How can the financial vulnerability of an oil-exporting country to market shocks be assessed? A widely used metric is the fiscal breakeven price, defined as the price of oil that is just high enough to generate government revenues sufficient to avoid a deficit in the national budget. A high fiscal breakeven price – especially when it exceeds the market price of oil – is viewed as a sign of financial stress. The International Monetary Fund (IMF) pioneered this metric in 2008, and many analysts now offer independent estimates of the fiscal breakeven prices facing individual countries. These estimates are scrutinized by governments, international financial organizations, banks, credit rating agencies, the media, and academics.
However, an analysis recently published by KAPSARC shows that the prevailing estimates of fiscal breakeven prices are both misguided in theory and misleading in practice. These estimates assume that a country’s oil production remains fixed in the face of price changes, but this is a faulty assumption. Since the movement from the current price to the alleged breakeven price would trigger changes in global demand and other producers’ supplies, the country’s production level must change for the market to remain balanced. Moreover, the country could achieve a better outcome and protect against a deficit by adjusting its production in response to other market participants’ reactions. This inconsistency in the prevailing method leads to an exaggeration of the financial vulnerability of oil-exporting countries, artificially increasing the perceived risk of a public deficit.
The prevailing treatment of the external breakeven price – the oil price that balances a country’s current account – suffers from the same methodological flaw. While previous critiques of the prevailing approach focused on its implementation, KAPSARC’s analysis challenges the logic of the approach itself.
In addition, KAPSARC’s analysis corrects the prevailing methodology and provides a proper measure of both the fiscal and external breakeven price, as well as the size and likelihood of demand shocks that would threaten a country’s ability to break even. For instance, based on its projected 2023 budget, Saudi Arabia’s true fiscal breakeven price was $7.16 per barrel lower than calculated by the prevailing method. The true external breakeven price was lower than the prevailing estimate by a staggering $16 per barrel. To force the country into a public deficit, assuming fixed government expenditures, would have required a negative shock to oil demand exceeding 3.5 million barrels per day, the probability of which is estimated at about 2%.
Importantly, the KAPSARC approach is practicable, with simple Excel spreadsheets that enable users to estimate fiscal and external breakeven prices for any country based on their own data and market views. Breakeven price concepts are used by many organizations to assess the sovereign credit risk or the financial health of oil-exporting countries. Getting them right is therefore critical.
The full KAPSARC paper is available Here
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