AS they gathered in Jakarta 10 months ago OPEC oil ministers were in an upbeat mood. Oil prices had been running above most expectations for about two years and they were convinced that demand for OPEC oil was rising. Having left the quota system unchanged for nearly three years, ministers agreed on a pro-rata hike in the production ceiling of about 9 per cent.

No country appeared more convinced of the good prospects for OPEC and oil prices than Saudi Arabia, which had led the lobbying for larger quotas. How wrong they all were. Prices plunged after the meeting and have only stabilised since OPEC cutbacks began to bite in July.

Many factors have contributed to the oil price crash of 1998 but the misreading of the market by Petroleum & Mineral Resources Minister Ali Naimi and his advisers must count among them. Unwittingly, the Jakarta decision to raise quotas from 1 January changed sentiment dramatically and OPEC has been back-peddling ever since. Once again Saudi Arabia has become the OPEC swing producer - a role it has eschewed since the oil market collapse of 1986.

In deals agreed in March and June it has pledged to make the biggest production cutbacks as part of a collective effort to remove 3.1 million barrels a day (b/d) from a glutted oil market. Venezuela is making bigger cuts in percentage terms, but Saudi Arabia is sacrificing a far higher volume.

Despite the two decades spent pursuing a strategy of economic diversification, oil revenues still hold the key to the performance of the Saudi economy, which is likely to contract this year after achieving modest growth in the previous two years. The major factors are:

Oil

With lower export volumes and lower average prices, most analysts expect oil revenues to be down by about $13,000 million in 1998 at $30,000 million. This presumes little improvement in the price of the Saudi benchmark, Arab light, which has averaged $11.15 a barrel this year. Production has dropped to about 8 million barrels a day (b/d) from an average of 8.62 million b/d in 1997 in line with pledges to cut 725,000 b/d from the February benchmark. Production is now 8 per cent lower than the quota agreed in Jakarta. Saudi Aramco made aggressive cuts in supplies to term buyers in September of 16-19 per cent and may make smaller additional cuts in October, although some observers discount this prospect. Some high quality oil from the new Shayba development has now entered the mix of Saudi crudes and has the potential - in a healthier market - to improve average prices.

Budget

The aim of a balanced budget by 2000 cannot be achieved. The budget announced at the start of the year anticipated a deficit of SR 18,000 million ($4,800 million). In reality the actual deficit is likely to turn out at about SR 50,000 million ($13,300 million) because of falling oil income (Cover Story, MEED 7:8:98). The budget projected spending of SR 196,000 million ($52,270 million), which is slightly below actual spending in 1997.

The room for making economies is relatively limited. Current expenditure - mostly wages, interest on domestic debt, and payments for supplies and services - accounts for about 75 per cent of all spending and is very difficult to reduce.

Capital spending will bear the brunt of the cutbacks and this is already apparent in the slowdown in new project commissions and persistent reports of economies in defence contracts with foreign suppliers. Some extra revenue will be raised from the recently announced increases in air fares and new airport taxes. Increases in the price of petrol, electricity and water are also expected.

Payments to contractors and suppliers are being stretched out to the 180-day limit. Most payments are still current, except at agencies with a poor payments record, where the prospects for getting paid in time are said to have deteriorated further.

The government is also making use of Saudi Aramco to increase its revenues. The national oil company, which has traditionally funded projects from cashflow, has not only slashed its capital spending programme but also boosted borrowings. This releases more oil revenue that can go straight into funding the state budget. The government is averse to international borrowing, which would entail a degree of disclosure it deems unacceptable, while Aramco has an excellent credit rating and can borrow more cheaply.

Saudi American Bank (Samba) estimates that Aramco will accumulate at least $3,500 million in new debt this year, transferring a similar amount of extra money to the government to help cover the budget deficit. In a late August assessment of the economy, Samba economist Kevin Taecker estimates that spending cuts and transfers from Aramco may reduce the outstanding deficit that remains to be covered by domestic borrowing to $3,000 million-4,000 million. This is likely to come in the form of additional bonds issued to contractors, farmers and other government suppliers or placed with agencies such as the Public Investment Fund and the General Organisation for Social Insurance.

Growth

Gross domestic product (GDP) is certain to contract this year, having posted gains in real terms of about 2 per cent a year for the past two years. National Commercial Bank in Jeddah has forecast a 2 per cent reduction in nominal GDP this year with a 10 per cent contraction in oil sector GDP. Non-oil activity remained relatively robust in the first half of the year, but will start to reflect the slowdown in government spending in the second half.

The collapse in commodity prices has already started to affect non-oil export revenues. Saudi Basic Industries Corporation, the industrial and petrochemicals giant, reported a 42 per cent drop in first-half earnings due to the fall in petrochemical, steel and fertiliser prices. Cement prices have also tumbled.

Current account

The August edition of the International Financial Statistics (IFS), published by the IMF, contained some surprise good news. It was already known that the current account had moved into surplus in 1996 - for the first time since 1982 - but revised figures show that the surplus, though modest, was three times the original estimate (see table). There was a small surplus in 1997 but the good news ends there - there is certain to be another massive deficit this year. Washington-based Petroleum Finance Company estimates the deficit could be as high as $13,500 million in 1998, which is equivalent to 10.7 per cent of GDP.

Export earnings will be down sharply while import levels are expected to remain relatively stable. The substantial deficit on the services balance is only expected to moderate slightly. Remittances have been trimmed in recent years due to the policy of Saudiisation and the successful campaign to expel illegal residents. But as long as expatriates account for about a third of the population, such transfers are not amenable to further reduction and will remain at about $15,000 million a year.

So far the difficult conditions created by the oil market collapse seem to have been managed with some skill, in striking contrast to the last time Saudi Arabia faced cashflow problems and government payments simply dried up. Bankers and economists give much of the credit for the savvier strategy to Finance & National Economy Minister Ibrahim al-Assaf and the skill of the Saudi Arabian Monetary Agency (SAMA - central bank).

SAMA intervened briskly and effectively in late August to support the riyal and has quashed speculation of a possible devaluation. The chances of speculation against the riyal succeeding are remote, bankers say. Most currency flows are connected to real trade, the country has huge dollar earnings and a positive net foreign asset position. However, it is also suggested that a premium on Saudi riyal rates against dollar rates may actually serve the market well as it will provide an incentive for Saudi private investors to repatriate funds from abroad.

While the outlook is for a difficult period ahead, the action taken so far suggests that there is a coherent strategy for steering the economy safely through the downturn. The private sector remains active and the business community sees the current difficulties as cyclical and manageable rather than systemic.