04 July 2015
RIYADH: With Saudi Arabia being a predominantly oil-based economy, major changes in the price of oil are likely to be followed by sentimental as well as real changes in the stock market. 

While sentimental changes often impact the stock market immediately, real changes will take effect over the longer term. If oil prices remain low, this ultimately affects economic policy framework, private sector activity and corporate profitability, according to a Jadwa Investment report.

The entry of qualified foreign investors (QFIs) into the Saudi Stock Exchange (Tadawul) and the recent weaker performance of the GCC stock markets, especially in the context of lower oil prices during H2, 2014, makes it worth assessing the nature of the Tadawul All-Share Index's (TASI's) relationship with global oil prices. 

When a major downward movement in international oil prices occurs, this will usually be accompanied by an immediate/short-term impact on the stock market, as a result of change in sentiment, the report said. 

Since retail investors make up around 90 percent of daily traded volumes, sentiment plays a bigger role in investment decisions compared to more developed stock markets. This can be highlighted by recent events following the steep decline in oil prices, by around 50 percent since mid-2014. In the case of the TASI, the downward trend was not reflective of market fundamentals, since a reduction in oil prices does not have an immediate impact on the growth of the economy or individual corporations.

The cause behind the slump was related more to panic selling due to dampened investor sentiment. As oil prices tumbled, many retail investors feared that lower oil prices would prompt the Saudi government to slow or, even worse, cut back on expenditure, squeezing corporate profits in the longer term.

However, investors' fears over lower fiscal and business related spending were allayed when the Saudi government pushed through an expansionary fiscal policy at the end of 2014. Since then the TASI's recovery has been helped by a smooth Royal succession, two salary bonuses to public sector employees, and a stabilization in global oil prices.

The second longer term real effect of oil price fluctuations can be broken down via two distinct but interrelated transmission paths, one through the public and the other through the private sector, the Jadwa Investment report said.

Since around 86 percent of government revenues are derived from oil revenue, a prolonged period of lower prices will impact government expenditure.

Looking at the public sector transmission, change in oil prices will affect government revenue. High oil prices sustained for more than year will result in a build-up in fiscal balances resulting in higher government expenditure, which pushes up GDP growth rates and corporate profitability and ultimately translates into a positive effect on the stock market. Sustained low oil prices have the opposite effect.

At every stage of the transmission process in the public sector there are direct linkages and knock-on effects to the private sector.

Looking back since 1974, there are three periods where prolonged lower oil prices have resulted in lower government gross fixed capital formation (GFCF). The first instance was between 1981 and 1986, when oil prices declined on a yearly basis over these five years, from an average of $35 per barrel in 1981 to $14.5 per barrel in 1986. Over the same period, government GFCF declined on a year- on-year basis, from SR73 billion in 1981 to SR25 billion in 1986. Only from 1988, as oil prices increased year-on-year, did government GFCF increase too.

The second instance was between 1992 to 1994. The decline in oil prices was less severe during this period, dropping from $19 per barrel to $15 per barrel. Nevertheless government GFCF dropped from SR45 billion in 1991 to SR23 billion in 1994. In 1995 oil prices recovered slightly, and GFCF rose to SR25 billion. 

In the third instance, oil prices dropped year-on-year in 1997 and 1998, which saw government GFCF drop in both 1997 and 1999, recovering immediately after.

Since H2, 2014 Saudi Arabia is in the midst another period of sustained lower oil prices. In 2014, oil prices averaged $99 per barrel and we forecast that Brent will average $61 per barrel in 2015, recovering slightly to $68 per barrel in 2016. Government GFCF peaked at record levels in 2014 at SR264 billion. 

In the current period of lower oil prices, the reduction in government GFCF will not be as extreme as in the 1980s and 1990s. The main reason for this is the large foreign reserves of SR2.6 trillion ($683 billion) held by Saudi Arabian Monetary Agency (SAMA), as of end of April 2015, which should provide a sufficient financial cushion for the government to sustain an elevated level of spending during 2015 and beyond. Furthermore, there is plenty of room for the government to raise debt given its strong credit ratings and record low debt levels. 

In fact we see the government shifting its financing strategy from using only foreign reserves to a combination of foreign reserves and debt to finance its fiscal deficit in 2015. Accordingly, Jadwa forecasts public debt increasing to 9.6 percent of GDP by the end of this year, compared to 1.6 percent at the end of 2014.

© Arab News 2015