Vienna Agreement: Buying Time, Persistent Macro Divergence

With OPEC members and friends (and the ever growing energy journalist cohort) meeting in Vienna, it seems apt to look at the economic adjustment of some of the participating oil producers. While most would gain from rising prices. Russia, and Iran, smaller GCC countries (Kuwait, UAE and even Qatar) as well as some U.S. producers would look to be the relative winners. The slowbleed of capital outflows, external and fiscal deficits are likely to moderate across most of the other producers including Saudi Arabia, Oman, let along more vulnerable countries like Nigeria, Angola which are still struggling with the aftermath of their FX policies.  With U.S. and global interest rates edging up, expect continued rate and sovereign risk divergence.
Rolling over the Vienna Agreement into mid/late 2018 seems a done deal with the key issues surrounding how long the extension will be and what measures will be selected to assess an exit.  Cue the central banking comparisons to forward guidance and exit strategy. As OPEC members are likely to approve a roll-over to end-2018 with review date in mid 2018, H2 2018 could be important for two important stock adjustments (but central bank balance sheets deserve a separate post).

Other lingering issues concern how OPEC members will address the volatile output from Libya and Nigeria, though the continued implosion and output declines from Venezuela are likely to buy time and space for that. Moreover, the increase in the oil price may actually embolden some of the warring political actors in these vulnerable MENA/SSA countries, increasing rather than reducing the output volatility. Typically when oil prices rise, warring factions have more of an interest in blocking their rivals.

Likely metrics for an exit are likely to include levels of US inventories compared to historical averages as well to a lesser extent, Asian inventories. I’ll be interested to see if both crude and product inventories are tracked in the U.S. and China. U.S. data suggests that oil production in the Permian basin if not other shale producers continues to grow, even if at a slower pace, and the recent drop in Canadian drilling looks to have reversed. This adds up to a persistence of the Brent/WTI spread and a moderate increase in oil prices on an annual basis for 2018. Note that the recent upward move suggests y/y trends should be higher for most of 2018 even if there’s a pullback in Q1.

Economically, the agreement will is likely to bring some convergence to producing nations as most see an economic recovery, albeit to different degrees. The balance sheet risks and debt accumulation patterns will vary.

Figure 1: Current Account Balances
Source:  IMF, National central banks, my calculations

Maintaining the oil output cuts/freeze and assuming a Brent price in $55-65 range for 2018 (now consensus) would make a lot of oil producers breathe easier. One important metric – the external balance bears this out  This metric, an important one along with the fiscal break even, helps measure whether the oil price is sufficient to pay for the country’s import needs. This helps map countries adjustment to the trend. For more on why its important, see Brad Setser and Cole Frank’s great paper from earlier this year, though I’ve adapted their methodology and updated it with some assumptions on production and price.

The results show that some of the wealthier GCC countries including Kuwait, UAE are shifting to a more comfortable level (though Qatar should continue to suffer some capital outflows as non-resident deposits ebb) This suggest that the baseline oil price environment should reduce the pressure on local currency pegs. Oman and even Saudi Arabia have less policy space.  Others including Russia and Iran are also likely to run meaningful surpluses and policy space increase even if sanctions and local issues cap long-term investment.

Two key dynamic factors shape these results – the exchange rate and fiscal policy. The exchange rate has been a critical adjustment tool for producers, maximizing the revenues in local currency terms (especially for those that have more scope for cutting imports) and supporting non-energy exports (again for those where the economy is better able to take advantage).

Fiscal policy too has been a key factor – restrained government spending has helped narrow external gaps and reduce the financing shortfalls. Relatively easy access to foreign capital limited the drawdown of reserves. Going into next year, fiscal deficits are likely to narrow and some countries shift back into modest surpluses. This will be tempered by a relaxation of some of the fiscal cuts across most countries as governments step in to offset for weak private sector lending. These trends suggest that regional sovereign wealth funds won’t have much new capital to play with.

These trends still suggest that most oil producers in the emerging and frontier world will continue to add to their debt stocks, looking to avoid drawing down reserves. With global interest rates edging up, expect to see some interest rate divergence. Rates are likely to climb in countries that previously benefited from low inflation (GCC), remain high (countries where past FX risks haven’t ebbed – Nigeria. Only in Russia and some other CIS countries would a significant further rate cuts seem likely. Even there interest rates are likely to remain high in real terms, adding to appreciation pressure on the ruble (and some challenges to non-energy exports). No wonder the Russians are more wary about the cut extension than their OPEC peers

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