Impact of Global Financial Crisis on Oil Pricing in Saudi Arabia

Theoretical Literature

The latest theoretical literature on the subject of the impact of global financial crisis on oil pricing in Saudi Arabia and its implications on the cash flow, suggests that corporate cash holdings are generally set and affected by three significant theories in corporate finance; the first is the trade off theory, the second is the pecking order theory and the third is the free cash flow theory.

The theoretical literature part of this research will explore these three theories on the light of the impact of global financial crisis on oil pricing in Saudi Arabia and its implications on the cash flow. According to the trade-off theory (TOT), Myers (1977) argued that corporations determine their best possible point of cash holdings through striking a balance between the marginal costs and the marginal benefits of holding cash.

The marginal benefits which are connected with the cash holdings are: the lower transaction costs (associated with using cash for payments without having to liquidate assets), decrease in the possibility of financial suffering and the likelihood of executing investment projects which may not be carried out without such funds because of having financial constraints. The major cost of holding cash is the opportunity cost of the capital invested in liquid assets.

It is noteworthy to mention that the oil sector has played a significant role in Saudi Arabia's economic development. Rising world oil prices and Saudi Arabia's response to meet world demand by increasing its output levels had always demonstrated the Kingdom's importance as the world's leading oil supplier. However, oil prices have witnessed drops every now and then coinciding usually with global financial crises.

In June 1981, The New York Times stated an 'Oil glut! ... is here' and Time Magazine stated: 'the world temporarily floats in a glut of oil,' though the next week a New York Times article warned that the word 'glut' was misleading, and that in reality, while temporary surpluses had brought down prices somewhat, prices were still well above pre-energy crisis levels.

According to Bates, Kahle, & Stulz (2009), this sentiment was echoed in November 1981, when the CEO of Exxon Corp also characterized the glut as a temporary surplus, and that the word 'glut' was an example of 'our American penchant for exaggerated language.' He wrote that the main cause of the glut was declining consumption. In the United States, Europe and Japan, oil consumption had fallen 13% from 1979 to 1981, due to 'in part, in reaction to the very large increases in oil prices by the Organization of Petroleum Exporting Countries and other oil exporters,' continuing a trend begun during the 1973 price increases. After 1980, reduced demand and overproduction produced a glut on the world market, causing a six-year-long decline in oil prices culminating with a 46 percent price drop in 1986.

The 1990 energy crisis was milder and more brief than the two previous oil crises. It lasted only six months and occurred as a result of the first Gulf War. As Saddam Hussein retreated, the oil fields of Kuwait were set on fire, causing damage that reduced the oil output until repairs could be performed. OAPEC decided that since the oil production in the Kuwait was falling, they would increase their oil supply and stabilize the oil market. Oil hit a then-record nominal price of $50.50 per barrel during this crisis.

In the second theory of pecking order theory (POT), Myers & Majluf (1984) suggested that the asymmetric information between managers and investors makes external financing costly. As a result, firms should finance investments first with retained earnings, then with safe debt and risky debt, and finally with equity to minimize asymmetric information costs and other financing costs. Additionally, according to this theory, firms do not have target cash levels, but cash is used as a buffer between retained earnings and investment needs.

As for the main cause of the current drop in oil prices, it is the strength of the U.S. dollar which is the most important cause as it is the key driver for everything, because when the dollar is strong, the value of commodities falls and global commodity prices are usually quoted in dollars and are likely to fall when the U.S. dollar is strong. Another reason for the oil prices drop, although not certified by clear evidence, is the nuclear agreement with Iran which would most probably allow more Iranian oil exports. Finally, U.S. crude oil inventories recorded the highest level in at least the last 80 years.

Saudi Arabia is not isolated from the world. Its economy and sectors have been directly and indirectly affected by the global financial crisis. The Kingdom's main oil production has witnessed sharp and frequent declines, Prices of petrochemicals, which are famous for manufacturing the Kingdom. It should be noted that in most of our Arab countries, our economy is economically dependent, i.e., it is based on one industry or one main resource. It is true that if the global economic recession hits this central branch of the economy, it will have direct repercussions on the rest of the sectors.

Banks and cash flows are naturally affected by these events. It is noteworthy to mention that the banking sector is the dividing line that reveals the reality of economic and financial stability in any economy or not.

The global financial crisis revealed some of the observations and some drawbacks on the Saudi banks and their cash flows, perhaps some of these observations are not the result of the financial crisis as much as the crisis has been revealed, including:

• High concentrations of lending and cash flows for limited names and companies, and it is time to address this phenomenon because of its far-reaching effects in the event of subsequent economic consequences or shocks.
• The investment of some banks for amounts and cash flows are considered relatively high outside the Kingdom in search of more profits.
• A little reservation to grant more local credit, this may be due to a short-term fear and reserve of the risk of over-granting unsecured credit to consequences and risks.
• Some of the losses suffered by a number of customers of Saudi banks as a result of their foreign investments or the result of debt trading and hedging contracts and toxic derivatives, which is a kind of imaginary transactions based on the adventure, which is closer to gambling and expectations of future prices, which had an impact on the repayment of their obligations to Saudi banks, indirectly affected their assets, their banking transactions after the financial crisis, in addition to the prospects of slowing the movement of projects and the decline in profitability.

Finally, as for the free cash flow theory (FCFT), Jensen (1986) assumes that managers possess a motive to accumulate cash so that they can increase the amount of assets under their control and to put on optional power over the company’s investment decision. The availability of cash flow in the company minimizes the pressure to perform well and allows managers to invest in projects that best suit their own interests, but which may not be in line with the shareholders best interest.

Coincided with the emergence of the global financial crisis and low oil prices because of it, constant assurances from the Saudi government that the financing of Saudi banks and investments in the Kingdom are mostly local, and that there will be no significant impact on Saudi banks because of this crisis, as most of the investments of domestic banks are directed at the Kingdom.

The Kingdom has witnessed a major development in the banking sector in recent years which has been shown to have an impact on increasing the volume of deposits, increasing assets and banks' profits, and coinciding with these increases in support of Saudi Arabian Monetary Agency (SAMA)'s institutional supervision by following some plans that support the sector such as compliance with Basel and Basel II, activating the work of audit committees, attention to compliance and risk management, and the Capital Market Authority's preparation of corporate governance principles that supported disclosure and transparency. As time progressed, there was a shift in this area and there became a mandatory implementation of some of these principles, in addition to the supervision of the Saudi Arabian Monetary Agency on Saudi banks or foreign workers in the Kingdom, all this led to the global financial crisis and the decline Oil prices have limited and non-significant effects on Saudi banks and cash flows.

It should be noted here that the Saudi government and the Saudi Arabian Monetary Agency played an unprecedented role in supporting banks to maintain cash flows in light of the decline in oil prices:

• Continue to ensure deposits and the integrity of the banking sector.
• Review monetary and fiscal policies to enhance bank liquidity.
• Support and support through increased deposits of government deposits in a number of banks.
• Provide and inject cash flows to ensure that the deadlock is broken and that balanced lending and credit rates are achieved.
• Direct some financial savings to:
• Support the state budget.
• High government spending, which helped keep the economic wheel going, and reduced the impact by maintaining high spending.
• Increasing the volume of capital expenditures inside, which compensates for the decrease in foreign investments.

In conclusion of the theoretical review, it transpired that neither the pecking order theory nor the free cash flow theory suggests that there exist target cash holding levels while the trade-off theory does. According to this theory, firms trade off the benefits and costs of holding cash to determine the target cash reserves, and when the actual cash holdings deviate from the target levels, firms tend to adjust their cash reserves to the target level.

Empirical Literature

There is significant empirical evidence to back up the existence of best possible target levels for corporate cash holdings in the extent literature. Drobetz and Gruninger (2007), Alles, Lian, and Yan (2012) and Rehman and Wang (2015) confirm the presence of target levels of cash reserves and firms tend to adjust towards target cash levels.

The existing research on corporate cash holdings is replete with evidence from the U.S and developed markets with little attention given to the emerging markets. Several factors make cash holdings different in emerging markets from that of developed markets. According to Scott (1995), institutional factors may affect firm's financial practices such as cash holdings.

One of these factors is the socio-economic factor including laws, and actor's attitudes which is considered to be weak in many emerging markets relative to that in developed markets such as the US. This is likely to raise the level of uncertainty in transactions and consequently encourage a range of unproductive practices such as cash retention. Moreover, slow institutional development (i.e., stock market, bank, and other financial institutions) may motivate firms to adopt conservative financial practices.

The impact of the global financial crisis on the Kingdom and the decline in oil prices have become evident through several channels, the first through the oil market, where most estimates indicate a decline in global demand and therefore the expected production from the OPEC countries and may continue to decline if the recession continues for a longer period, the Kingdom of oil, began to signal OPEC's decision to reduce its production ceiling.

If we take into account the 1997 Asian financial crisis and the drop in world oil demand accordingly and consequently the prices and its impact on OPEC production as an indicator, we will notice that the OPEC production ceiling has fallen continuously since the beginning of the global financial crisis and thus reduced the Kingdom's production. After the end of the Asian crisis, demand has recovered and OPEC production has also recovered until it reached a high level.

Thus, the impact of the global financial crisis and the difficulty of obtaining loans to finance business operations, future projects or cash flows are evident. Assuming that the Kingdom's oil production will continue to grow, its production for the coming years will be less than the current production, and the price levels will often be lower than their average, which means a drop in oil GDP and a decrease in cash flows.

According to Chaubey (2016), oil prices have witnessed many crises since its boom in the 1970’s leading to significant revenue shortfalls in many energy exporting nations, while consumers in many importing countries are likely to have to pay less to heat their homes or drive their cars. From 2010 until mid-2014, world oil prices had been fairly stable, at around $110 a barrel. But since June prices have more than halved. Brent crude oil has now dipped below $50 a barrel for the first time since May 2009 and US crude is down to below $48 a barrel.

The question of why did the oil prices fall dramatically is not a simple question. However, the answer stems from the simple economics of demand and supply. However, the main cause of the current drop in oil prices is the strength of the U.S. dollar which is the most important cause as it is the key driver for everything, because when the dollar is strong, the value of commodities falls and global commodity prices are usually quoted in dollars and are likely to fall when the U.S. dollar is strong.

The decline in oil prices is expected to have limited impact on the economy of Saudi Arabia on the short run as the government largely used its deposits with the Saudi Arabian Monetary Agency (SAMA) to finance fiscal deficit. However, on the long run, the Saudi government should improve its spending efficiency, adapt price reforms and expand non-oil revenues as part of fiscal consolidation strategy to face any current or future drop in oil prices.

The decline in oil prices as a result of the global financial crisis leads to a decrease in the Kingdom's general revenues and the value of exports, which reduces the budget surplus and the current account surplus in the balance of payments to GDP. As an emerging market, Kingdom of Saudi Arabia has different business practices. KSA is an oil rich country, the stock market is relatively underdeveloped and an Islamic banking system is present, the legal origin is based on Sharia Law.

Two of the most important aspects of the Islamic values relating to corporate financing are that Islamic law prohibits loan interests whether giving or taking by individuals or business institutions. Second, the obligation of Zaket that should be giving, calculated based on the capital of the business or individual, and given to specific groups.

Conclusion

This literature provided two approaches to the impact of global financial crisis on oil pricing and cash flow in Saudi Arabia; these approaches are theoretical and empirical.

Regarding the first approach, recent studies suggest three theoretical models that can help identify which firm characteristics determine corporate cash holdings decisions: Trade-off theory, Pecking order theory and Free-cash flow theory. As for the second approach, there is significant empirical evidence to back up the existence of best possible target levels for corporate cash holdings which confirms the presence of target levels of cash reserves.

References

1. Alles, L., Lian, Y., & Yan, X. (2012). The determinants of target cash holdings and adjustment speeds: An empirical analysis of Chinese firms.
2. Al-Najjar, B. (2013). The financial determinants of corporate cash holdings: Evidence from some emerging markets. International Business Review, 22, 77e88.
3. Al-Nodel, A., & Hussainey, K. (2010). Corporate Governance and Financing Decisions by Saudi Companies. Journal of Modern Accounting and Auditing, 6(8), 1e14.
4. Bates, T., Kahle, K., & Stulz, R. (2009). Why do U.S. firms hold so much more cash than they used to? Journal of Finance, 64, 1985e2021.
5. Drobetz, W., & Gru¨ninger, M. C. (2007). Corporate cash holdings; Evidence from Switzerland. Financial Markets Portfolio Management, 21, 293e324.
6. Chaubey, D. (2016). World’s Oil Scenario –Falling Oil Prices Winners and Losers a Study on top Oil Producing and Consuming Countries. Imperial Journal of Interdisciplinary Research (IJIR). 2. 378-383.
7. Ferreira, M. A., & Vilela, A. S. (2004). Why do firms hold cash? Evidence from EMU countries. European Financial Management, 10, 295e319.
8. Jensen, M. (1986). Agency cost of free cash flow, corporate finance, and takeovers. American Economic Review, 76, 3e43.
9. Kariuki, S. N., Namusonge, G. S., & Orwa, G. O. (2015). Firm characteristics and corporate cash holdings: A managerial perspective from Kenyan private manufacturing firms. International. Journal of Advanced Research in Management and Social Sciences, 4, 51e70.
10. Myers, S. (1977). Determinants of corporate borrowing. Journal of Financial Economics, 5, 147e175.
11. Myers, S., & Majluf, N. (1984). Corporate financing and investment decisions when firms have information that investors do not have. Journal of Financial Economics, 13, 187e220.
12. North, D. (2005). Understanding the process of economic change. Princeton University Press.
13. Opler, T., Pinkowitz, L., Stulz, R., & Williamson, R. (1999). The determinants and implications of corporate cash holdings. Journal of Financial Economics, 52, 3e46.
14. Rehman, A., & Wang, M. (2015). Corporate cash holdings and adjustment behavior in Chinese firms: An empirical analysis using generalized method of moments. Australasian Accounting, Business and Finance Journal, 9, 20e37.
15. Scott, R. (1995). Institutions and organisations. London: Sage.