The recent period of oil price instability has exposed how effectively major oil-producing countries utilise their revenue. Writer Daniel Maalo

Whether viewed as a blessing or a curse, the discovery and commercial production of oil has had a transformative effect on the countries that hold substantial oil reserves. However, the oil price instability of 2008, which saw prices hit a high of $147 per barrel before plummeting to $32 later that year, has brought renewed attention to how major oil-producing countries manage their revenue. The test provided by the recent price volatility has strained the fiscal positions of certain oil-producing nations, such as Venezuela and Nigeria, while others have been able to overcome it due to a history of considerable fiscal surpluses and healthy sovereign balance sheets.

When it comes to using their oil revenue, the governments of big oil-producing nations are often caught between the more immediate compulsion to redistribute the income as part of a broader fiscal expansion, and that of containing inflation, which requires fiscal restraint. The main long-term consideration is the need to save and invest windfall revenue, particularly as oil is a finite resource.

Oil revenue has traditionally been used for the accumulation of foreign exchange reserves, the import of foreign goods and services, and the reduction of government debt. For example, Kuwait and Saudi Arabia, two of the world's leading oil producers, used revenue to address the debts they had accrued as a result of the Gulf War of the early 1990s. Oil revenue can also be spent in the domestic economy, though this area of deployment has produced mixed results.

Venezuela Spends, spends, spends

Venezuela, one of the world's leading oil exporters, is an example of a heavyweight oil-producer that invests significantly in its domestic economy. Driven largely by ideology, the country's president, Hugo Chávez, has overseen a dramatic increase in spending at home since taking office in 1999. A key instance of this is the role played by Petróleos de Venezuela SA (PDVSA), Venezuela's state-owned petroleum company, in public spending. According to International Oil Daily, an energy trade publication, PDVSA spent $14.4bn on social programmes in 2007, a significant increase on 2005's figure of $6.9bn.

Seemingly undeterred by the oil-induced 2.9% contraction of the economy in 2009, the Venezuelan government intends to continue deploying its revenue at home. Its 2010 budget commits 45.73% of total expenditure to be directed towards social spending "aimed at poverty reduction and improving the quality of life for Venezuelans", according to a government spokesperson. What makes this striking is that the government's fiscal expansion in recent years has contributed to Venezuela having Latin America's highest inflation rate - 25% in 2009. Moreover, earlier this year, the government devalued the country's currency and has increasingly depleted its off-budget development fund, Fonden, in a bid to maintain domestic spending. The government has also issued billions of dollars-worth of local and international debt, raising the country's overall debt-to-gross domestic product (GDP) level to 17.2% last year from 13.8% in 2008. In short, Venezuela's approach has raised more questions than answers.

Nigeria's indiscipline

Another country with a questionable commitment to fiscal discipline is Nigeria, one of the world's top 10 oil exporters. The country's Excess Crude Account (ECA), created in 2003 to save windfall oil revenue and guard against price fluctuations, has been increasingly tapped by federal, state and local authorities, a process that accelerated under the country's previous president, Umaru Yar'Adua. Nigeria's former minister of finance, Dr Ngozi Okonjo-Iweala, recently revealed the ECA had fallen from $20.1bn at the end of 2008 to $7.8bn in December 2009 as a result of a bid to offset the impact of lower oil revenue on the budgets of the various tiers of government.

The depletion of the ECA has been compounded by increased government debt levels in recent years; for example, the federal government's domestic debt amounted to $21.8bn at the end of 2009, a significant increase from $13.6bn at the end of 2006. However, Stephen Bailey-Smith, head of research for Africa at Standard Bank, believes the government is attempting to address the ECA's problems. "The 2010 budget's key dimensions - the price of oil and the level of production - have been revised downward, so that is likely to lead to more money going to the ECA. This will help top up the account after a year during which it was frequently tapped by federal and state authorities," he says.

MENA countries pass the test

Quite apart from the experiences of Venezuela and Nigeria, the Gulf region's major oil producers have embarked on increased spending in recent years but were able to draw on high fiscal surpluses and strong sovereign balance sheets to help withstand the period of oil price volatility. "The Gulf countries passed the test imposed by the oil price volatility in 2008-09 with flying colours. They did not bring investment pipelines to a halt and supported weaker segments of their economies, such as Abu Dhabi's support of Dubai's debt troubles and Qatar's assistance to its financial services sector," says Florence Eid, founder and CEO of Arabia Monitor, a London-based research and advisory firm specialising in the Middle East and north Africa (MENA) .

A notable example of the Gulf's successful navigation of the crisis is Saudi Arabia, the world's leading producer and exporter of oil. Cushioned by its central bank's estimated $431bn of assets under management, Riyadh was able to boost spending by 6% in 2009 by drawing on government assets, rather than borrowing. The government's estimated 34% fiscal surplus from 2008 was also a contributing factor. Spending is expected to increase again this year but the government's fiscal position is likely to be strengthened by higher oil revenue.

Libya has also been able to draw on its healthy fiscal position to sustain its spending plans. Having benefited from budget surpluses since 2000 due to high oil prices, Libya's government can push ahead with its $207bn programme for economic diversification and urban development. The government's budget for this year outlines a 32% rise in expenditure as the country strives to develop itself. "Libya has a lot of ground to make up. In terms of per capita oil production, the country is similar to Saudi Arabia but lags behind it in other respects. It has to find a way of becoming a functioning market economy so that it can effectively benefit from its oil wealth," says Charles Seville, director in Fitch Ratings' sovereigns group.

SWF Salvation

While distributing oil income addresses more immediate concerns, accumulating assets has a longer-term focus and has become particularly popular among some of the big oil-producers. Sovereign wealth funds (SWFs), a number of which have been established for decades, are designed to maintain domestic economic stability in times of commodity price fluctuation and provide an income stream for future generations. The profile of SWFs has increased in recent years due to the rapid increase in the price of oil, leading to a greater emphasis on saving and investing windfall revenue. "During the oil price boom from 2003 to 2008, oil income grew much faster than the oil-producing countries were able to spend," says Mr Seville. According to International Financial Services London, SWFs funded by commodities exports totalled $2500bn at the end of 2009.

Norway's SWF, the Government Pension Fund - Global (GPFG), is particularly noteworthy. Strengthened by Norway's status as a leading oil exporter, it has become the second largest SWF in the world and is also Europe's biggest stock market investor. Estimated to have had $445bn of assets under management by the end of last year, GPFG has proved its resilience to the global economic downturn and has even helped Norway's government to weather the difficult conditions.

GPFG climbed by NKr613bn ($97bn) in 2009, a 26% rise in its value. The fund reportedly gained 34.3% on its stock holdings and 12.5% on bonds, a welcome boost following a record NKr633bn loss in 2008 as a result of the financial crisis. The gains recorded for 2009 serve as an endorsement of GPFG's prudent investment strategy that has seen it create a diversified portfolio of securities, as many as 8000, from many countries, while moderating the risks attached by owning an average of 1% of each company.

Norway's sizeable asset base allowed the government to pass a NKr20bn fiscal stimulus package in early 2009 to boost growth and employment as the country's economy struggled in the face of the global economic slowdown. NKr16.75bn was allocated to public building works, schools and infrastructure, and NKr3.25bn in tax relief. In spite of the spending splurge, the government maintains strict fiscal control, so much so that the non-oil budget deficit is not allowed to exceed the expected real return of the fund.

Largest SWFs (End 2009)

Largest SWFs (End 2009)

Oil - proven reserves (Jan 2009)

Oil - proven reserves (Jan 2009)

Gulf reserves

Notwithstanding Norway's exemplary fund, it is the Gulf region's SWFs that are the most prominent due to their longstanding presence and often glamorous investments. The Gulf's SWFs have been empowered by their respective governments, according to Mr Seville. "The Gulf's SWFs have a treasury-like as well as a wealth management function, in that most of the oil surpluses end up with the SWFs rather than the central banks. Saudi Arabia is the one exception in this regard," he says.

As Mr Seville notes, Saudi Arabia is the exception as its central bank manages the government's foreign assets, rather than a specific body as happens in Kuwait and Abu Dhabi. Saudi Arabian Monetary Agency (SAMA) Foreign Holdings is estimated to hold $431bn of assets, making it the world's third largest SWF. According to the SWF institute, SAMA tends to invest the government's surplus oil revenues in low-risk assets, such as sovereign debt. Saudi Arabia's distinctive characteristics, including its large and fast-growing population, mean SAMA's asset portfolio differs from that of its Gulf counterparts, according to Ms Eid. "There has been a variation among the Gulf's oil players' appetite for acquiring foreign assets. Kuwait and Abu Dhabi have been acquiring assets for some time but Saudi Arabia's domestic priorities, for example, are different. They have been somewhat less inclined to acquire foreign hard assets using sovereign wealth."

Abu Dhabi Investment Authority (ADIA), established in 1976, is estimated to hold $627bn of assets under management, making it the world's largest SWF by some distance. ADIA's investment strategy is far more diversified, encompassing equities and fixed-income assets across a range of international markets; its strategy can also be viewed as riskier, such as its residential real estate portfolio that suffered during the recent market decline, particularly in Europe. ADIA made headlines in November 2007 for its agreement to buy $7.5bn of stock in Citigroup when the bank was troubled by its subprime writedowns, a move that has since turned sour with ADIA seeking to renege on the agreement due to its belief that it was misled about the investment.

On the other hand, Kuwait Investment Authority (KIA), acknowledged as the world's oldest SWF, having been established in 1953, has had a better experience in its dealings with Citigroup. KIA profited from selling its 6% stake in the US bank late last year, gaining $1.1bn on its original investment. KIA, the world's seventh largest SWF with $203bn of assets to its name, benefits from 10% of Kuwait's oil revenue every year. As its stake in Citigroup indicates, KIA invests in a range of asset classes in a variety of geographical areas, including stakes in financial services firms and industrial organisations.

In contrast to the KIA's decades-long existence, the Libyan Investment Authority (LIA) SWF was established just four years ago but has made significant strides in acquiring foreign assets. The LIA's estimated $70bn of assets under management include recent property investments in London, where it has benefited from a fall in prices and a weaker UK pound, as well as stakes in Finmeccanica SpA, an Italian state-controlled defence and aerospace company, and international media company Pearson. Given Libya's immense reserves of oil, believed to be the largest in Africa, the LIA can be expected to strengthen its asset base in light of the positive outlook for oil prices and external demand for the commodity.

Algeria's Fond de Regulation des Recettes (Revenue Regulation Fund), another recently established SWF, has also grown rapidly. Created in 2000, the fund now manages approximately $47bn in assets and is helping Algeria's government to finance its expected deficit this year. The deficit is due in large part to the government's drive to develop its economy, prompting a 12.9% increase in spending in this year's budget. "North Africa's major oil players, Algeria and Libya, have begun to seriously deploy their oil wealth at home by pursuing economic diversification strategies. These changes are among the most significant in the Arab World," says Ms Eid.

Lessons to be learned

The positive role played by SWFs has undoubtedly influenced leading oil-producing countries yet to create one. In April, Nigeria's president, Goodluck Jonathan, told the country's National Economic Council he would like an SWF to be established within months. The fund is expected to be used for investing in international capital markets and will eventually replace the ECA.

Emerging oil producers are also taking note. Ghana is expected to begin producing oil in commercial quantities later this year. Although output is expected to be modest compared to the majors, it intends to channel approximately 30% of its oil revenue into two funds, one of which will have a stabilisation function similar to Nigeria's ECA while the other is expected to be an SWF modelled on Norway's GPFG. It should be noted that the majority of Ghana's oil revenue will still go to the government.

For the time being, the governments of oil-dependent economies seem intent on spending in order to pursue economic development and diversification, a sensible strategy given that their oil reserves will not last for ever. However, the trend of saving windfall revenue is already under way and is expected to gather momentum as the governments of major oil-producing countries move from fiscal expansion to restraint.

The stable outlook for oil prices is helping the MENA region's major players, according to Mr Seville. "The MENA region's major oil producers are likely to respond to the more stable outlook for oil prices by seeking to balance the pursuit of development strategies, which require spending, with the need to save their oil revenue for the future," he says.

The Gulf's major oil producers are likely to continue spending for some time to come, believes Ms Eid. "The Gulf's oil-producing nations have to spend, although the reasons for this vary. For example, Saudi Arabia needs to cater to a growing population at home while Qatar wants to increase its [global status]."

The risks associated with continued spending are likely to be offset by ongoing demand for oil, primarily driven by the emerging economies of Asia and the Middle East. A recent forecast published by the International Energy Agency suggests the demand for oil is likely to increase between 1% and 1.4% annually to reach 90 to 92 million barrels per day by 2015. Such a scenario substantiates Mr Seville's view that oil will remain important in the foreseeable future. "The post-oil era is still a long way off. Oil will remain a vital input in the world economy for several decades to come. If oil becomes scarcer, it is likely to help its producers as they will benefit from higher prices."

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