What if this time isn't different? (page 1 of 3)

First, let us lead off, as we did in May, with the experience of the 1980s for the region. The headlines are that the whole region contracted almost 18% in nominal USD terms, while the GCC economies collapsed by over 45% and it took Saudi Arabia almost two decades to surpass its 1981 peak. If you look in terms of GDP per capita, the picture is even more disturbing. Even for the UAE economy, for all the impressive work on the diversification front, GDP per capita will only likely surpass its 1981 peak this year. For Saudi Arabia, the peak of close to USD 19,000 is only likely to be surpassed around 2008. This means that even with the current oil boom, people's earning power has largely stagnated for the past 25 years. And this does not account for the effects of inflation on real incomes.

This raises the question of what would prevent another economic outturn similar to that seen in the 1980s following this oil boom. In May, we argued there were five reasons why this time is different:

1) Better demographics
2) Governments have spent the oil windfall more wisely
3) Economies are diversifying
4) Governments have been investing in the wider region
5) Oil prices are, in our opinion, now structurally higher than in history.

The crucial assumption for the GCC economies is that oil prices will not return, on a long-term basis, to the USD 24pb average seen between 1980 and 2004. When I was in Saudi Arabia a couple months ago, the view that oil prices could fall even as low as USD 40-45pb on a sustainable basis was highly debated. Most were thinking that oil prices would go up to USD 80pb, USD 100pb or even USD120pb on a sustainable basis. This suggests most believe our forecast for a USD 45pb long-term average is too cautious.

However, the recent sharp decline in oil prices appears to have reduced the conviction that a sharp rise, particularly on a sustained basis, is inevitable. Moreover, it is possible we are all wrong and oil prices will slump back to historical averages. Here, we analyse the implications for economic activity of a sharp fall in oil prices in 2007. Before we present the findings, it is important to look at the assumptions underlying our analysis.

First, we assume oil prices fall to an average of USD 25pb in 2007, an extreme assumption to say the least, but it does give us some insight as to what may happen even if oil prices were to fall in a more gradual fashion.

Second, we assume this leads OPEC to cut production by a further 4m barrels per day to try to stem the decline and that this is equally shared across the OPEC countries, including those in the GCC.

Third, we assume governments would continue to boost economic activity via stimulatory economic policy even as their fiscal accounts go into significant deficit. Clearly, this would be the case, but it is important to note that this is just taking a one year scenario. If the decline were to happen over a longer period, governments would likely become more frugal over time, resulting in the total impact on the economies being larger, but less dramatic, than in our simplified one year scenario.

The results of our analysis are very interesting, although perhaps not surprising. The first thing to note is the collapse in nominal GDP across the region. All countries would experience a double-digit decline, with most of the countries experiencing around a 30% decline in activity.