What if this time isn't different?

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. The outliers are the UAE, which we estimate would contract a 'mere' 13%, and Kuwait, which would almost halve in size even assuming a very large fiscal stimulus. Clearly, this difference comes down to the vast differences in the hydrocarbon sector as a percentage of GDP. For the UAE, around a third of the economy is generated by the hydrocarbon sector where as for Kuwait, the number is over 75%. Qatar's heavy reliance on hydrocarbon prices and oil production will be offset, to some degree, by the fact that it will be able to increase gas production in line with its expansion plans in this area.

In real terms, the picture is more diverse, but less important. Three of the six countries would see a contraction in real terms, largely due to the production cuts. However, the picture for the UAE, Bahrain and Qatar is much better. Again, Qatar would be much less afflicted by volume declines as it is mainly a gas, not an oil, producer and indeed is expected to expand gas production dramatically in 2007. Therefore, in real terms growth would actually remain strong. The UAE benefits from its diversified base and thus would be expected to expand in real terms, albeit at a slower pace due to production declines. A similar picture is painted for Bahrain, with the key difference being that the fiscal position in Bahrain is much poorer than in either of these countries.

Indeed, Bahrain is in the worst fiscal situation in the GCC, with a break-even oil price, based on current spending patterns, of around USD 43pb. Saudi Arabia comes in just under USD 40pb, Qatar and the UAE just over USD 35pb (although Qatar's will fall significantly with time) and Oman just under USD 35pb. Kuwait is in the best situation at USD 30pb - although even very aggressive non-oil growth forecasts cannot avoid the Kuwaiti economy contracting in both nominal and real terms. Kuwait's strong financial position, alongside the UAE, is being further boosted by non-oil revenues. These emanate largely from asset positions built up by governments in the region. For instance, we estimate Kuwait has over USD 500bn in foreign assets which, even assuming a mere 5% return, would generate USD 25bn a year in revenues. For an economy with a GDP of less than USD 90bn, this is clearly very significant. The UAE probably has a similar foreign asset position, but it also has significant stakes in local companies. For example, the Dubai government is the sole owner of Emirates Airline, while it has over a 30% stake in EMAAR, the country's second largest company by market capitalisation. The longer oil prices remain high, the larger these state foreign asset holdings will be and more solid the long-term outlook.

Other countries in the region do not have as strong an asset position as these two countries, with Saudi Arabia and Qatar having an estimated USD 200bn and USD 24bn, respectively, in net foreign assets, although these are clearly rising quickly. For Qatar, they are expected to continue growing exponentially going forward. Meanwhile, the accretion of state-owned foreign assets in Saudi Arabia is likely to continue increasing significantly on our core scenario as it has almost finished in paying down the debt incurred largely from the first Iraq War.

All this suggests countries in the region would be able to spur their economies for an extended period should oil prices slump. However, if the slump were to be structural rather than cyclical, then ultimately such an ability would be tested.

The above analysis highlights one very obvious issue facing the GCC countries. While much has been made about the efforts to diversify the economies away from their reliance on the hydrocarbon sector and traditional capital-intensive areas of diversification, these efforts still have a long way to go. The key challenge facing the region is creating enough jobs for a burgeoning labour force. This cannot be achieved in the hydrocarbon sector alone.

Ironically, the country that has made the biggest strides so far, the UAE, looks set to outperform in this area going forward. As noted above, the hydrocarbon sector, despite the elevation of prices, accounts for only a third of the UAE economy. The diversification drive has been led by Dubai, in part spurred by the fact that oil reserves are projected to run out in the not too distant future (oil accounted for less than 6% in 2005). While we expect Dubai to continue to lead the way in this regard, Abu Dhabi is expected to diversify dramatically in the coming five years as it invests USD 175bn in the economy.

Clearly, if oil prices remain high, then the ability of the public sector to absorb large numbers of labour market entrants will remain. However, a structural decline in oil prices below USD 30pb would make this already second best outcome difficult for many countries. Of course, this would put additional pressure on the government to push ahead with reform, although sometimes these reforms result in short-term costs and, hopefully, long-term benefits.

Therefore, pre-emptive reform is far superior to reactionary reform. Governments have been doing a lot of hard work in this area, but whether they will create enough jobs for the rapidly expanding labour force has yet to be answered. Clearly, the longer oil prices remain high, the more likely a favourable outcome will be found.