Tuesday, March 10, 2020 /04:19
PM / By Vetiva Research / Header Image Credit: Oilprice
OPEC+ split to yield excess crude output
Brent, a benchmark for Nigeria's crude, slumped more than 20% to $35/bbl (down 47% year to date) on Sunday, its lowest price since early 2016. The plunge in oil market was an aftermath of the breakdown in supply cut negotiations at the OPEC+ meeting last week, which subsequently triggered the split of OPEC+ alliance (notably Saudi Arabia and Russia). Taking a step beyond a refusal to deepen cuts, Russia has indicated its intention to flood the oil market in a bid to squeeze out U.S. shale frackers, who had initially been reaping the benefits of earlier OPEC+ cuts. In the same vein, Saudi Arabia, with a spare capacity in excess of 2 mb/d, has revealed its plans to raise supply and also offer its crude at deep discounts to win customers next month. We believe the intended move by these two large oil producers could further drag Brent price to south of $30/bbl in the next couple of weeks.
Based on the afore-mentioned, U.S. shale producers could be compelled to trim output at the Permian basin amidst tough oil economics, stemming from a rapidly narrowing spread between the cost of fracking shale and West Texas Intermediate (WTI). Notably, the fringe players in U.S. shale industry, with a unit cost exceeding current WTI, have already shut down operations in Texas and New Mexico. While the anticipated drop in U.S. output could result in a slight recovery in the oil market (likely taking Brent to a little north of $40/bbl), we note that the demand leg remains vulnerable to the global spread of coronavirus. For instance, the International Energy Agency (IEA) recently reduced its forecast for world oil demand by almost 1 mb/d in 2020- the first demand contraction since 2009. Overall, with anticipated dynamics pointing to an enormous supply overhang and a significant demand shock coupled with the uncertainty around coronavirus containment, we do not expect Brent to trade beyond $45/bbl in the near term.
Low oil price environment to strain Nigeria's budget financing
The Nigerian government will have to come to terms with the reality of a low oil price environment and may have to revise the expenditure plans in the 2020 budget and revenue estimates in the MTEF 2020-2022 to accommodate the current reality. Crude oil is currently trading at a discount of over 40% to the 2020 benchmark of $57/bbl. This is likely to weigh on Nigeria's fiscal capacity, given that the 2020 budget is based on this assumption. The 2020 budget has an oil revenue target of N3.7 trillion based on this oil price assumption. If oil price were to remain at current levels or even test lower levels, oil revenue in 2020 could underperform by a trillion naira or more, adding to the current budget deficit of N2 trillion.
To salvage the fiscal situation, the government will most likely be faced with two options; either cut back on proposed expenditure or increase borrowings to plug the deficit. Given that the government's body language is pro-growth and infrastructure expansion, taking on more debt may seem to be the easier option to fill the hole that the plunge in oil price has created in the budget - especially in an era when there is a glut in global liquidity and global interest rates are near zero. Nonetheless, we opine that capex implementation will suffer in the near term, should fiscal borrowings fall short.
A recourse to borrowings could increase the country's financial liability to FPIs in debt securities and also support FX inflow into the country. However, existing safety-conscious FPIs will continue to pull their funds from Nigerian assets, putting pressure on the CBN's FX reserve assets. As a result, we expect the surplus in the financial account to narrow. Also, a low oil price environment could result in the worsening of the current account deficit, considering that crude oil accounts for the bulk of Nigeria's exports.
It could also result in slower mining and quarrying sector activities, amid the PIGB impasse. This will further constrain efforts by the government to increase non-oil revenue from royalties in the sector. On the bright side, the lower crude price will result in lower fuel landing costs, allowing oil marketers to resume importation of PMS at profitable levels. Thus, the government will be able to reduce petroleum subsidies and can redeploy the free funds into financing projects in the critical sectors of the economy.
In the FX market, a low oil price environment means a faster rate of decline in the FX reserves if the CBN continues its interventionist policy in the market to keep rates stable. The case for devaluation rests on a thin line between economics and politics. Whilst it is probably economically viable to devalue the naira, a devaluation is considered a negative in the political sphere. Hence, we believe the first response of the CBN will be to raise the discount rates in the OMO market to keep foreign investors interested in Nigerian treasury assets while possibly stemming the rate of outflow from the market. The rates at the parallel market might inch higher in the short-term as a result of panic buying by locals who are seeking safety from currency shocks.