘winners’ camp need to act on this
In addition to the more immediate and direct          opportunity by employing the right reforms,
impacts, the oil price drop will have various         developing more infrastructure, reducing
knock on effects for growth markets’                  their dependency on oil, while passing on the
governments, businesses and consumers.                positive effects to consumers to reduce their
                                                      cost of living. The ‘losers’, will be really forced
Governments, which are now paying                     to review their dependency on oil at the
significantly less for their crude oil imports, can   hardest time.
remove subsidies – such as the fuel subsidies in
India and Indonesia – with much less financial        Impacts on key growth markets
impact on and opposition from consumers.              Against this backdrop, it is interesting to
In addition, these governments are able to            see how some of the world’s major growth
free up more of their budgets to reduce deficits,     markets are most impacted by the oil price
gradually increase fuel taxes and improve             developments, and how their respective
infrastructure, increase housing, enhance             governments are responding.
transportation and increase manufacturing.

Nigeria                                               country’s GDP. With its high dependence on
As major oil exporter, Nigeria has felt a             oil, the Nigerian economy is poorly diversified,
significant negative impact of recent events on       and its tax base is lower than other economies
its economy. Market growth expectations for           at a similar level of development. The negative
2015 have fallen significantly, precipitated by       effects of the drop in oil price adds to a set of
a declining oil price and increase in political       already existing concerns such as production
instability, most recently seen in a delay to         failures, spillages, high bunkering and theft
presidential elections by six weeks.                  rates which all put downward pressure on
                                                      production volumes.
The oil sector has changed the structure of
the Nigerian economy since production began           A falling oil price has traditionally placed
in the 1960s. Today it is the main source of          significant pressure on the local currency’s
export earnings and government revenue.               (Naira) exchange rate band. The Central Bank
In 2013, Nigerian oil accounted for 90% of            of Nigeria has responded to the recent oil price
Nigeria’s export revenues, around 70% of the          decline by drawing down on reserves and
government’s income, and nearly 11% of the            accepting greater exchange rate flexibility.
India                                               for additional revenue of up to US$2.4 billion
A falling crude oil price is certainly a blessing   (INR 15,000 crore) this year. Besides the
for India and coming at the right time, as it       benefits to the government’s coffers, the public
helps macroeconomic management -both                sector oil companies’ profitability could benefit
budget and fiscal – by improving the macro          too from these measures in the longer term.
fundamentals such as inflation, fiscal deficit
and current account deficit reduction. India        A lower oil price will provide room to the
imports more than two-thirds of its energy          Reserve Bank of India in adopting a growth-
requirement, which constitutes around 30%           centric approach while reviewing monetary
of total imports. A fall of each dollar in oil      policy. It results in lower inflation, gives
price, saves the country about US$0.64 billion      comfort to the Reserve Bank of India in
(INR 40 billion). Adding to that, the fall in       cutting interest rates and provides flexibilities
international oil prices will help reduce           in budget and fiscal management. The biggest
subsidies that sustain the domestic prices of       impact on India can be that the government,
oil products (LPG, kerosene) in India. This has     if it wants, will now be able to spend more on
made it possible for the Finance Ministry to        much needed and expected development.
increase excise duty rates for petrol and diesel

China                                               retail consumers. Chinese consumers are, at
As the largest net importer of oil, China           any rate, more likely to save, instead of spend a
benefits significantly from lower prices. China     significant portion of their unexpected windfall
is taking advantage of low prices to build up       until real estate prices, stock markets, and the
it's oil inventory in the Strategic Petroleum       economy in general, stabilise and recover.
Reserve. Moreover, the negative impact on its
own state-owned oil companies is more than          Perhaps more importantly, a sustained lower
offset by lower operating and transportation        oil prices may frustrate Beijing’s attempts to
costs in general, while Chinese consumers in        achieve greater energy independence through,
time will pay less for heating their houses,        for example, domestic shale production. It
fuelling their cars, and a wide variety of other    may also reduce the negative environmental
items. In fact, the World Bank estimates that       impact of the hyper-growth of the last 30
lower oil prices will boost China’s GDP by          years through investments in numerous green
0.1-0.2% and further widen its current              energy initiatives, including wind and solar
account surplus by another 0.4–0.7% of GDP.         power as well as electric vehicles.

Nevertheless, the impact on China is much           Indeed, the most important impact of lower oil
lower than for other oil-importing countries,       prices for China may well be that it provides
as coal still accounts for roughly two-thirds of    Beijing with additional headroom to slow
total energy consumption (versus ca. 18% for        down further investment-led growth, while
oil). In addition, the continued existence of       implementing much-needed structural
price controls set by the government reduces        reforms, upgrading the industrial base,
the pass-through effect of lower oil prices to      and cleaning up the environment.
Russia is probably impacted more than most
Russia                                                           other oil exporters as it is simultaneously
The decline of oil prices globally has had a                     suffering from sanctions (including a self-
severe impact on Russia. The country is one                      imposed ban on food imports from the EU
of the largest oil exporters and its economy                     which has increased inflation). These
has insufficiently diversified. Russia is highly                 sanctions limit its access to financing in
dependent on Oil & Gas revenues for both tax                     particular and have had a negative impact on
revenues and further investments into the                        interest rates, deepening the crisis. As Russia
economy. Over the years, there has been a                        has substantial reserve funds in foreign
very strong correlation between the rouble                       currency, it can survive lower oil prices for
and the oil price due to this dependency                         a longer period if these sanctions are lifted.
leading to a large fall of the rouble against                    However if oil prices would bounce back to a
other major currencies. The benefit for the                      level below US$90 (which could very well be
country is that this has in the short term                       the case given the cost level at which shale oil
softened the decline of income in local                          producers can operate) then significant longer
currency. However, it will still put the budget                  term cuts in the Russian budget are required
in deficit and has led to an expected GDP                        and GDP growth will be limited. Therefore the
decline of 3–5% in the short term with very                      medium term outlook for the economy is also
high inflation (15–20%) as a result of the low                   negatively impacted by the shift in the supply
rouble and the high dependency on imports.                       and demand balance.

It remains to be seen what will happen to the oil                that they seize the current moment to reform
price, but it is widely expected that the current                and diversify their economies. For those growth
low price level will not be structural and an                    markets heavily depending on oil imports, it is
increase will occur again eventually. Though                     equally important to use the oil price windfalls
this might be good news for the net oil exporting                wisely and prepare their economies for
countries and their governments, it is essential                 continued growth and development.

Yeroen van der Leer                                              Andrew S. Nevin, PhD
Growth Markets Centre Assistant                                  Partner, Africa Advisory – Strategy
Leader, Singapore                                                and Operations Consulting Leader
                                                                 Nigeria Advisory – COO
David Wijeratne
Growth Markets Centre                                            Suman Jagdev
Leader, Singapore                                                Emerging Markets CoE Leader, PwC India

John Jullens                                                     Martijn Peeters
Partner, Strategy&, China                                        Partner, Strategy and Operations, PwC Russia

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