Cheap Oil and Budget Cuts Oil Producers’ New Reality

Many countries and regions are discovering that having large oil reserves is no longer a license to print money. Several formerly affluent countries and provinces have entered an unfamiliar world of budget cuts, deficits, heavy borrowing and tax increases because of the collapse of oil prices.

Brent crude, the global benchmark for crude oil, hit its lowest price in 11 years on December 31, 2015, $36.63 (€33.73) a barrel, because of news that Saudi Arabia has refused to lower production. The low prices are creating a world of pain and austerity for governments used to depending on oil revenues to pay the bills and dispense lavish benefits to their peoples.

News reports indicate that political leaders from Riyadh to Alaska are grappling with a disastrous drop in government revenues. The disparate locations where oil’s dramatic collapse is wreaking havoc upon governments include the following:

1.   Alaska

Bill Walker, the governor of America’s northernmost state, told CNBC that his government’s budget is not sustainable without oil prices of at least $110 (€101.29)a barrel. Walker has proposed a number of fixes, including a six percent income tax, the first in the state in over 35 years, The Atlantic reported. Walker is trying to deal with government revenues that have fallen by 81% since 2012.

Alaska is facing such a budget crisis because it is one of the few American states that gets most of its revenue from oil. To make matters worse, there is no guarantee that Walker’s plan will work, because it has to be approved by the state legislature and possibly a popular vote under Alaska’s constitution. Alaska could turn to the U.S. Congress for help, but there is no guarantee that body would bail the state out.

If Walker’s plan is not implemented, the state could be facing massive cuts in basic government services, including roads and education. A prolonged period of low oil prices could turn Alaska into an economic backwater similar to West Virginia, dependent on welfare payments from the U.S. federal government and tourism for its economy. One result of that could be that the state will start losing population as people move out in search of jobs.

2.   Saudi Arabia

One person who certainly understands Walker’s predicament is Adel Fakeih, Saudi Arabia’s Minister of Planning and Economy. Fakeih told the press that his 2016 budget is not “radical austerity” even though it contains a $223.76 billion (€206.03 billion) reduction in spending, according to Bloomberg.

The cut is designed to lessen the kingdom’s $97.76 billion (€90.02 billion) budget deficit. Fakeih admitted that the deficit occurred because the 2015 budget was designed for a Brent crude price of $74 (€68.16) a barrel. Even with the cuts, Fakeih’s ministry admitted that his nation will have an $87 billion (€80.11 billion) budget deficit in 2016.

Saudi attempts to cover the deficit include what amounts to a tax increase. Bloomberg reported that cuts in energy subsidies will effectively double the price of gasoline and utility bills in the kingdom. One of the ways the Saudi royal family buys popular support is to keep utility and fuel costs artificially low. New taxes on tobacco, soda pop and energy drinks and a value-added tax (VAT) are planned in the future.

The major cause of Saudi Arabia’s budget deficit is clear: the $80 billion (€73.66 billion) the nation spends on its military. The armed forces absorb about 25% of Saudi Arabia’s budget, according to Business Insider. Military budget cuts are obviously out of the question because of the threat from ISIS and Saudi Arabia’s ongoing war in Yemen.

That means further budget cuts will have to be in areas such as health, social services and education, which could lead to popular unrest. Fakeih’s 2016 budget includes a $49 billion (€45.12 billion) discretionary fund designed to pay for emergencies, such as additional military spending.

The Saudis seem to be dealing with cheap oil in the short term but could face a struggle in the long term. Saudi plans to make up for lower oil costs include increased mining, which might not work because mineral prices are also falling dramatically. Iron ore prices fell by 43% in 2015, The Australian reported. Gold also hit a six-year low of $1,050 (€966.82) an ounce just before Christmas, and some investment banks are predicting it will soon fall below $1,000 (€920) an ounce, The Week reported.

To maintain its current level of government spending, Saudi Arabia will need a dramatic increase in oil prices at some point in the next few years. If that does not occur, the country could face total economic collapse—something that Venezuela is already dealing with.

3.   Venezuela

The country hardest hit by the oil price collapse is Venezuela, where the economy contracted by seven percent in 2015, according to The Latin American Herald Tribune. President Nicolas Maduro has responded to the collapse by declaring what he calls an economic war.

The economic war includes a decree mandating that firms use only Venezuela’s official exchange rate when setting prices, an income tax increase for the rich, higher taxes on financial transactions and government control of the oil and mining industry. Maduro’s war also includes rhetoric blaming the rich and business for the nation’s problems.

Those problems include a rate of inflation that has reached 100%, widespread civil unrest and a constitutional crisis in which Maduro is trying to block the opposition from taking control of Parliament and dismantling his regime. The crisis could lead to a coup and possibly trigger a civil war.

Venezuela is obviously the worst-case scenario that could be triggered by low oil prices. The nation’s economy is simply unable to function without high oil prices. The government’s failure to deal with that reality has led to economic collapse and could soon trigger political collapse or civil war as well.

Saudi Arabia’s Bold Gamble

It remains to be seen if Saudi Arabia can avoid the kind of catastrophe unfolding in Venezuela, although the situation in the two countries has some similarities. In both nations, the government used profits from oil to finance lavish military and social spending.

Saudi Arabia has been able to avoid the kind of chaos seen in Venezuela because of its well-organized authoritarian government and advanced economy. Unlike the Venezuelans, the Saudis have been able to maintain their system while selling oil at a low price.

One way they have been able to do this is to increase the volume of oil they sell. Saudis pumped 10.130 million barrels of oil a day in November 2015, up from 9.584 million barrels a day in November 2014, The Wall Street Journal reported.

Saudi Oil Minister Ali al-Naimi has said his country has no plans to cut production anytime soon. That’s a rather brilliant strategy because it encourages oil use, discourages energy efficiency and the adoption of alternatives such as electric vehicles and hurts competitors such as Venezuela.

The danger the kingdom faces is that it needs a large increase in oil prices within the next few years for the strategy to work. Since there is no way to know if that will occur, the Saudis are taking a major gamble with their future.

The future looks very bleak for oil producers because of the collapse of oil prices. It looks as if some formerly wealthy and powerful nations and regions could soon be reduced to the status of economic backwaters.