Energy transition a political risk nightmare for least competitive oil producers
Political Risk Outlook 2021
by James Lockhart-Smith and Franca Wolf,
This insight is part of our Political Risk Outlook 2021, which explores five key themes we’re tracking for our clients this year. You can find the other themes at our #PRO21 hub, as well as related webinars.
With the energy transition accelerating, and Covid-19 hollowing out any recovery oil made over recent years, time is running out for a number of countries that have failed to diversify their economies away from exporting fossil fuels. According to our data, Algeria, Iraq and Nigeria will be among the first casualties of a slow-motion wave of political instability that will engulf the most exposed oil producers over the next 3-20 years. But the likes of Angola, Gabon and Kazakhstan will also be swept up unless they adapt to the oncoming threat that the global shift away from hydrocarbons poses to them.
Those that don’t adapt could face step changes in credit risk and policy or regulatory volatility as they enter doom loops of shrinking hydrocarbon revenues, political turmoil, and failed attempts to revive flatlining non-oil sectors. Mid-century price forecasts range between USD95 and just USD48, reflecting uncertainty over energy transition. In a low-oil future, even the lowest-cost Gulf countries that are poised to capture market share could eventually face a reckoning.
The good, the bad and the ugly
As Figure 1 shows, most oil-producing countries have failed to diversify – or have gone backwards – since the 2014 oil price crash. Whether in or out of OPEC, most exporters doubled down on production in the years after to try and plug revenue gaps. Despite this, the majority took a hit on their foreign exchange reserves anyway, including Saudi Arabia, which has burnt through almost half of its 2014 dollar stockpile.
The handful of countries that have diversified are success stories that can’t be easily emulated. Norway offers limited lessons for emerging market counterparts. Qatar’s sustained focus on non-oil industrial growth has begun to bear fruit, but its attempt to creep up the metals value chain is still swamped by hydrocarbon exports. In others, notably Oman, fossil fuel exports have shrunk in relative terms because of oil industry problems, not because non-oil exports have thrived. Almost none have reduced their dependence on oil by more than 5 percentage points.
This matters because it underscores just how hard export diversification is – not just economically, but politically too.
For a few dollars (per barrel) more
When, if and how severely the storm hits each country will depend on three key factors: break-even costs, the capacity to diversify, and political resilience (see Figure 2). Alongside our Political Stability Index to assess political resilience, we’ve used eight of our other proprietary risk indices to measure corruption, human capital, business access to finance, respect for property rights, and the quality of infrastructure as the most important institutional determinants of diversification capacity.
Recent devaluations are a harbinger of the bleak options ahead for oil producers – diversify, or experience forced economic adjustments
Figure 2 shows how and why the energy transition could unravel the status quo. Currently, if countries’ external break-evens – the oil prices they need to pay for their imports – remain above what markets can offer, they have limited choices: draw down foreign exchange reserves like Saudi Arabia since 2014, or devalue their currency like Nigeria or Iraq in 2020, effectively rebalancing their imports and exports at the expense of living standards. Recent devaluations are a harbinger of the bleak options ahead for oil producers – diversify, or experience forced economic adjustments.
Our analysis suggests that many, if not a majority, of net oil producers are going to struggle with diversification largely because they lack the economic and legal institutions, infrastructure and human capital needed. Even when such institutions are in place, the political environment, corruption or governance challenges and entrenched interests mean some may not reform their way out of trouble, even where it is clearly the rational course.
Those most at risk will be the higher-cost producers with substantial dependence on oil revenues, little capacity to diversify and higher levels of political instability. If a storm breaks, it will break first in Algeria, Nigeria, Chad and Iraq. It will be all the more disruptive here because of these countries’ fixed or crawling exchange rate regimes. Venezuela and Libya, in the feared bottom right of Figure 2, have experienced state failure and economic collapse for other reasons, but they show how bad things could get.
It is telling that most of the politically more fragile countries in the ‘medium’ political risk category in Figure 2 are also in the ‘ugly’ quadrant of Figure 1, having both failed to make any progress on diversification in recent years and lost much of their fiscal safety cushions. These are the countries next in line for trouble as energy transition proceeds – not just because of their high break-even costs, but because they will be first in the firing line for majors looking to de-risk their portfolios.
Alongside Azerbaijan, these include a set of West African producers with fragile autocratic or semi-autocratic political systems: Angola, Gabon, Congo, Cameroon and Equatorial Guinea. Again, all these countries have restrictive FX regimes that lay them more open to abrupt devaluations. Russia and Kazakhstan, though with floating exchange rates, also belong in this group, as efforts to diversify have been repeatedly frustrated by politics and vested interests.
Low-cost Gulf states better placed for transition
For a fortunate few, towards the left of Figure 2, diversification looks like an increasingly viable offramp. The UAE and Qatar, along with Saudi Arabia and Kuwait to a lesser degree, are not only more politically stable than most of their oil-producing counterparts, their economic institutions and resources make them better able to diversify. They are also those most likely to capture market share while energy transition unfolds, and potentially even thrive if demand periodically outpaces supply through to mid-century due to the collapse of new investment projects elsewhere.
Economic transformation in some countries will translate into opportunity, particularly for multinational foreign direct investors and in private markets
Yet there is a major caveat when it comes to these Gulf producers. Authoritarian political stability is anything but stable over the long term and, as lower-for-longer oil prices cut into social spending, additional pressure will pile on these deceptively fragile political systems. Even diversification could come with its own political risks by challenging traditional petro-state social contracts: legitimacy to rule in return for hydrocarbon largesse.
Diversification or bust
As the energy transition train gathers pace, oil-dependent producers will find themselves tied to the tracks. Some will escape in time, but our data suggests a very high risk that many won’t. Adjustment to new socio-economic realities will come for them via political upheaval and market turmoil. Even some of those that do build alternative industries will face elevated political risks as diversification undermines existing social contracts.
The playing field isn’t entirely tilted against investors and corporates though. Economic transformation in some countries will translate into opportunity, particularly for multinational foreign direct investors and in private markets. Spotting those that will successfully adapt quickly enough to the new realities of a low-oil future will be the challenge for them.