Middle East and North Africa: The challenge of a long-term strategy for oil exporting countries


By Rahmat Poudineh, Senior Research Fellow and Director of Research, the Oxford Institute for Energy Studies

This blog is part of a series on tackling COVID-19 in developing countries. Visit the OECD dedicated page to access the OECD’s data, analysis and recommendations on the health, economic, financial and societal impacts of COVID-19 worldwide.

Oil refinery plant in Qatar

There is no single successful strategy to shield oil-exporting countries of the Middle East and North Africa (MENA) from the long-term risks of an oil price crash, exposing them to serious long-term challenges.

Diversification for example, works only when it reduces risk by pooling uncorrelated income streams and sectors. If countries diversify only into sectors that rely on hydrocarbon infrastructure and where relationships (tangible and non-tangible) exist across fossil and non-fossil fuel businesses, they cannot build resilience. On the other hand, if they diversify into substantively different areas that have little in common with their current primary industry, which is the core of their comparative advantage, they run the risk of not being competitive. Moreover, the cost of reducing the long-term risks and increasing resilience of their core sector is to accept lower expected return on existing hydrocarbon assets, for instance, by investing in measures that align their hydrocarbon sector with low carbon scenarios. This lowers the overall return but reduces the risk of disruption in the long run.

The double shock of COVID-19 and the oil price collapse has once again revealed the economic vulnerability of MENA oil exporters. IMF forecasts that the budget deficit as a percentage of GDP will rise sharply in these countries in 2020 and 2021. However, the main problem for these countries is not the cyclical fluctuations in oil prices due to market and non-market factors, but the structural decline in oil demand due to the energy transition. In the long run, global initiatives to reduce carbon emissions are expected to disrupt revenue and reduce the market share for the fossil fuel industry. Furthermore, the COVID-19 pandemic may accelerate the energy transition if decarbonisation targets are factored into the economic recovery of major economic centres like Europe.

Despite what we always hear, the long-term strategy for oil exporting countries is about risk reduction and not just revenue generation. There is no benefit in creating new sources of revenue if they are subject to the same risks as existing revenue sources. The old saying of “don’t put all your eggs in one basket” is meaningful when (i) there is exposure to risk and (ii) not all ‘baskets’ are affected by the same risks. Otherwise, it would of course make sense to put all the eggs in the same, best-performing basket (or sector) to maximise economic efficiency.

Economic diversification initiatives in MENA oil exporting countries (which originally started in the 1970s) are connected with their hydrocarbon sectors, through tangible and intangible relationshipsultimately exposing them to the same shocks. The initial focus was on developing heavy industries especially petrochemicals, chemicals, fertilizers, steel and aluminium, mostly because of abundant and low-cost hydrocarbons. In recent years however, with global oil demand expected to decline due to the energy transition, the focus has shifted to replacing hydrocarbon exports with new energy carriers – like hydrogen and ammonia – that can be produced using existing oil and gas resources.

These strategies however suffer from three drawbacks. First, energy intensive industries that use cheap unabated hydrocarbons with high carbon content are susceptible to carbon border tax adjustment. Second, there is some degree of correlation between prices of all energy vectors, given their substitutability in the end user market. Third, with the growth of decentralised technologies, future energy systems will be characterised by a high level of competition and the absence of energy superpowers. This means it will become increasingly difficult to extract rent beyond marginal costs from new energy products such as hydrogen or ammonia. These strategies might also fail to deliver other government objectives such as local job creation, as the energy industry is very capital intensive. There have been attempts in some countries to expand to service sectors such as banking and financial services, tourism and entertainment, among others. Success in these sectors, however, depends on implementing extensive economic, institutional, governance and business environment reforms to remove barriers to private sector participation and facilitate growth of these industries. There is huge uncertainty however on whether such extensive reforms can be implemented in these countries, given their rigid political structure.

In sum, MENA oil exporting countries face serious hurdles to achieve meaningful risk reduction through diversification. The more their diversification strategy is reliant on the hydrocarbon sector the more competitive it is, but the downside is that it is subject to same risks as the oil sector. On the other hand, the further they move away from the hydrocarbon sector, the lower their chance of being affected by the same shocks as the oil sector. However, establishing competitive productive sectors entirely independent from the oil and gas sector is very difficult in these countries.

Furthermore, reducing risk comes at the cost of reducing return. Sovereign wealth funds (SWFs) that convert oil and gas rents into a diversified portfolio of financial assets can play an important role in income and economic diversification. However, if these funds are used only to insulate countries from commodity price volatility, rather than as a long-term investment vehicle to bolster uncorrelated non-oil productive sectors, their role is diminished to merely that of a stabilising fund. History shows that this has dominated the investment and operational strategies of Sovereign wealth funds in MENA oil exporting countries, as they significantly liquidated assets to cover withdrawals over the previous oil price cycle of 2014-2016. Ultimately, if the hydrocarbon sector is to be part of the long term risk reduction strategy of oil exporting countries, they have no choice but to accept lower return on their existing assets by incurring the cost of aligning them with the requirements of a low carbon future.