Second Order Questions and Sterilising the Oil Price Effect

Consider, if you will, an oil exporting nation. Consider further those nations whose commodity exports far exceed their budgetary needs. What is a nation to do with such excess wealth?

There are two main approaches to this. The first is the more conventional strategy inherited from central banks, in many ways the precursors to SWFs. This method, which I will call risk-off, seeks simply to hold foreign exchange reserves, usually the US dollar, in the form of high quality, low risk assets, usually US Treasury bonds.

The second strategy, which I will call the risk-on, borrows heavily from pension and endowment funds. Investments are made not to protect value, but to create value so as to meet future obligations. Not only is public equity as an asset class targeted, but all manner of alternative investments including but not restricted to private equity, hedge funds, real estate and high yield debt.

So as not to confuse the point that I am trying to make, I would like to clarify that there is no right or wrong to which method a government chooses, as the choice is driven by policy considerations not investment considerations.

Back to our story. If an oil exporting country with a risk-on strategy suddenly faced oil prices dropping by 50%, what is the net effect to its revenue? Using Norway as an example, their circa 1.7 million barrels per day of export would lose USD 85 million per day in revenue or USD 31 billion per year.

I am purposefully ignoring costs in this example, both costs of extracting and selling the oil as well as the costs of managing the SWF’s assets. The point of this article is not lost, without delving into the murky business of oil production costs and the even murkier asset management costs.

Back to our example. If the effect on Norway’s finances of the oil price halving is a loss of USD 31 billion in revenue, what other effects are there? One major impact is on the SWF returns. You see, with the oil price halving, a risk-on strategy is going to do extremely well as lower energy costs boosts global productivity.

What is the incremental increase in return that the SWF needs to offset the oil price cut? Well, the USD 890 billion of SWF assets that Norway has needs an increase of 3.5% in returns to offset the USD 31 billion fall in oil revenue.

Is a 3.5% increase in the annual return of the SWF assets easy or hard to achieve in light of a 50% drop in oil price? I don’t know. But I’m willing to bet it is doable.

More importantly, we cannot stop with just first order questions (oil price drops so oil revenue drops therefore this is bad). We need to ask the second order questions such as what is the real budget break even? What can oil exporters do (savings, trim the expansionary budget)? Importantly, is oil revenue fluctuations sterilised by a SWF risk-on strategy?

You may also enjoy a trio of related articles on oil: Saudi Oil Price, Saudi Oil Price Redux and Oil: Through the Looking Glass.