The ‘lower for longer’ oil price environment is hurting hydrocarbon dependent economies worldwide. Despite a higher cushion of cash reserves in the region, GCC states saw their budgets fall into deficits over the past 18 months, and with oil prices currently hovering around $40 a barrel this year, further deficits are expected.Certainly the most obvious victim of low oil is the energy sector, which has lead state oil giants such as ADNOC, Qatar Petroleum, Kuwait Petroleum Corp., and Saudi Aramco to revise their strategies, pushing for discounts on contracts and cutting staff. In the realization that the days of $100 oil are over, the region’s largest oil exporter Saudi Arabia is embarking on an ambitious economic transformation plan that includes the listing of Aramco to help ease reliance on oil revenues that currently contribute 73 percent of its budget.
Amid the casualties in the energy sector, the region’s domestic energy, power and water providers are coming up trumps. Long under pressure from tariffs kept artificially low, limited private sector participation, and the absence of a structure offering competitive bidding among contractors, these companies are now finding themselves the surprising beneficiaries of falling oil prices. In January 2015, Abu Dhabi increase its electricity and water tariffs, after which petrol prices were aligned with international rates across all emirates in the United Arab Emirates. Qatar followed suit by increased water and electricity prices in September, and fuel prices in January 2016. Meanwhile, Saudi Arabia increased the price of petrol at the pump by 50 percent in January this year and raised electricity tariffs, mainly for high usage consumers and industrial consumers.
These subsidy reforms will not only bolster government finances, but are likely also to encourage more long-term investment into the electricity and water sector, Moody’s Investor Service said in a recent report. This is good news, for three reasons:
- Government backing for utilities, demonstrated by the bold move to begin rolling out subsidy reforms, means that utilities are now in a stronger position to borrow to fund their operations.
Power and water plants are massive, capital-intensive and long-term projects, which require substantial debt. In March, Saudi Electricity Co (SEC) refinanced a $1.14 billion loan for its Riyadh PP11 independent power project, following a number of Gulf companies turning to refinancing as liquidity is squeezed.
Lifting subsidies is of course not a guarantee for securing funding – Moody’s cautioned on the tightening liquidity environment where sovereign borrowing and a rise in non-performing loans are pressuring the banking sector – but the move does encourage a longer-term positive credit rating for the region’s utilities. While utility firms in Doha or Abu Dhabi are expected to have neutral credit implications, as their operating cash flows are derived from long-term purchase agreements where the recent subsidy increases do not apply, those in Oman for example will fare better as their revenues are directly linked to tariffs. Fully integrated utilities firms such as SEC are expected to be positively impacted in both the long and short term as the new tariffs will directly filter into current budgets, which would improve its standalone credit quality over time.
Evidence that subsidy reform is a positive step has already started to emerge. This month SEC reported a narrowing first-quarter net loss as higher tariffs boosted its operating income. The company, which the government aims to split into several components this year to improve efficiency, made a loss of 1.37 billion Saudi riyals in the three months to March 31 2016, versus a loss of SR1.94 billion in the same period a year earlier.
- Utilities have long suffered the brunt of government subsidies.Many state-owned utilities in the Gulf have been incurring unsustainable losses on their balance sheets despite government support, and officials have often cited difficulties in securing loans to further develop new projects. Dubai’s fuel provider Emirates National Oil Co. (ENOC), for example, had to obtain financial backing from its richer neighbour Abu Dhabi last year in order to secure a $1.5 billion loan, which it managed to finally close this month, according to reports.
Energy subsidies have not only hurt utilities. Generally, subsidies tend to divert resources from more productive to less productive uses. In this case, subsidies that promote consumption of fuel, water or power lead to higher waste and carbon emissions, as users have less motivation to conserve resources. Earlier this year Saudi Arabia’s Deputy Oil Minister Prince Abdelaziz bin Salman warned that the Kingdom is using as much as 38 percent of its own oil and gas wealth to meet domestic energy needs, a level that is unsustainable in the long term.
Subsidy reform, therefore, gives added impetus to initiatives that aim to boost efficiency and preserve the region’s limited natural resources. Saudi Arabia has already embarked on a number of such initiatives. For example, the Electricity & Co-generation Regulatory Authority in 2013 initiated a development strategy for smart meters and smart grids to improve the efficiently level of electricity transmission and distribution networks in the Kingdom. ECRA expects this programme to generate benefits of around 100 billion Saudi riyals ($26.7 billion) against a cost of 12 billion Saudi riyals for implementing it.
The Kingdom has also established the Saudi Center for Energy Efficiency, which is spearheading a national program to rationalize and improve the efficiency of energy consumption in coordination with government bodies and the private sector, and expects to save 1.5 million barrels of oil equivalent per day by 2030.
- And, finally, the reforms will provide welcome relief to ongoing state investment in the sector as governments strive to support growth.“Free market prices shall, in the long term, stimulate productivity and competitiveness among utility companies and open the door to investment and diversification of the energy mix in the Kingdom,” according to Saudi Arabia’s Vision 2030. With ambitious economic growth plans across the GCC, increased domestic access to power and water is essential to sustain a population expected to increase by a third to more than 50 million people by 2020. That translates into power and water demand growth of about 8 percent a year.
Of course, there is still work to be done. The energy tariff increases across the GCC were boosted from a very low base, so additional rounds of increases will be required to support utilities in the long-term and trigger a serious change in behavior. In addition, the reforms target certain users, such as expats, or industrial users: in Saudi Arabia, for example, 83 percent of the population will not be impacted by the price changes, according to officials. Meanwhile, as Gulf states turn to the private sector to help them keep up with demand, in those nations with less developed regulatory frameworks, overall development of the industry may be slower than domestic demand requires as private companies seek more clarity on investment returns
Still, subsidy reform is a welcome and bold first step, and is likely to lead regulators in the region to take further action that will bode positively for the sector as well as improving operating efficiencies across the value chain including generation,transmission and power distribution. In the case of Saudi Arabia, ongoing reform will ensure sufficient power and water supplies to support the leadership as it embarks on the National Transformation Plan, ushering in a new phase of sustainable and diversified economic growth.