The fall in global oil and gas prices will reduce the Papua New Guinea government’s revenue by at least K1.1 billion in 2016. A new Budget strategy is needed, argue economists Stephen Howe and Paul Flanagan, who suggest a solution may lie in the government selling its Oil Search shares.

Prime Minister Peter O’Neill

The extent to which falling international commodity prices will hit the PNG has been revealed by the ANZ Bank’s Pacific Quarterly Review.

While the authors say the lower prices will not end PNG’s LNG boom, their detailed analysis of LNG pricing in Asia-Pacific shows prices will fall by 42 per cent next year.

Although the PNG LNG contracts are long-term contracts, they are variable when it comes to pricing.

The ANZ analysis indicates that, by the second quarter of 2015, the LNG price will have dropped by 42 per cent compared to last year.

They use formula-based pricing, which links changes in prices for the Japanese Crude Cocktail to prices for PNG LNG, and so falling oil prices lead to falling LNG prices after a few months. The ANZ analysis indicates that, by the second quarter of 2015, the LNG price will have dropped by 42 per cent compared to last year.

Lower government revenue

This is forecast to reduce government revenue by at least K1.1 billion in 2016 –around 9 per cent of all domestic revenue.

There is already a major gap between funds allocated and existing government policy, and so we estimate the overall budget challenge for 2016 at K3.365 billion. That’s more than 20 per cent of planned expenditure levels.

Prime Minister Peter O’Neill has stated the impact of the oil price fall should ‘not be underestimated’ and that ‘hard decisions’ may be needed.

Treasurer Patrick Pruaitch

Treasurer Patrick Pruaitch has also confirmed a reduction in government revenue this year because of lower commodity prices.

‘Total revenue and grants had risen to K11.5 billion compared with the final budget outcome of K9.83 billion in 2013 but lower than the K12.69 billion forecast in the original 2014 budget,’ he said in a statement.

The ANZ analysis suggests LNG revenue losses may be K1 billion in 2015, K1.1 billion in 2016 and K0.7 billion in 2017.

Multiple challenges

Commodity prices are unlikely to rebound to historic highs.

The CEO of ExxonMobil, Rex Tillerson, has predicted that oil prices will stay low, and PNG’s Central Bank governor, Loi Bakani, agrees.

The budget challenge must be faced at the same time as the exchange rate challenge and monetary policy challenges. Clearly, the current budget targets will be next to impossible to meet.

If a different strategy is not taken now, PNG’s Budget situation will continue to face increasing cash shortages, and businesses will continue to face foreign exchange shortages.

For 2016, that would require finding (in expenditure cuts or revenue gains) K3.365 billion relative to the 2015 budget. [This is obtained by adding the K1.1m hit estimated by ANZ from falling commodity prices to the K2.265m in expenditure falls as outlined in the 2015 Budget.] This is eight to ten times greater than the “budget emergency” challenge unsuccessfully dealt with by Treasurer Joe Hockey in Australia.

Paul Flanagan

The aim to move to a budget surplus by 2017 will need to be abandoned. A realistic path towards fiscal sustainability is what matters, not an unrealistic target.

Hard choices

So, very hard choices will be needed.

Given the speed of expenditure growth over recent years, sensible expenditure savings should be available, on both the operational and the capital side of the budget.

On the revenue side, one clear option is selling the Oil Search shares, which PNG bought via a US$1.2 billion (K2.9 billion) loan with UBS Bank in 2014. The shares are currently worth about K2.4 billion mainly because of the exchange rate movements. While that may represent a loss of about K500 million, the dividends from those shares aren’t high enough at this stage to pay for the ongoing interest costs on that loan.

But more more must be done, including on national public service savings and inappropriate grand infrastructure.

This is one of ways of getting back to a more sustainable deficit. But more more must be done, including on national public service savings and inappropriate grand infrastructure.

Winding back large expenditure increases, as well as moving towards more sustainable revenue options, are vital.

If a different strategy is not taken now, PNG’s Budget situation will continue to face increasing cash shortages, and businesses will continue to face foreign exchange shortages. If financing of the deficit is primarily through debt monetisation (or printing money) then the country will face higher inflation.

PNG is not in a crisis, but failure to act will indeed lead PNG down a path towards crisis.

This is an edited version of a piece by Paul Flanagan and Stephen Howes originally published on the Development Policy Centre’s Dev Policy blog. Paul Flanagan is a Visiting Fellow at the Centre, which is based at the Australian National University, Canberra. Stephen Howes is Director of the Centre. Their full analysis can be found here.