There is no doubt that America’s war on Iraq will be the dominant event shaping the world economy and financial markets during the next few weeks and months. The current paralysis won’t be resolved until the ongoing war comes to an end. However, even before the actual conflict began, the prospect of war had several economic consequences. Most notably, oil prices had risen to about $40 per barrel, the highest in several years. More particularly in the US, this oil price shock raised the business cost and depressed consumer sentiment, at a time when the US economy was already burdened by corporate caution about investment and a sharp decline in Wall Street’s equity markets.
The Kingdom will be positively affected by higher oil prices, and indirectly yet negatively through its effects on the rest of the world. In addition, there has been massive uncertainty leading up to the hostility, which had an adverse effect on business and consumer confidence. Beyond those observations, there remains a good many unknowns given that the conflict itself may not be contained in Iraq. On the one hand, Saudi Arabia may be drawn into what is likely to be a very major humanitarian crisis with possibly hundreds of thousands of displaced persons in the Kingdom and the region. However, it is not the purpose here to explore such possibilities and the extent of human tragedies, but rather to trace through some of the effects of the war on oil prices and the Saudi economy. Of course, a lot will depend on the course of the war as well as the aftermath of the conflict.
While the impact of oil can be estimated, there’s no precise way to quantify the impact of risk aversion linked to war on Saudi economic performance, but the drop of cement sales during the first two months of 2003 is very revealing. It is only realistic to expect that activities around the country will essentially remain rather sluggish, as it has been since early this year. The war threat in the last few months has been turning off buyers and pushing investors to be on the sidelines. Meanwhile, driven by population growth, retail and wholesales are likely to grow, yet modestly, while durable goods, on the other hand, are expected to fall sharper during the second quarter of this year.
The Saudi business has been very cautious during the last few months due to concerns about the Iraqi crisis, as the ongoing war will probably delay any upturn in capital spending until companies have far more confidence in economic outlook. The fall in investment spending was becoming more noticeable lately, as private imports of machinery and building material have registered a sharp drop, particularly in the fourth quarter of 2002. While Saudi firms are reluctant to add to capacity, new Saudi investment and inflow of foreign capital from abroad will be on hold as investors’ risk aversion also remains high.
Apparently, the US war on Iraq will harm the Saudi economy. It’s only a question of how deep, how long, and where the damage will be the greatest. From the construction sector, manufacturing, trade, and real estate to financial services and religious tourism, hardly any single big industry in the Kingdom will do well.
A drawback in the number of pilgrims from within, as well as from outside the Kingdom due to either safety concerns or the difficulty to travel would have a negative impact on the services sector, especially restaurants, hotels and transportation modes. Furthermore, an increase in the cost of shipping and insurance of transportation would delay many businesses from taking place into the domestic economy. However, a few companies may find pockets of profit potential from the war, mainly for those that will cater to demand for good and services related to security type of spending by the Saudi government, and to a lesser extent by large corporations, but overall most industries will suffer. A definite exception, however, is the oil industry, which could get a significant gain but only in the short-term.
If that pattern of the second Gulf War in 1991 is repeated, the private sector activities would probably rebound to a growth rate of 2 percent to 3 percent in the second half of 2003, after expanding at an annualized rate of around 1 percent in first half of the year. Under the better scenario, a short war lasting less than two months, the Saudi economy in 2003 could grow in nominal terms by around 2 percent pace, owing largely to around 10 percent gain in the oil sector. Furthermore, with a protracted war, the Kingdom’s economy is likely to shrink by about 1 percent. Moreover, employment would be rather stagnant under both war scenarios.
Scenario planning for the aftermath of the war is extremely hard to predict. Will a US control of Iraq destabilize the Middle East and send oil prices higher than they already are? If all goes according to US plans, the military will occupy Iraq for several years. Pessimistically, there is the threat of instability of other countries in the region. Moreover, oil was a lever of economic power that Saudi Arabia and other major producing countries in the region have been enjoying. Alternatively, if the United States establishes control over Iraq’s oil supplies, the second largest in the world, oil prices could take a dramatic dive. Arab countries would be deprived of that leverage they now employ within OPEC to shape oil policies. Arab countries, including first and foremost Saudi Arabia, probably would not be able to keep their economies buoyant. On the optimistic side, it is worth pointing out the experience after the short 1991 Gulf War, when the Saudi economy picked up rapidly following the end of the war. That is also likely to happen this time because an end to the war may bring a relief from all the uncertainty that has been surrounding the region for the last two decades, providing significant inflow of foreign capital to Saudi Arabia in highly needed mega infrastructure projects.
Any sort of uncertainty in the Middle East is very serious because of the possible effects on oil prices and, in turn, the likely effects on the economies of the rest of the world. Iraq is particularly significant because its proven oil reserves are 112 billion barrels or about 10 percent of the world’s total. In fact, Iraq’s reserves are second only to Saudi Arabia. Further exploration is likely to significantly increase Iraq’s proven reserves. Iraq’s oil is also known to be very attractive because it is easy to recover and accordingly production costs are among the lowest in the world. Currently, Iraq’s sustainable production is around 2.8 million-2.9 million barrels per day, with a net export potential of around 2.3 million-2.5 million barrels per day. Meanwhile, total world oil production averages around 76 million barrels per day and the Organization of Petroleum Exporting Countries’ (OPEC) production of 25 million barrels per day, or 33 percent of the total. The US is by far the biggest consumer of petroleum in the world consuming around 19.6 million barrels per day of which net imports are 10.9 million barrels per day.
Iraq’s production potential has been limited due to an aging infrastructure with a poor maintenance. The UN sanctions over the last decade prevented the importation of spare parts and other necessary equipment. The volume of Iraqi oil exports permitted under UN sanctions (the oil-for-food program) was much lower at around 1.6 million barrels per day; however, some additional oil was smuggled out of Iraq. According to the US Energy Information Agency, some oil experts think that Iraq’s oil production could double in the next few years provided sufficient investment were to be made and the UN sanctions lifted. On the ending of the war, the prospect of continued and possibly expanded Iraqi production is a far gone conclusion. Expected increase in non-OPEC’s production would also help moderate oil prices. In the longer term, supplies from non-traditional sources, including the Caspian region, could put a significant downward pressure on oil prices.
Oil prices have increased throughout most of 2002 and into 2003, from about $20 per barrel in mid 2002 to around $35 per barrel up to 20th March 2003. There have been many oil analysts willing to suggest that oil prices may peak at much higher values. A pessimistic case scenarios have been published that estimate oil prices increasing to $75 per barrel by the Brookings Institute and $80 per barrel by the Center for Strategic and International Studies. While such figures reflect only worst case scenarios, large sudden price increases cannot be completely ruled out.
The most recent trend in oil prices and its prospects suggest an average of $27 a barrel for Brent crude in 2003. Meanwhile, considerable uncertainty will continue to surround oil production, averaging around 8.7 million barrels a day, thereby bringing Saudi oil revenues to SR234 billion in the current year. Assuming non-oil revenues to decrease slightly to SR46 billion, this puts total government revenues for 2003 at SR280 billion, surpassing initial budget estimate by 65 percent or SR110 billion in absolute terms. On the expenditure side, although government is expected to follow a conservative fiscal policy, but given the ongoing war, significant security and emergency related spending will become necessary, pushing outlay for the year 2003 to SR230 billion, compared to original estimate of SR209 billion. However, it is likely, that the combination of those factors may push, with verifying degrees, the level of revenues and expenditures above expectation, reversing the initially budgeted estimate of SR39 billion deficit of the year to a projected surplus of SR50 billion. Although revenue estimates are necessarily high, however, the overall positive impact on the economy is likely to be smaller, hence such increase in oil revenues this year is likely to be faster than projected expenditures, leading to only 2 percent projected nominal GDP growth for the whole 2003.
(Said Al-Shaikh is chief economist at the National Commercial Bank in Jeddah)
Arab News Business 2 April 2003