December 4, 2014 / 1:17 AM / 5 years ago

Oil states' recourse to sovereign funds could rattle world markets

LONDON (Reuters) - Energy-exporting countries which have stashed billions in windfalls in sovereign investment funds may be forced to draw down on them as oil revenues shrink, sending a chill through stock, bond and property markets worldwide.

The word oil is pictured on an oil bank at a recycling yard in London March 2, 2011. REUTERS/Stefan Wermuth

Oil-based sovereign wealth funds are a major force in international finance, holding more than $5 trillion in assets, according to David Spegel, an emerging markets expert at BNP Paribas.

The funds’ money is typically split into baskets serving distinct functions, propping up government spending at times of falling export revenues or managing windfalls over decades for future generations.

Norway’s government is allowed each year to take up to 4 percent of its $850 billion wealth fund, the world’s largest, though it only spent 2.8 percent in 2014, using the money to pay for tax cuts. Nigeria’s stabilization fund accounts for around 20 percent of its total sovereign wealth pot.

With Brent crude oil prices languishing at around $70, it is currently well below the fiscal break-even point needed by many major energy exporters, including Saudi Arabia, Russia and Nigeria, to balance their budgets, as the following graphic shows:

Many funds are already making use of the stabilization components.

In October, Norway’s government said it may lift the cap on how much of its sovereign wealth fund it can tap to counter the economic impact of a weak oil price. Oil has dropped more than $20 per barrel since.

For Russia, falling oil prices merely add to pressure to tap sovereign wealth funds. Moscow has already looked to its $82 billion National Wealth Fund as a source of emergency financing for companies hurt by Western sanctions imposed over its involvement in Ukraine.

Stabilization funds typically hold more low-risk and liquid instruments, especially bonds, that can be swapped for cash quickly.

“The bulk of the money (in stabilization funds) is invested in higher-grade assets, with a lot in U.S. Treasuries and other government bonds,” Spegel said, quoting an IMF estimate that recycled petrodollars usually keep U.S. Treasury yields about 50 basis points lower than they would be otherwise.

Sovereign funds “also invest in equity markets, to some extent,” Spegel said, highlighting Nigeria, Kazakhstan Kuwait and Iran as examples of funds with money set aside to help national treasuries in times of need.

A worst case scenario for oil producers, with oil prices falling further and for a sustained period, could prompt governments to tap the funds run for future generations.

This type of sovereign fund often holds more long-term and illiquid assets such as real estate. Sovereign investors were involved in some of this year’s biggest property and infrastructure transactions.

Any potential withdrawal of sovereign funds could therefore eventually hit commercial real estate values in some of the world’s biggest cities.

In London, for example, sovereign funds such as the Qatar Investment Authority own some of the city’s most prominent landmark commercial buildings, including the upmarket Harrods department store.

“Sovereign Wealth Funds have retained their focus on Central London, although the total volume is difficult to estimate as purchases are often made through fund managers.  Around 5.2 billion pounds ($8.2 billion) of overseas investment in the last year can be classed as ‘private’, much of which could be sovereign wealth,” said Stephen Clifton, head of central London at property company Knight Frank.

But the impact of stabilization funds on markets may not be apparent for some time, says Massimiliano Castelli, Global Head of Strategy for global sovereign markets at UBS.

The oil price may bounce back and even if it does not, many oil exporters, particularly in the Middle East, have been prudent enough to withstand at least a year of low oil prices.

“The majority of countries in the Middle East have been very wise (and) are sitting on substantial amount of reserves which will allow them to sustain for one or two years oil prices of $60-$70 dollars,” he said.

Reporting by Chris Vellacott; Editing by Ruth Pitchford

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