As 2015 closed, it was difficult to find much optimism among regional business leaders about the outlook for 2016, with most bracing for a tough year ahead.

With oil prices hitting seven-year lows in December 2015, and finance ministers across the region putting the finishing touches to their 2016 budgets, it is clear that the most significant change to be expected in the year ahead is a tightening of fiscal belts as governments cut back on capital spending in order to balance the books.

Metals producers [are] swamped by a flood of low-cost materials that are undercutting their prices

The ramifications were already becoming apparent in the second half of 2015, with a clear slowdown in major project contract awards as well as a raft of reports about schemes being shelved or scaled back. And, as the year slowed to a close, news started to emerge about cash flow problems across the regional construction industry as a result of delayed payments by clients.

Supply glut

But it is not only the slowdown in government spending that is casting a shadow over the regional economic outlook. The slowdown in growth across the emerging markets that has been a key factor behind low oil prices has also led to a slump in demand for raw materials, triggering a supply glut in key materials.

After years of heavy investment in expanding production capacity in steel and aluminium, the region’s metals producers now find themselves swamped by a flood of low-cost materials that are undercutting their prices and stifling demand.

“We will see some companies going out of business,” said Emirates Steel CEO Saeed al-Romaithi, speaking in Dubai on 15 December at the Middle East Iron & Steel Conference, organised by the UK-based Metal Bulletin.

Al-Romaithi was joined by regional manufacturers in calling for greater government action to enforce World Trade Organisation trade regulations and improve regulation of quality controls.

Underpinning the gloom is the 20-month fall in the energy market that has seen prices for the international benchmark oil Brent Crude collapse from close to $115 a barrel in June 2014 to a seven-year low of about $36 a barrel on 14 December 2015 – the biggest sustained fall in oil prices in history.

Despite current prices being unprofitable for a significant proportion of global production, few analysts expect any significant recovery in 2016. Some are predicting prices to slump further in the first half of 2016 to near the $30-a-barrel levels seen in 2008, as a result of economic sanctions on Iran being lifted and Iranian exports starting trading. Tehran says it will add 500,000 barrels a day of crude to the market as soon as sanctions are lifted, with a further 1 million barrels a day being added to global supply in the subsequent 12 months.

Iranian exports

Many doubt whether the Islamic Republic could bring this level of crude to the market as quickly as it says, but, whether or not it becomes reality, the perception that the potential exists will continue to weigh on prices.

Over the long term, oil prices are set to stay low as global supply continues outpacing growth in global demand for energy. In late November, Opec oil producers, led by Saudi Arabia, reaffirmed their commitment to maintaining current record levels of oil production in order to retain market share. But the reality is that they have few alternative options. Cutting production to push up prices will simply empower competitors and weaken their position.

Not everybody agrees the outlook is as one dimensional as most suggest. While most analysts believe the most likely scenario is for prices to remain low, all agree that there are many countervailing factors at play that could lead to considerable volatility in energy prices in the coming years.

On the downside, the resilience of high-cost shale oil production in the US and disagreement among members of Opec over strategy suggest oil prices will remain weak. While upside pressure on oil prices stem from regional unrest, there is potential for an increase in global energy demand growth in 2016 and for further investment cuts.

But the broad consensus view is that prices will not return to anywhere close to the levels last seen in 2014. In its latest outlook report for the regional economy, the Washington-based IMF forecast that oil prices would remain in the $40-60 a barrel range in 2016 and the Brent Crude average would remain between $50-70 a barrel until 2020.

Slower growth

The consequence of lower oil prices and conflicts on the region in 2015 has been a slowing in economic growth and increasing budget deficits. According to the IMF, Mena oil exporters lost about $360bn in oil revenues in 2015 and real GDP growth in the GCC slowed to 3.2 per cent in 2015 from 3.4 per cent in 2014. The fund projects a further slowdown in economic growth in 2016 to about 2.7 per cent.

GCC governments have sought, however, to minimise the impact of the slowdown by tapping their foreign currency reserves and selling off foreign assets to finance a fiscal deficit as they have continued to spend.

The result has been a sharp deterioration in fiscal and current account balances across the region. Together the six nations of the GCC are projected to run a $700bn combined budget deficit in 2015, equal to 13.2 per cent of GDP, with Saudi Arabia’s fiscal deficit reaching 21.6 per cent.

Even though the GCC oil producers have enough in assets and financial reserves to maintain deficit spending at current rates for another five years, the position is fiscally unsustainable and cuts in spending and other adjustments in fiscal policy will start to be rolled out over the next two months as finance ministries announce their budgets for the year ahead.

Fiscal consolidation

Governments will also be under increasing pressure to implement structural reforms such as the removal of subsidies and other burdens on state finances, as well as introducing new taxes and other measures to increase and diversify government revenue streams.

“Many countries have built up buffers, and have started to consolidate their fiscal position, but fiscal deficits, averaging almost 13 per cent for Mena oil exporters, are likely to persist for years. Sizeable, sustainable fiscal consolidation is needed,” said Masood Ahmed, IMF director for the Middle East and Central Asia, on 21 October.

It is inevitable that the axe will fall most heavily on projects as authorities have only limited policy options available to them to help them balance their books.

Real GDP growth in the GCC slowed to 3.2 per cent in 2015 from 3.4 per cent in 2014

Source: IMF

Oil production, the source of more than 80 per cent of the region’s income, is already running at close to full capacity and cannot be significantly raised, while driving new non-oil revenues through taxation is politically unpalatable.

This leaves spending cuts as the main option, and the primary focus will be on capital spending, which accounts for more than 10 per cent of regional GDP, and is easiest to cut. Public sector wages are protected, but some governments are looking at fuel subsidy cuts, a step already taken in the UAE. There will also be a slowdown in the rate of hiring in the public sector. The deepest cuts, however, will come on project spending.

It is clear from the changes in the regional projects market in 2015 that a slowdown in spending is already under way. At the end of 2015, about $3.24 trillion-worth of projects were planned or under way in the Gulf, with about $2.6 trillion of this in the GCC.

But for the first time since 2010, the size of the region’s projects market has shrunk over the past year, down 3.2 per cent in the GCC and 3 per cent for the wider Gulf.

The lion’s share of the fall is explained by a slowdown in Saudi Arabia’s projects sector, which shrank 15.6 per cent in 2015 to about $1 trillion as real estate schemes have been placed on hold. The kingdom accounts for 38 per cent of the total value of the GCC projects market, and it is inevitable that this kind of contraction will reshape the entire regional market.

Strongest performer

The UAE, Kuwaiti and Bahraini markets all grew through 2015, with Kuwait being the region’s strongest performer. The total value of projects planned or under way in that country grew 16.4 per cent over the year.

Outside the GCC, Iran’s projects market expanded 12 per cent in 2015 to about $260bn as optimism spread at the prospect of economic sanctions being lifted. Iran’s projects market ended 2015 on a similar scale to Qatar ($277bn) and Kuwait ($246bn). All three offer bright prospects for 2016. Hit by low oil prices and security problems, Iraq’s projects market shrank 9.8 per cent in 2015.

Outside the Gulf, Egypt’s projects market offers huge potential as President Abdul Fattah al-Sisi continues his economic turnaround programme. Of a similar scale to Kuwait’s projects market, Egypt awarded $22bn-worth of major projects in 2015, up from $13bn in 2014. There is considerable uncertainty, however, about progress on some of Egypt’s project deals and the country is being held back by concerns about an overvalued pound. But the long-term view is positive for the Egyptian market.

But while all spending will be under review, the underlying drivers of policy in the region – high levels of population growth and the need to develop modern, competitive, diversified economies – mean that project investment is still a long-term necessity.

The GCC oil producers may cut capital expenditure in 2016 budgets, but they will continue to spend heavily on projects. Priority projects will be included in budgets, with non-critical schemes cut.

The priority will be placed on social infrastructure projects covering education, healthcare and housing; transport and logistics projects, including rail and airports; new oil and gas production; downstream diversification; and security.

Return to borrowing

Riyadh in particular says it will continue to invest, although at lower levels. But the question now is: What projects should move ahead in 2016?

Riyadh scaled back project ambitions in 2015. Eleven stadiums Saudi Aramco planned in 2015 have stalled. Ongoing infrastructure schemes, such as the Riyadh Metro, have been scaled back and, in October, the Finance Ministry instructed agencies not to award any more contracts in 2015.

Meanwhile, a range of major construction schemes are at tender and prequalification stages. Authorities are thought to be close to awarding contracts for the construction of more metro lines in Mecca, and firms have been invited to prequalify for the Jeddah light rail network. Metros are also planned for Medina and Dammam.

But such schemes require significant funding, and will test the kingdom’s commitment to infrastructure spending. It will seek to raise finance from borrowing.

Riyadh has ample room to issue fresh debt in order to fund the deficit without depleting reserves. It has the world’s lowest debt-to-GDP ratio at about 6.7 per cent in 2015. This is projected to rise to about 17.3 per cent in 2016.

Riyadh issued about $9bn of debt issued in local currency-denominated bonds in 2015, its first bonds for eight years, and it is set to continue domestic and international issuance in 2016.

Other countries will follow. To deliver projects, governments will look to increase borrowing. They will also seek to tap international and private sector finance through new and alternative funding models. 2016 will see an increase in government borrowing and public-private contract models such as public-private partnerships (PPPs).

In Saudi Arabia, Taif International airport is being developed on a PPP basis. This follows the June 2015 opening of the Medina airport expansion, developed by Tibah Airports Development Company on a 25-year PPP concession.

The lifting of sanctions on Iran in the first quarter of 2016 will fundamentally alter the regional economic landscape. With 79 million people and the world’s biggest gas reserves, Iran is the region’s second-largest economy, with a GDP of about $404bn in 2015. Its highly diversified economy offers wide-ranging trade and investment opportunities. But its return to business will have dramatic consequences for the region, continuing to affect energy prices and adding to tense geopolitical relations.

Iran potential

The Islamic Republic could become one of the world’s fastest-growing countries, and will enjoy rising living standards and steady progress in social indicators. On the lifting of sanctions, Iran has the potential to enter an era of high growth, driven by strong exports of oil, gas, petrochemicals and manufactured goods.

Required investment in infrastructure and productive capacity will be comfortably met from accumulated government and private sector savings, domestic financial resources and an expected inflow of foreign direct investment.

In these conditions, Iran’s real economic growth is expected to rebound, growing 4-5.5 per cent in 2016/17, driven by higher oil production and lower trade and financial transaction costs. But severe structural challenges remain, including lower oil prices.

The banking system faces high non-performing assets that have led to high interest rates and stagnant credit. Comprehensive reforms will be critical to attracting investment and delivering macroeconomic stability and high growth.

“The lifting of economic sanctions brings a unique opportunity,” said IMF Iran mission leader Martin Cerisola on 6 October 2015. “Prudent policies have allowed the economy to return to positive growth last year and to reduce inflation to around 15 per cent. The authorities have also regained stability in the foreign exchange market and advanced with subsidy reform.”

After a decade-long boom, albeit with a short, sharp shock in 2009-10 as a result of the global financial crisis, the GCC is set to come back to earth with a crunch in 2016 as the effects of lower oil prices and a slowdown in global growth take effect on the region.

The next 12 months will see a sharp contraction in the market and a hardening of economic conditions as both the government and private sectors adjust to the new reality. But the underlying drivers of the region remain in place, and by the end of 2016 the outlook will become more positive as oil price volatility eases and the regional market returns to stronger growth. And with substantial markets developing rapidly in Egypt and Iran to add to the strength of the GCC, the outlook beyond 2016 is bright.