Taking action: In the face of falling oil revenues, GCC governments are introducing subsidy and price reforms

In a region that produces 20% of the world’s crude, the decline of oil prices was bound to have an impact. For the six member states of the GCC, hydrocarbons are the basis for their economies, a major export earner, and the main source of government funds. The drop in global oil prices that began in mid-2014 has therefore squeezed state revenues and pushed all six into budget deficits for 2016 (and all but Qatar in 2015). To be sure, large fiscal reserves built up during the years of high prices have helped cushion the fall and cover budgetary shortfalls. Yet it has become increasingly clear that current fiscal systems are unsustainable in the long term, and thus are in need of reform to lower state spending and boost revenues.

Time For Change

Among the most immediate and important changes catalysed by low oil prices is subsidy reform. Economists and international agencies have long seen the region’s low domestic oil prices, particularly for fuel and electricity, as unsustainable; now all countries in the GCC are making moves to address the issue. Many of them had long planned to reform subsidies and incrementally increase costs for products such as petroleum. In some cases, limited price rises had already been implemented.

Yet broader reform across the region had been delayed for several reasons. One was political sensitivity. Another was the benefits low energy prices bring for the domestic manufacturers that are central to long-term economic diversification. With gvernment revenues stable thanks to high hydrocarbon prices, reform did not seem a pressing priority. As the British think-tank Chatham House said in a 2016 report on price reform in the GCC, “State-controlled prices are one way of protecting national living standards, sharing national hydrocarbon wealth and incentivising industrial growth and investment.”

As Chatham House notes, several GCC member states had implemented piecemeal pricing reform before the recent oil price slump. The UAE has been increasing transport fuel prices occasionally since the 1990s. In 2007 Bahrain started raising natural gas prices with the aim of reaching cost price by 2021. Oman and Saudi Arabia have piloted new pricing frameworks on industrial electricity use.

Manifold Benefits

While the challenges presented by pricing reform are significant, the benefits have become ever clearer. First, such reform will reduce pressure on budgets by easing subsidies and raising the revenue earned through fuel and utilities sales. That should lower deficits and, over the longer term, free up more money for investment in priority areas such as education, health care and development of new economic sectors. Lower deficits and future surpluses also reduce the need for GCC countries to dip into their sovereign wealth funds.

A second upside is that reducing domestic use of hydrocarbons (and in some cases, water and other limited resources) through the price mechanism can free up more resources for export or for use in key industries, thus lowering the rate at which reserves are depleting. The longer the GCC countries can make their resources last, the stronger their fiscal position, particularly as some (such as Oman) face rising investment costs to access new reservoirs of oil. There are also environmental benefits in reducing – or at least slowing the growth of – the use of hydrocarbons; all six GCC member states are in the top-10 by per capita carbon dioxide emissions, according to the World Resources Institute, and all are committed to improving their environmental performance.

A third perk is rationalisation in business. Subsidies, while desirable in some cases, tend to distort market incentives. By gradually raising the costs of fuel and power, governments can encourage efficiency gains by private companies, and more prudent use by citizens. In a related benefit, raising the cost of fuels can spur and provide funds for more investment in alternative sources of energy, particularly solar power.

Kuwait Moves

In August 2016, Kuwait became the latest GCC member state to raise petrol prices as part of a package of economic reforms aimed at lessening pressure on the budget after the fall in oil prices. The rises were significant in proportional terms, but petrol remains very affordable by global standards, particularly given Kuwaitis’ strong purchasing power.

The price rises, which came into effect on September 1, 2016, increased the cost of low-octane fuel by 41% to 85 fils ($0.28) per litre and of high-grade petrol by 61% to 105 fils per litre ($0.35). The price of “ultra” premium petrol, the most environmentally friendly, rose 83% to 165 fils ($0.55). The government said that it had set the new prices after examining “global rates” following a review established in early 2015. It said that a commission would review petrol costs every three months, keeping them “in harmony” with such rates – though fuel prices in Kuwait are among the world’s lowest.

The first rise in petrol prices for nearly two decades came as the country faced a budget deficit of $29bn in the 2016/17 fiscal year, up from $18.3bn in the previous fiscal period. The move came months after parliament approved measures to raise electricity and water prices for apartments and commercial properties for the first time in nearly five decades.

Electricity prices for apartments will rise from 2 fils ($0.007) per KWh to 5 fils ($0.017) for the first 1000 KW, 10 fils ($0.033) for 1000-2000 KW and 15 fils ($0.05) for over 2000 KW. Apartments are overwhelmingly used by expatriates; at the time of writing, it was not clear whether the rises would apply to Kuwaitis living in apartment buildings. The limited raises saw considerable opposition in Parliament.

However, Ahmad Khaled Al Jassar, minister of electricity and water, underlined how pressing reform was becoming, saying that the government was paying $8.8bn a year to subsidise power and water, a bill that could swell to $25bn by 2035 without price rises. Conversely, the measures imposed are expected to cut consumption by 30%, while increasing revenues.

Seal Of Approval

After the 2016 changes were passed, the World Bank described them as “politically and economically bold”. The bank sees the establishment of an automatic pricing mechanism as the first stage in the transition to a fully-liberalised pricing and supply system. In a statement, the organisation said that, by taking the opportunity to cut subsidies that low oil prices present, Kuwait would help boost its diversification efforts by encouraging a shift towards more labour-intensive industries.

The bank noted that the transport sector is generally less responsive to fuel price fluctuations than other areas of the economy – particularly with fuel prices in Kuwait still at only half the European average – and that vehicle usage might not be greatly reduced initially. However, combined with Kuwait’s efforts to improve public transport, there could be a long-term slowdown in petrol consumption for transport. Lastly, the bank argued that price restructuring could be combined with other reforms to manage energy supply and demand to make energy use more efficient.

Gas Pricing

While not as immediately sensitive as petroleum, prices of natural gas are a challenging issue in the GCC, given its heavy use by industries that are central to member states’ strategies of diversification and increasing value-added (using resources as inputs to manufacturing rather than merely exporting crude or part-refined products). Bahrain has continued to raise domestic gas prices following its 2007 decision to move them towards market level, while Oman doubled its domestic price in 2015, and Saudi Arabia did the same in 2016.

Rises in industrial gas prices have not been universally popular. Omani cement and ceramics producers have been among those reporting lower pre-tax profits, and the UAE steel industry is particularly wary of cost increases given the sagging global market for its output. Nonetheless, with a number of major manufacturers across the region being state-owned, governments have the ability to absorb rising costs for strategic industries in the short to medium term.