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Middle East Economic Survey, Lebanon / Looking Beyond Petroleum: A Stronger Case For Economic ...

Middle East Economic Survey

 

VOL. XLIX

No 15

9-Apr-2007

 

Looking Beyond Petroleum: A Stronger Case For Economic Diversification In MENA Region

 

This paper has been prepared by APICORP Research to support a communication to the forthcoming Seventh Doha Forum on Democracy, Development and Free Trade (23-25 April 2007). It is an adaptation and generalization to the MENA region of an original analysis developed by Ali Aissaoui in: Algeria: The Political Economy of Oil & Gas, published by the Oxford University Press in 2001 for the Oxford Institute for Energy Studies. The paper is published concomitantly in APICORP’s monthly Economic Commentary dated April 2007. Comments or feedback may be sent to research@apicorp-arabia.com.

 

It is widely admitted that specialization in a single economic sector, understood as the antonym of diversification, is a source of high risks. If the single sector involves natural resources extraction such as petroleum then these risks stem first and foremost from the exposure to the uncertainties of the international markets. The resulting vulnerability to external factors, together with other “resource curse” pathologies such as “Dutch disease” (the crowding out of the non-petroleum tradable sector as a result of the appreciation of the real exchange rate) or “rent-seeking” (the process by which some economic agents influence or manipulate governments’ economic policies to their sole interests and benefits) are well documented in economic literature. According to Andrew Rosser (2006:7) who reviewed extensively the topic: 

 

“Rather than a blessing, this literature has suggested that [dependence on an abundant natural resource] increases the likelihood that countries will experience negative economic, political and social outcomes including poor economic performance, low levels of democracy, and civil war.”1

 

Among the wide variety of policy recommendations on how to avoid these conditions, a great deal emphasize economic diversification to reduce natural resource dependence and support sustainable long-term economic growth and employment creation.

 

Although economic diversification has often been discussed within the MENA region, it has neither been translated into concrete governments’ policies – barring very few exceptions – nor has the urgency for it gained enough momentum. In order to provide a stronger case for it, this commentary highlights three critical issues. The first is the false sense of abundance of petroleum resources. Indeed, in the absence of significant alternative assets, petroleum revenues will hardly meet fast growing fiscal demands. The second is the daunting task of stabilizing these revenues in a context of unrelenting oil markets volatility. The third is the petroleum industry’s inability to provide sufficient jobs, which is at variance with its strong economic weight. This being established, the key question becomes what should constitute a viable pattern of diversification in the MENA countries.

 

MENA’s Overwhelming Petroleum Dependence

As usual in this commentary, the MENA region is defined to include the Arab world and Iran. However, as the focus will be on oil and gas producing countries, it is relevant to note that in 2006 these countries represented 82% of the total MENA population and 91% of its aggregate GDP. 

 

One should also define diversification, which means different things to different economists. Those involved in political economy would agree that it is the process that leads to a growing range of economic outputs being produced. They would further add diversification of export markets and that of fiscal revenue sources. In this sense diversification can be relatively easily measured. In 2006, the petroleum sector (oil, gas and hydrocarbon derivatives) accounted for 36% of total value added of the MENA region, 82% of export revenues and 71% of governments’ fiscal receipts, making the region still overwhelmingly dependent on petroleum.

 

Obviously, the above averages conceal significant variations shown in the 3D Figure 1 (flattened to 2D for clarity). Each key country is plotted using the share of its petroleum industry in a) GDP, b) exports and c) fiscal revenues. The least diversified countries – those lying above MENA average – are Qatar, Kuwait, Saudi Arabia and Oman. Within the GCC area, the UAE appears relatively more diversified. In between lie countries endowed with additional natural resources or assets such as Algeria and Iran. By comparison, Norway – which has had a consistent policy of reducing its dependence on petroleum revenues – can be seen as having achieved a significant degree of diversification.2

 

Limits To Petroleum Rents

As mentioned earlier, the first critical issue that needs to be highlighted is the limited extent of the petroleum rents to meet long-term fiscal demands in face of rapidly expanding populations. The main determinants of petroleum rents (simply defined as revenues above factor costs) are very complex and difficult to discuss in any detail here. However, to facilitate a long-term trend analysis, assumptions need to be made regarding reserves, production and costs.

 

Reserves. MENA’s proven oil and gas reserves total 190bn toe (58% crude oil and 42% natural gas). Their life expectancy (the ratio of proven reserves to current production) is about 100 years starting in 2006. Although this ratio is static (in the sense that it does not account for future discoveries), it provides a timeframe for the analysis.

 

Domestic Demand. Domestic primary energy demand is assumed to be met by domestic production. This demand, including the own use of the petroleum industry, will continue to grow at an average rate of 4% per year until 2015 and decrease by steps, first to 3.5% until 2030, then 3% until 2050, moderating much further afterwards.

 

Exports. Petroleum exports – a mix of crude oil, condensate, oil products, LPG and natural gas (in both LNG and pipeline gas) – can be expected to continue to build up in line with recent trends at 2.5% per year until 2015, then be constrained by a plateau in overall production the following 30 years or so, before declining with production at a rate of 1.35% per year.

 

Price Structure. Despite deregulation and liberalization of the main international markets, prices of MENA export products are assumed to continue moving together. Taking into account the price structure of recent years, the resulting ratio of the average export price (in $/boe) to the price of Brent (taken as a benchmark) (in $/B) is set at 0.75.

 

Petroleum Rents. These are captured through taxation. With a current average full cost of production of $3/boe, a royalty on production of 16.25% and a tax on profit tax 75%, governments’ share of the value of production is expected to be around 65%. As domestic prices are set against the industry’s average costs, the rent basically derives from the value of exports.

 

Figure 2 illustrates a “base case” scenario where production is increased until 2015 to a plateau to be sustained over 30 years (a costly assumption in the absence of major new discoveries). Despite the mitigating effect of discounting, this scenario highlights the critical period around 2045 as the inflection point after which production ceases to meet part of domestic requirements and therefore exports.

 

This rather simple but illustrative scenario provides a broad range of expected revenues. Based on a discounting factor of 10% reflecting expected inflation, the net present values (NPV) of export-generated rents vary from 2.53 to 4.42 of current GDP (2006) (Table 1). However, these possible outcomes cannot be translated into policy guidelines, unless population dynamics is factored in.

 

By mid-century, MENA’s population will have more than doubled, increasing from 408mn in 2006 to 828mn in 2050. To maintain the rent per capita constant at its 2006 level of $6,850 over the next 40 years or so, the MENA region needs a much higher price than the current $60/B of light sweet crude. The resulting NPV of $10,920 per capita corresponds to a price of $90/boe for the export mix, that is $120/B for Dated Brent.

 

As governments can hardly influence world energy markets to that extent, securing higher petroleum rents through higher oil prices is probably not realistic. A more viable option is to consider capturing additional rents downstream in the domestic market. But will this make a difference?

 

Will Downstream Rents Make A Difference?

In simulating the rents generated by the exploitation of hydrocarbons, it has so far been assumed that energy supply to the domestic market is priced at cost recovery level. However, MENA governments can capture, through a more appropriate domestic pricing regime, the portion of the resource rents so far relinquished to the downstream industry, particularly the petrochemical sector.

 

In a context where the region’s governments are keen to articulate new policies to shape more sustainable energy consumption patterns, energy prices should become key instruments. This is more notable for natural gas whose current prices are far too low by any measure (Table 2).

 

Ideally, gas prices should be determined by competitive markets. However, in spite of a move towards price deregulation, such a prospect remains distant. For the time being, the MENA average weighted price (about $0.90/mn BTU) is well below the average replacement cost of some $1.50/mn BTU or the average netback export price of $4.00/mn BTU (under 2006 oil price conditions). At constant prices, the respective differences of $0.60/mn BTU and $3.10/mn BTU give the corresponding net benefits available to the government to appropriate. Based on future volumes of tradable gas on the domestic market (roughly half the primary energy demand), the NPV value of non-captured rent varies from 0.13 to 0.65 of current GDP (2006 – see Table 3).

 

Accordingly, although based on sounder pricing policies that could result in more efficient allocation of petroleum resources, capturing the portion of the resource rent so far relinquished to the downstream industry, particularly the petrochemical sector, will not make a great impact on future fiscal revenues.

 

Daunting Task Of Stabilizing Governments’ Revenues

Whatever the outlook for enhancing petroleum fiscal revenues, these will continue to be subject to unpredictable adverse developments in the world oil and gas markets. Therefore, the most challenging task facing governments in the region is stabilizing export-generated petroleum revenues, which can be envisaged along three main paths:

 

Stabilizing Oil Prices. This path, followed by OPEC member countries, has led to a collective oil production management policy. Although OPEC has gained enough market power and sophistication to be able to protect its members’ economic interests against price downside risk, its capacity to stabilize prices in this way is bound to be inefficient without broader consensus and stronger discipline (see Economic Commentary Vol. 2 No. 2 and MEES, 5 February).

 

Removing Price Uncertainties.  Making revenues more predictable can be done through hedging. However, the only well documented example of a large hedging by a sovereign oil producer is the case of Mexico (on the eve of the 1991 Gulf war). Even though this experience has been reported as reasonably cost-effective for the Mexican Treasury, it may not be relevant for other producers. The issue is not so much the cost-benefit of a discrete operation than the need to ensure continuity of fiscal policy within a long-term framework.

 

Smoothing Income Flows. This can be achieved through stabilization funds. In these schemes, hydrocarbon revenues in excess of budget requirements are saved to reduce the impact of fluctuating receipts. Algeria, Iran, Libya, Oman and Qatar have established such funds under various denominations. Others, such as Kuwait, set up funds designed to meet the need of future generations. What the MENA governments have so far achieved with these funds appears to be mixed. Suffice to read IMF literature to note that success depends on the institutional framework, the degree of adherence to the fiscal objectives and operational guidelines, and transparency and accountability.

 

Petroleum Industry’s Inability To Provide Sufficient Jobs

Whatever the prospect for the petroleum rents and the extent of their exposure to the volatility of international markets, the one critical issue the expansion of the petroleum industry cannot solve directly is the region’s severe unemployment. Despite the paucity of official data, tentative statistics from international organizations put these rates between 12% (ILO) to 15% (IBRD), double the world’s average. Furthermore, their distribution is skewed towards the most populated countries, which exhibit unemployment rates higher than 25%. In addition, most countries in the GCC area have been relying heavily on imported labor, while the domestic labor pool is expanding.

 

So far, policy prescriptions to tackle unemployment seem to have focused on boosting economic growth. Recent performance – a modest average real growth of 4.1% during the decade 1996-2006 (Table 4) – has been insufficient to reduce the number of unemployed and absorb new entrants into the labor market. According to these policies, given a population growing at a rate of 1.6% and an active population growing at 3.6% per year, it would take a sustained 7% to 8% growth of GDP over the next decade to stabilize then reverse current aggravating trends.

 

However, as long as the petroleum sector remains the main economic engine, growth alone cannot reverse the trend of rising unemployment. The most apparent cause is the low labor content of the value added of this sector, which is highly technological and capital intensive and extraordinarily productive. As noted before, while the value added of the petroleum industry represents 36% of the region’s aggregate GDP, its contribution to employment when counting in all petroleum-related activities is less than 5%.

 

Possible Patterns Of Diversification?

The following suggests a possible pattern of diversification:

 

Diversification inside the Petroleum Industry. APICORP’s review of energy investments in the MENA region for 2007-11 has underscored much higher levels of capital requirements of some $395bn, representing 24% of the world’s energy capital requirements (see Economic Commentary Vol. 1 No. 10 and MEES 2 October 2006). According to the International Energy Agency (IEA 2006:316) ”beyond the current decade, higher investment in real terms will be needed to maintain growth in production capacity”.3  This upbeat outlook will involve even greater requirements of goods and services by the petroleum industry. In this context the MENA private sector should be encouraged to seize such opportunities within the framework of policies aimed at developing oil services and oil supply industries with local content.

 

Diversification outside the Petroleum Industry. Improved productive capacity of the private sector outside the petroleum sector is also a must. It should help stimulate productive investment and greater non-petroleum output, bring new fiscal resources to complement the petroleum rents, contribute to the expansion of export markets beyond petroleum products and offer longer-term solutions to unemployment through the promotion of more labor-intensive activities.

 

Regional Cooperation Is a Further Means of Diversification. Its potential stems from the economic and social diversity of key countries and areas within MENA. This should enhance the complementarity of their economies in terms of labor markets and sources of goods and services.

 

Improvement of the Investment Climate. Finally, as repeatedly emphasized in our previous commentaries, for all such policies to succeed further improvement of the investment climate, particularly in the non-GCC area, should remain a key focus of policy.

 

Notes:

1.    Andrew Rosser (April 2006), “The Political Economy of the Resource Curse: A Literature Survey”, Centre for The Future State and Institute of Development Studies, Working Paper No 268.

2.       ?ystein Noreng (November 2004), “Norway: Economic Diversification and The Petroleum Industry”, MEES 47:45.

3.    IEA (2006), World Energy Outlook [2005-2030], OECD, IEA, Paris.

 

 

Figure 1

MENA Countries Dependence on Petroleum

 

 

 

Figure 2

Assumed MENA Long Term Production Profile

 

 

Table 1

MENA Export-Generated Rents

 

 

Export-Generated Rents Assuming A

Period 2006-45

Nominal Discounting Factor Of 10%

Dated Brent Price ($/B)

40.0

55.0

70.0

MENA Export Price ($/boe)

30.0

41.25

52.5

NPV of Revenues ($Bn)

3,820

5,250

6,680

NPV of Revenues over 2006

2.53

3.47

4.42

 

Source: APICORP Research – Adapted from Aissaoui (2001).

 

Table 2

MENA Domestic Gas Prices

 

 

2005 Avg Base Price

Expected Annual Escalation

Annual Escalation Needed To Unify

 

($/Mn BTU)

During 2007-11 (%)

Prices to $1.50/Mn BTU In 2011 (%)

Algeria

0.65

3.0

18.2

Egypt

1.00

A1

8.4

Iran

0.75

-

14.9

Kuwait

1.252

3.7

3.7

Libya

0.50

-

24.6

Oman

0.80

2.0

13.4

Qatar

1.252

-

3.7

Saudi Arabia

0.75

1.2

14.9

UAE

1.10

2.0

6.4

UAE Dolphin

1.30

1.7

2.9

 

1.  Actual price from netback value of exported final products.

2.  Assumption for new gas-based export projects.

Source: APICORP Research - Industry estimates.

 

Table 3

MENA Downstream-Generated Rents

 

 

Non-Captured Domestic Rent Assuming

Period 2006-45

A Discounting Factor of 10%

Price Differentials ($/Mn BTU)

0.60

3.10

NPV of Revenues ($Bn)

190

980

NPV of Revenues over 2006 GDP

0.13

0.65

 

Source: APICORP Research – Adapted from Aissaoui (2001).

 

Table 4

Selected MENA Socio-Economic Indicators

 

 

Unit

MENA

World

Population

Mn

406

6,500

Population growth

%

1.58

1.14

Employment to population ratio

%

47

61

Labor force participation

%

54

66

Real GDP Growth 1996-2006

%

4.1

4.6

Employment growth 1996-2006

%

3.6

1.6

Unemployment

%

12.2

6.7

 

Source: APICORP Research using ILO and IMF database.

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