Although prices have not yet reached the highs of July 2008, the oil producing countries in the Middle East must still be pleased with the revenues coming in this year.

In late March, the cost of a barrel from Opec’s basket of 12 crudes rose above $120. Brent, meanwhile, has regularly climbed above $125 a barrel this year. At these levels, all the oil-rich countries of the region should be able to balance their budgets with comfort.

However, the history of oil prices shows the need for caution. After hitting a high of more than $140 a barrel in early July 2008, the average price of Opec crude fell sharply to less than $34 a barrel by late December that year.

This means that governments in the region face a conundrum. Everyone can see that oil prices are high on international markets and it is no secret that finance ministry coffers are awash with the proceeds. With little in the way of democratic legitimacy to fall back on, the authorities have to respond with higher spending to show that they are sharing the windfall with their citizens. Kuwait, for example, is planning to increase spending by 13 per cent compared with last year, taking the figure in the 2012/13 budget to KD22bn ($79bn).

State spending control

But the more prudent governments know there is also a need to ensure that public finances do not get too far out of line with the longer-term reality. Inflation needs to be kept under control and any spending that creates unrealistic expectations for the future could cause problems when oil prices fall away again.

Everyone’s breakeven [oil] price is rising because everyone is spending more

Liz Martins, HSBC Middle East

The need for this balancing act goes some way to explaining the habit oil producing governments have of making price assumptions in their budgets that are well below the prevailing market rate. Not all governments publish the average price they are expecting, but at the moment most  are thought to be pitching it somewhere between $65 and $85 a barrel.

“You want to remain quite conservative in terms of the oil price assumptions because at some level you want to control spending,” says Jarmo Kotilaine, chief economist at National Commercial Bank in Riyadh. “This is common in oil producing countries the world over. If you are more realistic about the price, the chances are that people will want to spend more of the windfall.

“There is the risk that overspending will start fuelling inflationary pressures and that’s certainly not what you want. For the Gulf countries, there is a structural need to try and contain the government spending and encourage other modes of financing for some of the big projects that are currently under way. That is more difficult if the government creates the impression that they are flush with money.”

Many of the budgets for this year project a deficit. At a price of $65 a barrel, for example, Kuwait is expected to run a deficit of KD8bn. However, given that the oil price assumption looks so conservative it is more than likely that Kuwait, as most of its peers in the region, will in fact end up with a surplus when the final sums are calculated.

“The likelihood is that the market prices will significantly exceed the assumptions in the course of this year and give these countries surpluses, with the possible exception of Bahrain,” says Kotilaine.

Saudi Arabia’s budget already projects a surplus of SR12bn ($3.2bn) for this year, based on revenues of SR702bn and expenditure of SR690bn. However, both income and spending are likely to be higher in reality.

The local Jadwa Investment says the budget appears to be based on a price of $69 a barrel for Saudi export crude, which is equivalent to $73 a barrel for Brent crude. It estimates that actual revenues and spending will be higher than the budgeted levels and it is forecasting a surplus of SR91bn for Riyadh by the end of the year.

Oil breakeven prices

The conservative nature of oil price assumptions means that the more relevant figure when looking at the budgets is often the breakeven price for oil – the level at which governments are able to balance their books.

Among the GCC countries, there is quite a wide disparity in this area. According to estimates by Capital Economics, a London-based research firm, they range from $55 a barrel for Qatar to as much as $110 a barrel in the case of Bahrain. Economists’ predictions for the average price of oil in 2012 are in the range of $100-$110 a barrel. If this upper price is achieved or exceeded, even Manama may end the year with a surplus.

“Our oil price forecast is $110 a barrel,” says Said Hirsh, Middle East economist at Capital Economics. “Bahrain will need roughly that to balance its budget. Bahrain is a special case, but it’s ability to get support from other countries means it won’t really be facing a problem. The rest will still record a surplus.”

The key issue for all governments is what will happen in the longer term. Spending levels have been increasing over recent years, partly in an effort to appease locals in light of the revolutions in Tunisia, Egypt and Yemen, and the uprisings in Syria and Bahrain. Much of this additional expenditure has been current spending in the form of higher salaries for public sector workers and more generous subsidies for basic foods. The risk is that this will lock governments into commitments that they will later find hard to reverse.

Fiscal pressures in North Africa and the Gulf

This is as much a problem for North African countries as it is for the Gulf states. According to the IMF, increased government expenditure in Algeria means that the oil price needed to balance the 2011 budget was $100 a barrel, compared with just $44 a barrel in 2006. It is likely to rise to $110 a barrel by 2016.

“We think governments are looking to use spending to increase stability, increase people’s living standards and create jobs,” says Liz Martins, senior economist at HSBC Middle East in Dubai. “Current spending doesn’t really do that. It just puts a sticking plaster on some of the problems and, as we’re seeing in Europe, it’s very hard to roll back. It’s always politically difficult to cut that kind of spending. It’s exactly the kind of cuts that are getting people out on the streets in Europe.”

This fiscal pressure will keep on rising for as long as the public sector dominates the economy, as it does in most of the region’s oil producing countries. With a high proportion of young people, who will need jobs and housing in the coming years, the failure of governments to properly diversify their economies and sources of revenue could come to haunt them. With some exceptions, such as Saudi Arabia, Iraq and Libya, most countries are close to their maximum oil production levels so they are likely to become ever more reliant on rising oil prices to balance their books.

“Everyone talks about diversification all the time and the need for less reliance on oil revenues, but the non-oil sector relies primarily on government spending and contracts,” says Hirsh. “Oil prices could fall as fast as they rise, as they have done previously which, given the breakeven prices we expect at the moment, could cause problems.

“Any kind of fall in oil prices, especially a prolonged one, could reduce government spending which would quickly turn into a disastrous situation. Government consumption essentially supports the entire non-oil economy. So if governments cannot spend as much, they could go into recession very quickly.”

Some governments look more exposed than others. Among the Gulf states, Bahrain is in by far the weakest position, with its economy continuing to suffer as a result of the political instability and continued social unrest. Iraq and Libya also need to increase production quickly if they are to make the most of the current high prices, while they try to rebuild their economies.

Bill Farren-Price, chief executive officer of Petroleum Policy Intelligence, a UK-based energy consultant, says he is bearish about the prospects for oil prices in the current climate, with economic recovery in the West just one of several reasons for doubt.

Global economic recovery

“There are serious risks to a recovery in the West and we’re also seeing slowing growth in the developing economies,” he says. “That means there’s a downside risk to oil demand growth this year.

“Combine that with a slew of new [non-Opec] supply …and the impact of high oil prices on demand itself. If we see any progress on Iran’s discussions [over its nuclear programme], then we could see weaker fundamentals reassert themselves.”

Few analysts expect prices to fall below $78-80 a barrel for a prolonged period, however.

Many governments will be hoping that assumption proves correct, but there will be others that find that even getting close to that level will cause difficulties.

“Everyone’s breakeven price is rising because everyone is spending more,” says Martins. “But we see oil prices staying high for the remainder of the year and we see everyone in surplus, even Bahrain. However, it does increase vulnerability in the event of a sharp correction.” 

Click here to read a previous feature on oil prices