What do you do when your customer is in financial crisis? There has been a lot of press about what it means to the US defense industry as the Gulf states suffer from declining petroleum prices.
The oil headlines are ominous as the price per barrel has tumbled more than 75% since 2012: China's economy and expected energy needs softening; OPEC refusing to cut production; immense US shale supplies, and the list goes on.
We can’t predict oil prices, but the spot market is speaking volumes, and the futures markets expect oil prices to remain below $52 a barrel /bbl for the next seven7 years — these are 2002-2004 prices into the mid-2020s. So what does this mean for arms purchases by Gulf states that are so dependent on oil revenues?
The stress on the economies of Saudi Arabia and its Gulf Cooperation Council (GCC) allies is becoming increasingly evident. Saudi Arabia recently announced public spending cuts and increases in taxes, fuel and energy prices in 2016. According to the BBC, the budget deficit soared to $98 billion, and government revenues were 15 percent below official expectations.
With the declining financial picture and emerging domestic austerity, it would be natural to wonder about future arms purchases — one of the largest discretionary spending categories.
However, in parallel with the GCC's economic decline, the security situation in the region has been deteriorating. Saudi Arabia's regional rival Iran is gaining international legitimacy after the nuclear accord. Iran's economy is expected to boom with sanctions relief and access to frozen assets.
In parallel, they are bolstering their military strength with advances in ballistic missile technology and improvements to air defense capabilities with advanced Russian systems. The proxy wars between the Sunni and Shia powers continue unabated, with the Yemen conflict remaining hot, and declining interest in negotiations to resolve the situation in Syria.
The tensions multiplied with the recent execution of a Shiite cleric and its aftermath, including destruction of the Saudi Embassy in Tehran, cessation of Saudi-Iranian diplomatic ties, and further escalating tensions.
In the tug-of-war between declining economic strength and deteriorating security, what gives? The first clue is from history. The adjoining figure shows the correlation between oil prices and military spending for five oil producing countries. There is a strong correlation between oil prices and military spending over the last four decades. But the connection breaks — in favor of stronger military spending — when there are steep oil price drops.
In the late 1980s it took seven years for the sharp oil price decline to be meaningfully reflected in defense spending. In 2009, the oil price drop was brief, and the blip did not noticeably affect the steady growth in those countries' military spending. Significant reserves from accumulated surpluses enable these states to continue strong defense spending even in times of negative fiscal balances or current accounts (budget and trade deficits, respectively).
With the perceived acute security situation on multiple external and internal fronts, Gulf states are likely to sustain healthy levels of defense spending and arms purchases even in the face of persistently low oil prices. For example, pressure is high on Saudi Defense Minister Prince Mohammad bin Salman to avoid another failure in Yemen and to keep a strong posture in the face of Iran's ascendency, and his father, King Salman, will approve almost anything that he proposes.
Similarly, given that their most important objective is to maintain the security of the House of Saud, any budget that impacts on internal security, which means the Ministry of the Interior, led by Crown Prince Mohammad bin Naif, will also not suffer.
In Kuwait, Oman, Bahrain and the rest of the GCC, the uncertainties and threats are as high as they have ever been. For example, in UAE the defense procurement budgets will stay intact, with an eye on the contradictory threats from ISIS and Iran.
So does this spell out good news for US arms exports? The answer to this is more nuanced.
Arms purchases in the Middle East are driven by a combination of need for weapons, and international relations between the buying and selling countries. The US is currently viewed as siding with Iran in the region, and US outreach to traditional Gulf allies has received tepid responses, exemplified by the lackluster participation in President Obama's Camp David summit last May.
However, on the summit's heels there have been notable US-Saudi deals such as the $1.29 billion sale of precision weapons approved in November and an $11.25 billion purchase of warships (for which Saudi Arabia is currently pushing for better terms).
But the Saudis are also looking to other non-US sources such as Turkey to enhance their bilateral relations, with other countries also dissatisfied with the Iranian-Russian axis and its push for influence in the region.
There are other complications, as well. Budgets are opaque, and even if published, never tell the whole story. Projects can proceed and then be canceled without warning, and others can arise swiftly out of nowhere.
Additionally, the fiscal situation will raise the bar for US weapon exporters as their customers push for more offsets to strengthen and diversify their local economies. But spending will remain robust as the monarchs see stability and security as enablers of their power. Our bet is that if the tensions remain at today's levels, security will trump fiscal responsibility and arms exports to the region will remain strong, albeit with a more demanding set of customers.
David Handley is a senior adviser to SM&A and previously served as director for the Middle East and Africa for the UK Security Service (MI5). Dr. Alan Berman is vice president of management consulting at SM&A.