Notes On Oil

I came up with some talking points for a presentation last week, and since so many people have been asking for a comment on the drop in oil prices, I thought I might as well publish them.

Why is the price of oil dropping?

Essentially, its a demand and supply imbalance. On the one hand, China has been slowing down while Europe has backslid and Japan went into technical recession after implementing a sharp increase in its consumption tax. The only two real bright spots of growth in the developed world is the US and UK, and the US has rapidly developed its domestic oil supply in the last five years. To compound this, the energy intensity of growth (how much energy is required to support a higher standard of living) has been declining for decades.

Which brings up the supply side – shale oil has almost made the US energy independent, producing about 4 million barrels per day (bpd) with another 1 million bpd expected to be added to supply in 2015. That wasn’t quite enough to upend the market though. The bigger factors are the recovery of Libyan production and Russian (and to a lesser extent, Iranian) desperation. These two explanations cover about 80% of the current 2 million bpd overhang in the oil market. Global growth is slow enough that it won’t be able to work through the increase in supply for at least 2-3 years. OPEC (which met on Nov 27) is taking a wait and see approach, which means they’re not taking supply off the market either, at least until the next meeting.

The other factor that should be mentioned is that the drop in oil prices isn’t an isolated market occurrence – prices of nearly all commodities have dropped more or less in concordance. Or to be more precise, the US dollar is strengthening against everything, goods and currencies all. So this isn’t just about oil, or about Malaysia alone.

What is the impact on Malaysia’s fiscal policy?

This is a pretty complex question. The explicit tax and non-tax government yield from oil & gas comes from a variety of avenues, which bear some explaining:

1. Petroleum income tax – this is applied on profits of upstream production companies only, with a statutory rate of 38%.
2. Royalties – this is essentially a production tax, and is applied on volume extracted. Again, this is upstream only.
3. Export duties – Any crude exported is subject to export duty.
4. Petronas dividend – this is the annual payment to Petronas shareholders.

Only number 4 is not directly sensitive to oil prices. However, it doesn’t stop there. All of the above revenue sources (except 4) are effectively based on upstream production or sales only. Downstream products like motor oil, avgas or LNG don’t fall under the specific ambit of petroleum taxation (petrol for instance has a 58 sen sales tax, which is not currently collected). Income streams from these products actually fall under corporate taxation or sales and services taxes, not the Petroleum Income Tax Act.

This is significant because Malaysia is no longer a net exporter of crude oil. We continue to be a net exporter of oil & gas products, but not of crude oil. Most of the trade surplus in petroleum related goods actually comes from Liquefied Natural Gas (LNG).

When looking at this issue, pricing isn’t obvious. LNG contracts are generally long term, and in Asia mostly either pegged directly or indirectly to oil prices (typically against JCC). The important point here is that LNG prices vary with oil prices but not completely (the elasticity is less than one) as contract pricing formulas effectively establish price floors and ceilings for LNG, protecting both buyer and supplier from excessive price volatility. Prices of other oil & gas derived products are probably even less volatile, and cheaper input costs suggests income might actually increase in these sub-industries.

The bottom line here is that the government’s revenue derived from oil and gas is much larger than the explicit oil & gas taxes, but is also less volatile than implied by changes in oil prices.

On the flip side, there’s last week’s shift to market pricing for petrol and diesel subsidies. At current prices, the reduction in subsidies approximately offsets the loss in revenue from lower oil prices. Lower oil prices would be more negative for revenue of course, since there are no other gains to be made from cutting subsidies. The exception is in natural gas, but since this subsidy is borne by Petronas and not by the government, there’s no direct implication on the fiscal balance.

The real wildcard here is therefore the Petronas dividend. I won’t comment much on this, as this is up to negotiation between the government and Petronas (your guess is as good as mine where that’ll end up), beyond noting that there is a lag effect to changes in the dividend from changes in prices i.e. the drop in prices in 4Q2014 is only likely to start turning up as reduced government revenue at the end of 2Q2015.

Given that taxes/subsidies are a wash, reductions in the dividend would then require cuts in the budget. I’ve read and heard plenty of analysis on how much, but it isn’t as straight forward as people think.

The key here is in taking into account the budget rules the government is attempting to adhere to. These are: the deficit target of 3.0% of GDP, the 55% of GDP debt ceiling, and the “golden rule” (only the development budget should be funded by borrowing i.e. the operating budget must be balanced). Most market analyses think all the budget cuts will be made on the development budget – that’s wrong.

Because all the petroleum related revenue (and expenditure) comes on the operating budget (which must be balanced), the government has to cut operating expenditure first. The development budget will also need to be cut, due to a factor that I haven’t heard anybody talk about yet – the drop in oil prices will impact nominal GDP (lower profit growth), which is the denominator for the deficit and debt ratios. In other words, the cuts in the budget(s) that need to be made will be steeper than that implied by the reduction in oil & gas revenue.

Now, how much will need to be cut I don’t know. In principle, the drop in oil prices will have a negative direct impact, but since the Ringgit (like other commodity currencies) moves in tandem with oil prices, the increase in external price competitiveness might boost other exports, especially manufactured exports, though with a lag. The decline in the Ringgit has also buffered about a third of the decline in oil and gas revenue, so that the revenue impact won’t be as large as the drop in oil prices. So there’s trade-offs present here, that might plug some of the budget holes.

In essence, it’s not just a simple revenue minus expenditure calculus. There’s multiple moving parts here that makes forecasting the results more than a little speculative. Having said that, I’m not as bearish on the prospects as the market appears to be.

Impact on real economy

In principle, there shouldn’t be one, at least as measured by real GDP. Here’s why: real GDP is measured as the numbers that would exist if prices were the same as in the base year, which in Malaysia’s present case is 2005. It doesn’t really matter what prices do in the interim, it’s the volume of production that matters. So you could in theory have real GDP increasing (you’re producing more), even if your income is flat or decreasing (you’re earning less).

In practice, price changes (i.e. nominal income changes) do effect the real economy, through spill-over effects. Higher (or lower) profits in one sector, through its linkages with other sectors, would tend to increase or decrease volume of output in those other sectors.

In this case however, as noted in the preceding section above, there could be an offsetting increase in economic activity through the indirect impact via the weaker Ringgit. Will it balance? I don’t know – that would need a full economy model, which isn’t something I have on hand. MoF does have one, but whether it will be complex enough to capture some of the specific price and volume movements talked about here is not something I’m privy to. But it’s possible, as someone said to me, we could get a reversed Dutch Disease effect. Bear in mind also, this will be a global effect not a local Malaysian one. Lower oil prices might boost global growth, which would heighten demand for Malaysian production. It would definitely reduce inflationary pressures, which means low nominal interest rates will be around for longer.

How long will this last?

The oversupply situation is, like everything else I’ve talked about here, pretty complex too. The three major components are:

1. Libyan production – notwithstanding the recovery in oil & gas production from Libya, it’s not exactly a stable situation. Libya is in the midst of a civil war, with two governments vying for control over the country and its oil production. There could be disruptions at any time.
2. Russian production – Russia’s political stability is much stronger, but not exactly a peaceful one. Putin’s domestic popularity is in inverse proportion to his international unpopularity. The Ukrainian incursion is as much about taking Russian minds off the economy, as much as it is about Russia’s strategic influence around its periphery. US and EU sanctions are biting, which is one reason why Russia is dumping oil on the global markets. But sustainability is an issue – Russia’s budget breakeven is a staggering USD160 per barrel, and another international default is potentially in play.
3. US production – This one’s interesting. One of the reasons floated for OPEC’s decision to maintain supply is the desire to squeeze out shale oil producers in the US. Middle Eastern oil is dirt cheap to extract – by contrast is only profitable above USD40 per barrel for even the lowest cost producers. Marginal producers are already being priced out of the market. Most of the OPEC producers on the other hand have the financial reserves to tolerate budget deficits for a while.

All told, that suggests that there will be floor beyond which prices won’t decline. As prices continue falling, investment will decline and future supply becomes tighter. What that floor might be, again I don’t know. The most recent low of USD40 per barrel (in 2009) might be one guess, though that’s taking things a bit far in my view.

Given that part of the reason for the decline in the oil price is the general decline in commodity prices generally and the strength of the US dollar, we’re also talking here about prospects for global growth.

It isn’t bright. Apart from India and China, I don’t see good short term prospects for any other major economies outside the Anglo-Saxon sphere. Europe is (to quote one of my visitors), a basket-case. Most of the larger emerging markets (Russia, South Africa, Brazil) look really shaky. The East Asian region has its bright spots (the Philippines for one), but is being hampered by poor productivity growth and demographic headwinds.

Unless there’s a break on the supply side, oil prices will be down for a good while.

Thoughts on future prospects

I’m going to be politically incorrect here and say that we were saved by Fukushima. The earthquake and tsunami that hit Japan fundamentally changed the energy market in East Asia. The shutdown of virtually all of Japan’s nuclear reactors caused a big jump up in LNG demand, and a startling divergence of gas prices between the major gas markets of Asia, Europe and the US. US gas is the cheapest – at one point, US natural gas prices were just one fourth of Asian prices, and half European prices.

One would think that would be a great arbitrage opportunity – buy US gas, and sell in the Asian market. In fact, that’s what many oil companies are attempting to do. Petronas’ foray into Canada is partly a direct response to this price differential. But the international LNG market has significant trade barriers – one of the reasons why US gas is so cheap is because very little of it can be exported. No, not because of the usual reason of government interference in the market, but because of the need for very specialised and expensive facilities.

As the US was for so long an energy importer (until oil prices rose enough that shale oil was commercially viable), almost no export facilities existed for natural gas export. LNG export is no simple task – pipelines are the safest and simplest, but impractical across oceans. Because natural gas is low density, it has to be compressed for shipping to be viable. The preferred solution is to liquefy it, but this requires specialised carriers and a regasification plant at the destination.

But with prices so elevated, people have been taking the risk of building the facilities needed. The few available now will be supplemented over the next ten years by a number of facilities large enough to compete directly with LNG sourced from East Asia – including Malaysia, which currently supplies a fifth of Japan’s LNG demand.

A more immediate problem is the potential re-commissioning of Japan’s nuclear facilities. Despite public objections, utilities and municipalities are beginning to petition for re-opening a few of the shut down nuclear plants. That would take off some of the demand (and profits) from Malaysian LNG.

So over the medium term, Malaysia’s oil & gas trade surplus which is largely built on LNG, is under serious threat. Not only that, the implication here is that we have a small window of opportunity (5-10 years) in which to really diversify the federal budget away from oil and gas revenue. Given that timetable, delays to implementing GST would have been deadly. The RAPID project in Johore, which would bring onshore more downstream processing of oil & gas products (i.e. reducing the vulnerability to primary oil price volatility) is also critical.

Bottom line

To sum up, I think the impact of lower oil prices will not be as negative as most people appear to be expecting. At least over the short term, the government can fiddle with the numbers enough to make their debt and deficit targets for next year, pace the negotiations over the Petronas dividend for next year. The impact on (short-term real) growth is likely to be minor, though lower commodity prices generally will engender a redistribution of income from rural and primary industries to secondary/tertiary and urban industries.

On the other hand, we really need to move away from government dependence on oil & gas revenue. We have a short window of opportunity to diversify government revenue sources, before the coming changes in the energy landscape.