Fiscal Break-Even Prices: What More Could They Tell Us About OPEC Policy Behavior?

Published on Monday, 14 Mar 10:49 am

By Ali Aissaoui

This article has been prepared by Ali Aissaoui, ‎Senior Consultant at the Arab Petroleum Investments Corporation (APICORP). It is published concurrently in APICORP’s Economic Commentary dated March 2011. The views expressed are those of the author only. Comments and feedback may be sent to: aaissaoui@apicorp-arabia.com.

As markets currently operate, oil producers’ fiscal policies are unarguably not a key determinant of international oil prices. Yet energy economists studying oil markets are tempted to approach fiscal break-even analysis with the feeling that it could shed more light on producers’ production policy. In this context a fiscal break-even price is commonly assessed as the oil price that balances governments’ budgets. Provided modeling, input data and the interpretation of results are correct, such an assessment might indeed provide a useful and relevant hint.

In this commentary we develop a two-step analytical framework for assessing and discussing fiscal break-even prices and what more they could tell us about OPEC policy behavior. In doing so, we take a short and long term view. The former focuses on current budget balances, the latter on future fiscal sustainability.

The Short Term View

The fiscal sector is of paramount importance to OPEC governments since revenue collection and public spending have a significant impact on their national economies. As suggested by Figure 1, governments mostly fund their budget from hydrocarbon rent, simply defined as revenue above factor costs and normal return within the petroleum industry. The rent, which is captured through royalty and hydrocarbon taxes, flows to the fiscal sector together with non-hydrocarbon (or ordinary) fiscal revenues as well as eventual flows from stabilization funds and cross-subsidy schemes. All or part of these revenues are spent on public goods, ie security, education, social infrastructure, health and other welfare programs, in addition to public debt amortization.

Figure 1: A Typical OPEC Government’s Fiscal Sector


Accordingly, a fiscal break-even price is the oil price at which petroleum rent contributes to balancing budget. Starting with the simple identity that government’s expenditures should equal hydrocarbon fiscal revenues (HFR) plus non-hydrocarbon fiscal revenues (NHFR), and assuming no exchange rate effect in this context,1  we derive from Formula 1 in Box 1 the fiscal break-even price in Formula 2. As detailed in that box, hydrocarbon fiscal revenues can be reduced to the sum of royalties and hydrocarbon taxes. Indeed, when budgets are balanced there are no flows to or from a stabilization fund. In the same vein, subsidies in excess of cross-subsidization in the end-user sector can be assumed to be included in government expenditures. Therefore, the break-even price can be expressed as a quotient of two algebraic expressions. The numerator is the sum of government expenditures, non-hydrocarbon fiscal revenues and the portion of costs incurred by the petroleum industry, pro-rata share of taxes. The denominator is the sum of pro-rata share of royalty and taxes of respectively net (commercial) production and exports. Furthermore, as the break-even price is expressed in terms of the value of OPEC Basket of crudes, an adjustment factor α is introduced to take into account the dislocation between oil and gas prices relative to that value.

Box 1: Government’s Hydrocarbon Fiscal Revenues

As can be derived from Figure 1, annual government’s hydrocarbon fiscal revenues (HFR)

are determined by Formula 1:

HFR = xQαp + y[Eαp –C] +∆F +(T-S) ……[1]

Where:

Q is net (commercial) production of hydrocarbon

E is hydrocarbon export

C is petroleum industry’s full cost

∆F is the flow to and from a stabilization fund

T is domestic end-user petroleum tax

S is subsidy on petroleum consumption

x is the hydrocarbon production-weighted royalty rate

y is the average rate of hydrocarbon taxation

p is the average oil export price

Ignoring ∆F (as explained in the main text) and assuming T = S, ie petroleum subsidies are covered by taxes on domestic end-users of petroleum, we can derive the fiscal oil break-even price from Formula 2:

p = α-1(EXP – NHFR +yC)/(xQ +yE) ……[2]

Where:

EXP is government budget expenditures

NHFR is non-hydrocarbon fiscal revenues

α is an oil-gas price dislocation factor relative to the value of OPEC basket of crudes

While the above model for working out each OPEC country’s break-even price is straightforward, gathering and analyzing the macroeconomic and petroleum data can be daunting task. In particular, the cost element, which is the least transparent, is very approximate. Obviously, we are here dealing with the full cost incurred by the petroleum industry. In addition to operating costs and security costs, this component includes interest on debt and expenses for depreciation and amortization.

Because a break-even price can be interpreted as a short term fixed cost, the results are presented in the form of a cost curve. As shown in Figure 2, the curve is drawn starting with the lowest country’s break-even price at the left and progressing through successively higher-break-even-price countries. It depicts the fiscal break-even price as a function of petroleum (oil and NGLs) production within OPEC. The curve gives key insight into the fiscal challenge facing some countries (or the investment opportunities offered to others) when market prices – less operating cost – are lower (or respectively higher) than their break-even prices. It also provides some hints about the production policy options available to different members within OPEC, which are examined below. Before that, however, the large inter- and intra-country variations exhibited in Figure 2 deserve some explanation.

 

Figure 2: Tentative OPEC ‘Fiscal Cost’ Curve for 2010

Notes:

Break-even prices are expressed in terms of the value of OPEC basket of crudes.

Bar width represent a country’s production; bar heights estimate price ranges.

Estimated fiscal break-even prices for 2010 vary from $41/B for Qatar to $94/B for Ecuador. In between, Saudi Arabia’s break-even price is estimated at $76/B, nearest to the OPEC weighted average of about $77/B. Explanations for these inter-country variations include discrepancy in fiscal regimes, differences in the structure and cost of the hydrocarbon industry as well as the degree ordinary fiscal revenues contribute to balancing budgets. Additionally, different structures of exports translate, in the current energy market context, into a price adjustment factor (α) varying from basically 1 for non-gas exporter Saudi Arabia, to about 1.1 for Algeria and a little more than 1.2 for Qatar. Furthermore, intra-country sensitivity analysis reflects greater data uncertainty in the case of Iraq, Iran and Libya and, to a lesser extent, Algeria and Nigeria. As a result, OPEC weighted average fiscal break-even prices lie roughly within a $70-90/B range. 2

 

It is fairly obvious from the above that OPEC members display very heterogeneous fiscal positions. The consequence is that no member’s preferred price matches another’s. This weakens the chances of making the fiscal break-even price a predictor of ‘OPEC’ price preference no matter how close to OPEC’s average is the most influential member, Saudi Arabia. How then could members, whose fiscal break-even prices are higher than the market price, behave? They could try and persuade the opposite side to take action to tighten OPEC output by lowering country quotas either pro-rata or otherwise. The expectation would be for market prices to increase to meet their higher break-even prices, even if they lose some volume in the process. The problem, however, would not so much be how to implement such a scheme (OPEC members are well skilled in the art of bargaining). Rather, it is how to validate and justify it in the first place. In any case, OPEC members cannot set expenditure which depends on other members surrendering market share. Our conviction is that, ultimately, countries would spend only what they could afford. As suggested by John V Mitchell (paraphrasing),3  high spenders have no escape but to adjust their fiscal policies and bring their spending closer to their revenues. As a matter of fact, their “preferred prices” are more an indication of their “preferred spending” than any price they are likely to achieve.

The Long Term View

‎By contrast to the short term view, where break-even prices have tentatively been computed on a country basis, in the long term view we look at OPEC as a block. Furthermore, instead of computing new fiscal break-even prices, we keep to the range found previously to determine whether they could sustain future stable levels of spending. From this perspective, our assessment of fiscal sustainability derives from Milton Friedman’s permanent income hypothesis (PIH).

In its usual ‎formulation, PIH states that the ‎choices made by consumers regarding their ‎consumption patterns are determined not by current ‎income but by their longer-term income expectations.‎ Translated to governments – provided they are forward looking – Dr Friedman’s premise would mean that their spending ‎is akin to consumption and therefore would be determined in a similar way. Under this assumption, sustainable government spending would be approximated by the annuity value of expected hydrocarbon wealth. Formally, such a stable spending would be determined using Formula 3 in Box 2. It is the net return on both financial assets (stemming from hydrocarbon fiscal surpluses) accumulated in a fund and the net present value of hydrocarbon fiscal revenues expected over the remaining lifetime of hydrocarbon reserves.


Box 2: Fiscal Sustainability – Using PIH

The economic literature on the use of Milton Friedman’s Permanent Income Hypotheses (PIH) is extensive, but dominated by the IMF’s empirical case studies.*

PIH provides a simple framework for assessing fiscal sustainability. Accordingly, sustainable government spending (GC), at any time t, is determined by the annuity value of expected financial and hydrocarbon revenues along the formula:

GCt = GC = r [Ft-1 + ∑ Tt+n (1+d)-n]         [3]

n=0,N

Where:

Ft-1 is the value of financial assets (stemming from hydrocarbon fiscal surpluses) accumulated in a fund at the end of the previous year, in constant prices

Tn is the revenue captured through royalty and hydrocarbon taxes in period n, in constant real prices

r is the expected average real rate of return on hydrocarbon wealth

d is the discount factor

N is the number of years until hydrocarbon reserves are depleted

The discount rate, which should reflect specific risks, is different from the rate of return on accumulated financial assets.

* An insightful review of the topic is provided by Paul Stevens and John V Mitchell, ‘Resource Depletion, Dependence and Development: Can Theory Help?’, Chatham House, London, June 2008.

It should be noted that while adhering to a permanent income that relates producers’ fiscal policy to their hydrocarbon wealth, we have kept to a simple integrated framework. This is in contrast to recent trends toward using the non-hydrocarbon balance as a key indicator of long term fiscal sustainability. Depending on the purpose for which the indicator is used, different definitions of the non-oil balance are adopted.4  We believe that the simpler model adopted suits our purpose.

The key determinant involved for calculating the annuity value (sustainable government spending) is OPEC petroleum depletion policy and the resulting aggregate production profile, as derived from OPEC’s world supply projections.5  Despite revising growth projections downward on concerns of demand reduction and further uncertainty about the extent of non-OPEC supply from non-conventional oil, OPEC does not anticipate a plateau for its crude oil and NGLS before 2030. At that horizon, the ‘call on OPEC oil’ would be around 48mn b/d in the reference case. This is nearly a median figure between the IEA’s estimated 44mn b/d and 50mn b/d resulting from its twin ‘New Policies’ and ‘Current Policies’ scenarios.6

Other essential determinants of fiscal revenues include export prices, ‎governments’ fiscal take, discount factor and long term population dynamics. All are summarized in Table 1 and briefly reviewed below.‎

Table 1: Basic Assumptions for OPEC Revenue Simulations

Reference Date 2010

Assumptions

Remarks

Petroleum proven reserves

223 Gtoe + 20% reserve growth and Y-to-F

Y-to-F: Yet to find from undiscovered resources

R/P ratio

112 years

Simulation horizon

Production profiles

Crude oil & NGLs

Tuned to the OPEC’s Reference Case (2010 WOO)

Petroleum export prices

0.70 of Dated Brent

Prices moving together in the long run

Domestic pricing

At Average Cost

No rent extracted on domestic consumption

Governments’ take

70% of export take

Past 5-year calibration, declining to 65% in 2030

Discount factor

5% real

Up-pricing of risks – Long term horizon

Population

400 million, doubling in 2050

Dynamics depends on labor imports in OPEC’s GCC

Source: APICORP Research using statistics from OPEC, IEA, BP and own assumptions.

 

● Estimates of OPEC proven hydrocarbon reserves total 223‎bn tons of oil ‎equivalent ‎‎(toe) at the ‎start of 2011. These reserves are ‎‎63% crude oil and NGLs and 37% natural gas. We further assume ‎that reserve growth and yet-to-find reserves from undiscovered resources would raise proven reserves ‎by 25% for OPEC.‎‎

● The R/P ratio (proven reserves over production) is about 112 years ‎starting in 2011. This ratio is often used to indicate a time to depletion‎. However, ‎because it is static, we only refer to it to justify the long term timeframe for the analysis.‎

● In contrast to hydrocarbon exports, which are valued on the basis of international prices, domestic ‎primary energy consumption (basically oil and gas) is valued at supply costs. Product export prices ‎are assumed moving ‎together in the long run. Accordingly, the ratio of the average export price to the price ‎of Dated ‎Brent, taken as a benchmark, is set at 0.70. ‎

● As a result of ineluctably rising costs, government’s fiscal take is assumed to decline from 70% of the total ‎value of ‎production in 2010 to 65% in 2030 for OPEC as a whole. ‎

● The discount factor, which reflects both time preference and risk, is taken to be in the order of 5%, moderate enough to match the very long term horizon set for the simulations.‎

● Finally, to factor in the effect of population dynamics, our calculations and results are expressed in per capita terms. In ‎this regard, despite a continuously decreasing rate of growth, OPEC’s population is expected to ‎double by mid-century from the current level of some 400 million.‎

 

On this basis, Figure 3 illustrates a baseline scenario where OPEC’s combined oil and gas production profile is assumed to reach a maximum of 3.3bn toe in 2030 and, as a consequence, aggregate exports ‎start declining. The falling off after a 10-year plateau is moderated by the greater weight of gas production in the long term.‎ Another critical horizon lies a little beyond 2050 when rising domestic demand hits production ceilings and, as a consequence,  hydrocarbon rents dry out. Obviously, some member countries would face declining exports much sooner than 2030.

Figure 3: OPEC Reference Production Profiles

Despite the implicit message in Figure 3 of possibly rising price trends above inflation, the resulting ‎simulations are performed with a price range of $70-90/B kept constant in real terms (2010 dollars). According to the definition and resulting formula in Box 2, the annuity values are computed as returns on both the value of accumulated financial assets and the net present value (NPV) of hydrocarbon revenues. In order to factor in country risk and other specific petroleum industry risks within OPEC, the NPV discount factor is set at 2% above the long-run rate of return on financial assets.

Figure 4: Annuity Values of Expected Fiscal Revenues

Figure 4 plots the resulting annuity values for both oil price bounds as a function of the NPV discount factor. The figure does not tell much about whether or not OPEC governments would be fiscally comfortable in the long run with a real oil price range of $70-90/B. To form an opinion about the question, we need to know what amounts of spending governments need to execute desired socio-economic policies. Regrettably, there is no clear indication of what such long term plans might be, not to mention quantification.

The historical record could help if it were not equally difficult to establish and interpret. Over the last 50 years OPEC’s hydrocarbon fiscal revenues in real terms, ie adjusted from inflation and the appreciation/depreciation of the US dollar, have exhibited large fluctuations around an average real rent per capita of about $995.7 It so happens that despite all the uncertainties, this average does correspond to our governments’ sustainable spending within what would be considered as a normal discount factor range of 5-6%. However, contrasting future sustainable spending with target income based on average historic rent would not be reasonable without further analysis of the paths of domestic investment and savings, which is clearly beyond the scope of this commentary.

Conclusions

In this commentary we have offered a two-step analytical framework for estimating current OPEC fiscal break-even prices, then testing whether, if held constant in real terms, these prices could sustain future stable levels of government spending. In the first part of the analysis we have drafted a ‘fiscal cost curve’ to highlight OPEC members’ heterogeneous fiscal positions and provide key insight into the challenges and opportunities facing them. What is critical to note is that low oil prices will return to haunt the high fiscal break-even price countries among them.

In the second part we have focused on a long term fiscal sustainability and inter-temporal analysis, assuming OPEC countries would be investing hydrocarbon revenues in excess of budget projections into financial assets. In doing so we have implicitly admitted that all expenditures are current expenditures that yield no long-term return. The consequence is that spending is kept low to enhance future financial returns. If we assume instead that government expenditures contain a non-negligible investment component then spending upfront may be a better course of action, provided returns from domestic social and physical investment are higher than those from financial investment abroad. This is precisely what some OPEC members have committed to: to use hydrocarbon fiscal revenues today to diversify their economies and progressively shift their reliance away from hydrocarbon revenues. Whatever concrete socio-economic plans OPEC members may have, we should expect the resulting spending pattern to affect their fiscal break-even prices and bear on their oil price preferences and production policy behavior.

Notes:

1. It is worth noting that petroleum exports, from which derive the bulk of fiscal revenues, are denominated and paid in dollars, while government budgets are run in national currencies. Therefore, the effects of exchange rate on balancing the budget should not be ignored in other contexts.

2. This range confirms the oil price band we updated in 2010. The band was found to lie at the confluence of producers’ fiscal requirements and the cost of developing frontiers petroleum projects. See A Aissaoui, ‘Taking a Long Term View Beyond the Market – Bringing Ethics into the Economics and Politics of Oil Prices’, Presentation on the occasion of the celebration of OPEC’s 50th anniversary, Riyadh, 18-20 October 2010.

3. Paraphrased from a communication with John V Mitchell, co-author with Paul Stevens of ‘Ending Dependence – Hard Choices for Oil-Exporting States’, Chatham House, London, 2008.

4. For an extended discussion of this approach, see Paulo Medas and Daria Zakharova, ‘A Primer on Fiscal Analysis in Oil-Producing Countries’, IMF Working Paper WP/09/56, March 2009.

5. OPEC, World Oil Outlook, 2010.

6. IEA, World Energy Outlook, 2010.

7. Author’s calculation using OPEC price database and OPEC-based inflation and currency adjustment methodology.

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