Recent drone and missile attacks on Saudi Arabia's oil infrastructure resulted in the temporary suspension of more than half of the country's oil production. Although oil production was restored fully by end-September, we believe that there is a risk of further attacks on Saudi Arabia, which could result in economic damage. We have revised our assessment of the vulnerability of Saudi Arabia's economic infrastructure to regional military threats as a result of the most recent attack.
Saudi and US intelligence assessments indicate Iranian responsibility for the recent attack; France, Germany and the UK have supported this assessment. Yemen's Houthis, which are widely thought to be backed by Iran, have claimed responsibility for this and a number of other attacks on Saudi Arabia over the past two years, the majority of which were intercepted. The attack follows a number of attacks on commercial vessels in regional waters since May 2019. No group or state has admitted responsibility for these attacks, although statements by US officials have suggested responsibility likely lies with Iran. Iran's authorities have detained or attempted to interdict several other vessels, and its military has shot down a US drone.
In our view, Saudi Arabia is vulnerable to escalating geopolitical tensions given its prominent foreign policy stance, including its close alignment with US policy on Iran and its continued involvement in the Yemen war. We see a risk that the US and Saudi Arabia could be drawn into a deeper conflict with Iran, as Iran or groups linked to Iran continue to seek to break the diplomatic impasse over regional security and nuclear issues.
Saudi Arabian Oil Company (Saudi Aramco, A+/Stable) has already restored or substituted the lost production, demonstrating resilience to the attacks. This reflects both the ability to implement rapid repairs and significant spare oil production and processing capacity before the attack.
Saudi Arabia's continued fiscal deficits are a contributing factor to the downgrade. We forecast a fiscal deficit of 6.7% of GDP in 2019, from 5.9% of GDP in 2018, reflecting an underlying loosening of fiscal policy in 2018-2019, and lower average oil prices and production. We assume that the Brent oil price will average USD65 per barrel (bbl) in 2019 (from USD71.6/bbl in 2018) and that Saudi Arabia's oil production will average 9.7 million bbl/day (from 10.3 million bbl/day in 2018). We assume that, despite a speedy restoration of oil production to pre-attack levels, Saudi Arabia will continue to under-produce relative to its 10.3 million bbl/day commitment to OPEC (currently set to last until 1Q20). The authorities intend to offset the lower-than expected oil revenue by slowing down spending programmes.
Further weakening of oil prices in line with our baseline Brent price assumption of USD62.5/bbl for 2020 and USD60/bbl for 2021 will create headwinds for fiscal consolidation and the government's goal of balancing the budget by 2023, as set out in the revised Fiscal Balance Program (FBP), although we do assume a 6% expenditure cut in 2020. So far, despite significant structural fiscal reforms boosting non-oil revenue and reducing subsidies, better-than-expected oil revenue has been the primary factor allowing the government to meet and exceed the FBP targets even as the expenditure trajectory has been revised upwards. Fiscal outturns so far in 2019 also reflected a temporary boost from a larger-than-usual dividend from Saudi Aramco in 1Q19. We estimate Saudi Arabia's fiscal break-even Brent price of oil at an average of around USD82/bbl in 2019-2021.
Any upward response of oil prices to further geopolitical tensions could help offset the fiscal impact of disruptions to production or economic activity. However, the most recent attacks appear to have left little lasting impact on oil prices. We estimate that a USD10/bbl increase in average oil prices over the course of a year would reduce the fiscal deficit by nearly 4% of GDP. We estimate that a one million bbl/day lower oil production relative to current levels over the course of a year would increase the fiscal deficit by nearly 3% of GDP.
Fitch forecasts the government's balance sheet to deteriorate further amid continued deficits. We forecast general government debt will be 26% of GDP in 2021 from 16% in 2018 and 14% in 2017, when we last downgraded Saudi Arabia's ratings. Although this will still be well below the 'A' category median (historically about 42% of GDP), we view Saudi Arabia's debt tolerance as lower than that of most rating peers due to weak structural features, including political risks, the undiversified nature of the economy and shortcomings in governance. We also assume SAR275 billion of deposit drawdowns in 2019-2021 (more than the SAR170 billion specified in the FBP), bringing general government debt net of deposits at the Saudi Arabian Monetary Authority (SAMA) to about 16% of GDP, from -3% of GDP in 2018 and -13% in 2017.
The 'A' IDR and Stable Outlook also reflect the following key rating drivers:
Saudi Arabia's international reserve position and its estimated sovereign net foreign asset (SNFA) position will remain one of the highest among Fitch-rated sovereigns, but SNFA are deteriorating. We expect SNFA to decline to 64% of GDP by end-2021 from 74% of GDP in 2018 and 87% of GDP in 2017, mainly on the back of government external debt issuance. Saudi Arabia's SNFA position mainly reflects exceptionally large SAMA reserves (expected at around 22 months of current external payments at end-2019).
We estimate the level of state-owned and government-related enterprise debt (excluding banks) in Saudi Arabia reached about 20% of GDP in 2018; this is still relatively low given the government's large role in the economy, and many state-owned entities remain unlevered compared with international peers. However, broader public-sector debt is increasing, led by Saudi Aramco and the Public Investment Fund (PIF) and its portfolio companies. Combined with an increase in government debt and a drawdown of assets, this could undermine the exceptional nature of Saudi Arabia's balance-sheet strengths.
Our forecasts for Saudi Arabia's fiscal and external balance sheets do not incorporate any proceeds from a potential public offering of Saudi Aramco. Our understanding is that any proceeds would flow into the PIF and would be deployed in relatively illiquid domestic and foreign investments; we do not consider the PIF as part of the general government or SNFA. Although the plans for a listing of Saudi Aramco have regained traction, there are continuing uncertainties around size, valuation and timing.
We expect the current account surplus to narrow to 3.5% of GDP in 2019 from 9.2% of GDP in 2018, remaining comfortably above the historical 'A' median of about 1% of GDP. Nevertheless, SAMA reserves, including gold, remain under pressure from continued acquisition of assets abroad by residents. According to SAMA, about 60%-70% of financial outflows in 2017 and 2018 could be attributed to public-sector entities. We expect SAMA reserves to decline slightly but remain at a high level in 2019-2021, amid a narrowing of the current account surplus and continued resident investment abroad, mainly by the PIF. The fall in reserves will be mitigated mainly by external borrowing and portfolio inflows into the equity market related to Saudi Arabia's inclusion in major indices.
Most structural features are weaker than the 'A' category median, including World Bank indicators of governance and competitiveness. Hydrocarbon extraction accounted for 67% of fiscal revenue and external receipts and 34% of GDP in 2018. Despite recent declines, at 12.3% in 2Q19, the Saudi unemployment rate remains relatively high, in our view, creating economic and social pressure. The banking sector is well-capitalised and well-regulated, although the ratio of nonperforming loans to total gross loans has risen from low levels in an environment of slow private credit growth.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Saudi Arabia a score equivalent to a rating of 'A-' on the Long-Term Foreign-Currency (LT FC) IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to rated peers, as follows:
- Public Finances: +1 notch, to reflect the large government deposits held with the central bank as well as other government assets.
- External finances: +1 notch, to reflect the large size of SNFA, largely held as international reserves and the strong net external creditor position.
- Structural finances: -1 notch, to reflect Saudi Arabia's vulnerability to regional geopolitical and military tensions as well as other risks stemming from the rapid pace of economic, political and social change domestically.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a LT FC IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The following factors could, individually or collectively, trigger positive rating action:
- Fiscal consolidation or an extended rise in oil revenues that generate a sustainable fiscal surplus and reverse the decline in the government's net creditor position.
- A sustained easing in geopolitical tensions in the Gulf region.
The following factors could, individually or collectively, trigger negative rating action:
- A significant deterioration of the public-sector balance sheet.
- A further escalation of geopolitical tensions that affects key economic policies and activities.
Fitch assumes that Brent crude oil prices will average USD65/bbl in 2019, USD62.5/bbl in 2020 and USD60/bbl in 2021.
Saudi Arabia has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's SRM and risks stemming from regional geopolitics and the rapid pace of change domestically are currently particularly high; this is therefore highly relevant to the rating and are a key rating driver with a high weight.
Saudi Arabia has an ESG Relevance Score of 5 for Rule of Law, Institutional & Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in Fitch's SRM and Saudi Arabia and Saudi Arabia scores well below peers; this is therefore highly relevant to the rating and a key rating driver with a high weight.
Saudi Arabia has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as World Bank Governance Indicators have the highest weight in Fitch's SRM and the Voice and Accountability Pillar remains a standout weakness for Saudi Arabia; this is therefore relevant to the rating and a rating driver.
Saudi Arabia has an ESG Relevance Score of 4 for Creditor Rights as willingness to service and repay debt is relevant to the rating and is a rating driver for Saudi Arabia, as for all sovereigns.
© Press Release 2019