Monthly Bulletin. Feature: Oil in retreat

Transcription

1 Monthly Bulletin Feature: Oil in retreat Oil price Oil prices slumped over the past month, as the cumulative effect of slowing demand growth and greater supply made the continued run up in oil prices unsustainable. WTI stood at $111 per barrel on September 1 compared to an all-time high of $14.3 per barrel on July 3. The factors that caused the recent fall in price are the same ones that were responsible for the surge over the last few years; supply, demand and their interaction with financial markets. (WTI, $/b) Rising prices have caused demand growth to fall substantially and in many parts of the world demand for oil is now declining. Oil consumption in the US in the first half of this year was 3.7 percent lower than in the corresponding period of 7. Consumption is also falling in much of Europe, where high taxes mean that fuel prices were pushed to exceptionally high levels. 7 6 Jan-7 Mar-7 Jul-7 Nov-7 Mar-8 Jul-8 Slower demand growth has helped ease concerns about supply and these have been further dampened by higher production from Saudi Arabia and confirmation that the Kingdom s production capacity expansion plans are on track. Five projects will lift Saudi Arabia s net production capacity by 1.2 million b/d to 12. million b/d. Financial markets have amplified these changes and generated short-term price momentum. We had been expecting prices to fall for some time. However, the fall comes from a much higher base than we anticipated, so we have revised up our oil price forecasts. We now expect WTI to average $11 per barrel this year (equivalent to $1 per barrel for Saudi crude), $13.7 per barrel in 9 and $117. per barrel in 1 ($98. per barrel and $111. pre barrel respectively for Saudi crude). At this level, oil prices remain exceptionally positive for the economic outlook for Saudi Arabia. Economy in brief: Our revised average oil price forecast combined with higher production means we now expect exceptional economic performance in 8. Nominal GDP is forecast to grow at its fastest rate since 198 and the budget and current account surpluses are project to hit all time highs in nominal terms (and highs since the mid-197s as a percent of GDP). For comments and queries please contact: Brad Bourland, CFA Chief Economist jadwaresearch@jadwa.com Head office: Phone Fax P.O. Box 6677, Riyadh 11 Kingdom of Saudi Arabia Stock market in brief: The Capital Market Authority has issued regulations that give foreign investors access to the stock market. While some details need to be clarified, this decision has profound implications for the market. It has further buoyed share prices that were rallying following the implementation of new disclosure rules earlier this month and we expect further gains ahead. 1

2 Oil prices have fallen... Oil in retreat Oil prices slumped over the past month, as the cumulative effect of slowing demand growth and greater supply made the continued run up in oil prices unsustainable. We had been expecting prices to fall for some time. However, the fall comes from a much higher base than we anticipated, so we have revised up our oil price forecasts. We now expect WTI to average $11 per barrel this year (equivalent to $1 per barrel for Saudi crude), $13.7 per barrel in 9 and $117. per barrel in 1 ($98. per barrel and $111. pre barrel respectively for Saudi crude). At this level, oil prices remain exceptionally positive for the economic outlook for Saudi Arabia. (WTI, $/b) (million barrels per day) Jan-7 4 Q1 Mar-7 Q3 Q1 Q3 6 Q1 Q3 7 Q1 Q3 8 Q1 Oil prices have fallen by over $3 per barrel in the last month. WTI stood at $111 per barrel on September 1 compared to an all-time high of $14.3 per barrel on July 3. The magnitude of this fall is unprecedented in dollar terms (though not as a percent); to put it into context WTI averaged only $28.8 per barrel between 1988 and 7. The factors that caused the recent fall in price are the same ones that were responsible for the surge over the last few years; supply, demand and their interaction with financial markets. Rising prices have caused demand growth to fall substantially and in many parts of the world demand for oil is now declining. Slower demand growth has helped ease concerns about supply and these have been further dampened by higher production from Saudi Arabia and confirmation that the Kingdom s production capacity expansion plans are on track (Saudi Arabia is the world s largest oil exporter and the only country that has significant spare oil production capacity). Financial markets have amplified these changes and generated short-term momentum. Signs of demand destruction have emerged throughout the world and are most pronounced in the US. Because of low taxes on fuel, US consumers are particularly exposed to changes in oil prices. The International Energy Agency (IEA) predicts that oil demand in the US will fall by 6, barrels per day (b/d) this year; consumption in the first half of this year was 3.7 percent lower than in the corresponding period of 7. Soaring oil prices appear to have caused a fundamental change in US fuel consumption habits. Sales of light trucks (which include fuel inefficient sports utility vehicles SUVs) slipped to 4 percent of total vehicle sales in July, compared to 6 percent two years earlier. 1, Fixed retail prices for fuel in many major emerging markets have sheltered consumers from the full impact of the surge in oil prices but governments have been increasingly passing on the costs to consumers, which is affecting demand. In Europe, high taxes reduce the responsiveness of retail fuel prices to changes in oil prices. Nonetheless, prices have been pushed to exceptionally high levels and consumers have cut back spending on fuel where possible. 9, 9, 8, 8, 7, While demand has slowed, supply has risen. In June, Saudi Arabia lifted production by 3, b/d in an effort to cool prices. A further output hike, of 2, b/d, was pledged in advance of a summit of oil producers and consumers held in Jeddah in July. As a result of these, total Saudi production has increased to 9.7 million b/d, the highest since August 1981, when the Kingdom was making up for output disrupted by the Iran-Iraq war. Jan-3 May-3 Sep-3 Jan-4 May-4 Sep-4 Jan- May- Sep- Jan-6 May-6 Sep-6 Jan-7 Jul-7 Nov-7 Mar-8...as US oil demand has slowed... Jul-8...and Saudi production risen (thousand barrels per day) 2

3 The agreement that emerged from the Jeddah conference emphasized the importance of ensuring adequate spare capacity across the upstream and downstream oil sector and using energy more efficiently. The more immediate and easier to achieve recommendations were focused on improving the transparency and timeliness of oil market data and data on financial market interaction with the crude market. A follow up meeting is scheduled for later this year in London. For some attendees at the Jeddah conference, national oil company Saudi Aramco gave a detailed presentation on its future expansion plans that should reassure that these plans are on track. Tight global spare production capacity (estimated at 1. to 2 million b/d) has been one of the factors driving prices higher. In these circumstances, supply disruptions (bad weather conditions, strikes, sabotage or political tensions) have caused sharp price spikes. Saudi Arabia has the largest production capacity building program in the world and there have been some concerns about how this was progressing, given the worldwide shortage of skilled labor and contractors. The, b/d Khursaniyah project, for example, was delayed. Production at Khursaniyah was scheduled to start at the end of last year, but it had still to commence at the end of July. However, other expansion plans are on target and total production capacity is on course to hit 12. million b/d during 9, up from the current level of around 11.3 million b/d. In addition, plans were outlined to raise production capacity to 1 million b/d if necessary. This larger target had been in place for a number of years, but appeared to have been dropped over the last 18 months as several times the oil ministry had said that this extra capacity would not be needed. It will be some time before the decision is made as to whether to go ahead with the new capacity, but by providing the basic details the Kingdom has reassured the oil market that additional supply will be forthcoming if required. Saudi oil production capacity expansion plans Oilfield Crude grade New capacity Expected (million b/d) completion Khursaniyah Arab light, medium. 8 Shaybah Arab extra light.2 8 Nuayyim Arab super light.1 8 Khurais Arab light Manifa Arab heavy.9 11 Additional increments if required Zuluf Arab heavy.9 Safaniyah Arab heavy.7 Berri Arab extra light.3 Khurais Arab light.3 Shaybah Arab extra light.2 The five capacity expansion projects to 11 will cost $6 billion. They will bring on stream 2.9 million barrels per day of oil. This is equivalent to 3 percent of global oil supply and greater than total production in Kuwait or the UAE). Total production capacity will increase by less than this as Aramco assumes some production declines elsewhere. The net addition lifts capacity by 1.2 million b/d from the current level of 11.3 million b/d to 12. million b/d. The bulk of the capacity to come on stream over the next few years is light crude. 3

4 A lack of suitable refining capacity has been one of the factors pushing up prices for light sweet crudes. Currently, virtually all global spare capacity is heavy sour crude that requires complex and expensive refining that many refineries are not configured for. As a result, demand is far higher for the lighter crudes that Saudi Arabia will bring on stream over the next few years. Significant new refining capacity is also about to come on stream. Over the next few years this will principally be in Asia (Armaco is involved in refining projects in China). A major expansion in Saudi refining capacity will occur through 13, with new 4, b/d refineries starting operations in Jubail and Yanbu and a 4, b/d capacity addition at the refinery at Ras Tanura. Several of the new refineries will be configured to handle heavy crudes. In total, Saudi Arabia will upgrade its refining capacity by 2 million b/d at a cost of $7 billion. The overall change in oil demand and supply over the last month or so has not been that large, but the cumulative effect of months of slowing demand growth and higher supply has been enough to undermine the case for further price rises. The retreat from prices of over $14 per barrel has been swift and led by the financial markets. Oil used to hedge against dollar weakness Jun-7 Jul-7 Aug-7 Oct-7 Nov-7 Dec-7 Feb-8 Mar-8 Apr-8 Jun-8 Jul-8 Aug-8 $/Euro Oil price (WTI) - RHS ($ per barrel) Financial investment in oil and other commodities has surged in recent years; financial institutions hold an estimated $2 billion worth of commodity investments, compared to just $1 billion in. In particular, oil has been used as a hedge against the US dollar, as oil is a dollar-denominated investment that was gaining value against other currencies even though the dollar itself is falling. (The recent fall in oil prices was not caused by the strengthening of the dollar, which started later, but as the dollar has gained value it has reduced the need to invest in oil as a hedge.) Over the short term investment activity can be driven by factors outside of demand and supply and it can in part explain why oil prices went so high and why they have fallen so fast over the past month. It is also the reason for some of the very sharp moves that have occurred recently; oil prices rose by 13 percent over the two days to June 6 and fell by 11 percent in the three days to July 17. (WTI, $/b) Oil prices will remain high f 9f 1f Outlook We think that oil prices will not continue to fall at the current pace. Demand growth has slowed and supply has risen, justifying a price adjustment, but global spare capacity is limited and demand is still likely to grow faster than supply over the next few years. We think that prices will remain sensitive to supply disruptions and that they are unlikely to fall significantly below $1 per barrel this year. We therefore forecast that WTI will average $11 per barrel in 8 (equivalent to $1 per barrel for Saudi crude). This is higher than our previous projection of $9 per barrel because oil prices peaked well above the level we were expecting. We expect WTI to average $13.7 per barrel in 9 and pick up to $117. per barrel in 1. Demand growth is likely to continue to exceed non-opec supply growth over the next few years, even assuming weak economic conditions in 9. The IEA projects that total global demand will rise by 9, b/d in 9. Declines in the US and Europe (of 3, b/d and, b/d, respectively) will be more than offset by higher consumption in emerging markets. China and the Middle East are 4

5 (percent) Middle East crude demand is rising f 9f expected to remain the largest sources of demand growth next year (at, b/d and 3, b/d, respectively). With global economic conditions likely to improve in 1, we expect that demand growth will quicken. High costs, shortages of the necessary skills and equipment and tougher access and terms by host countries are likely to restrict non- Opec supply growth. The IEA sees total non-opec supply rising by 64, b/d, due to increased output from Brazil, Kazakhstan and Azerbaijan, in particular. While non-opec supply is likely to pick up further in 1 as more new projects come on stream, we do not think it will grow as fast as demand. Opec is meeting in September and statements by member country officials indicate that it is unlikely to raise production. There is a clear divergence within Opec between countries that want to keep oil prices high (such as Iran and Venezuela) and those that want to lower prices to a level where they do not hurt global demand (such as Saudi Arabia). We do not expect an adjustment to Opec production quotas in September, but foresee modest production hikes over the next few years in order to keep the market well supplied (it would probably take a price of less than $7 per barrel for Opec to consider cutting production). We think that global spare capacity will remain tight over the next few years. It is also important to consider that new production capacity will not necessarily mean higher exports. Oil demand in the Middle East has risen by 1 percent in the last three years. In Saudi Arabia, total oil consumption has grown at an annual average of 8. percent over the three years to June 8, from 1.4 million b/d to 1.84 million b/d.

6 Economy watch Exceptional economic performance in 8 (precent) Strongest nominal growth for years f Current account surplus at all-time high Our revised average oil price forecast ($11 per barrel for WTI) combined with higher production means we now expect exceptional economic performance in 8. Nominal GDP is forecast to grow at its fastest rate since 198 and the budget and current account surpluses are project to hit all time highs in nominal terms (and highs since the mid-197s as a percent of GDP). The headline numbers will not look as good in 9 and 1, but the underlying strength of the economy will remain intact. Nominal GDP is forecast to grow by 38.3 percent this year, with the size of the economy exceeding $ billion. This means that the value of economic activity in Saudi Arabia will increase by $14 billion this year; $14 billion is the same size as the economies of Pakistan and the Philippines. It will not be immediately visible that the economy has grown at such a substantial rate as skill shortages and other capacity constraints mean that a lot of this money can not be productively spent at present. We therefore think that the bulk of this inflow will be saved. Growth in real GDP, which strips out the impact of price changes, is forecast to be strong, at 6.1 percent ($ billion) (percent of GDP) The combination of high prices and higher production is forecast to generate record oil export revenues of $33 billion this year. Non-oil exports are also expected to rise this year, owing to greater production and higher global prices of petrochemicals and metals. An increase in the volume of equipment and raw materials required for megaprojects will be compounded by higher prices to lift imports We have kept our forecasts broadly unchanged for the other components of the current account. They will be dominated by spending on imported services, which we expect to grow owing to their greater use and domestic skill shortages. In total, we forecast that the current account surplus will rise to $197 billion (37.4 percent of GDP). This will be reflected in a jump in official foreign assets, which are forecast to end the year at $49 billion. (percent of GDP) Very strong budget surplus f 9f 1f Budget revenues are forecast to approach SR1 trillion ($27 billion) because of the exceptionally high oil revenues. This gives the government plenty of scope to further increase spending. However, we have left our government expenditure forecast unchanged as we have already incorporated spending growth of percent and feel that the government will be largely unwilling and, with major capacity constraints affecting project implementation, unable to increase spending much further. Our forecast for the budget surplus has been revised up to SR443 billion (22.4 percent of GDP). Our projection of lower average oil prices next year (WTI is forecast at $13.7 per barrel) means that we expect the budget and current account surpluses to shrink and nominal GDP to grow slowly. With WTI forecast to rise to $117. per barrel in 1 both surpluses are expected to remain very large and nominal GDP growth will pick up. With non-oil private sector GDP growth forecast at around 8 percent, that the economy will remain in a very healthy position. 6

7 In brief: Economy (basis points) Jan-6 Mar-6 May-6 Pressure off the riyal Jul-6 Sep-6 Nov-6 Jan-7 Mar-7 Jul-7 Nov-7 Mar-8 Jul-8 The riyal has strengthened sharply in recent weeks in line with moves in the dollar on foreign exchange markets. The dollar has appreciated owing a shift in investor sentiment about the health of economic activity outside the US. Investors have for some time expected very weak economic performance in the US, but recent poor data means they are downgrading their forecasts for the outlook elsewhere in the world, therefore on a comparative basis the dollar has become more attractive. A stronger dollar will lower Saudi Arabia s imported inflation and has further reduced pressure in the financial markets for a revaluation of the riyal. One-year riyal forwards are currently pricing in virtually no appreciation in the riyal against the dollar over the next 12 months Commodity prices rises may have peaked Global commodity prices also point towards a slowdown in inflation. The IMF s global food price index fell in July and gold prices recently slipped to an eight-month low. Food accounts for 26 percent of the cost of living index (CLI), while gold is the main determinant of the price of most jewelry, which dominates the other goods and services section of the CLI (which constitutes 13 percent of the index). Lower prices for these goods may reduce the monthly rise in inflation, but the year on year change will remain high as over the past 12 months food prices are up by 4 percent and gold up by 2 percent. 7 Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul (percent) Money supply growth still high Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Private sector credit Money supply (M3) - RHS (percent) Measures to slow the growth in money supply appear to be taking effect. Money supply growth has stabilized at just over percent over the last five months and stood at.9 percent in annual terms in July following a series of increases to commercial bank reserve requirements. These requirements determine the proportion of their deposits banks have to place with SAMA; raising them therefore reduces the funds available for commercial banks to lend, potentially slowing inflation. However, private sector credit growth has continued to rise and hit a two-year high of 34.9 percent in June. (three-month interbank rate, percent) Demand continues to push up SAIBOR Jan-7 Mar-7 Jul-7 Nov-7 Mar-8 Jul-8 Higher reserve requirements and fallout from the global financial sector problems are continuing to have an impact on interest rates, as demand from banks for funds to make up for increased statutory deposits at SAMA is pushing up interbank rates. The three month interbank rate was 4.23 percent on September 2, up from its recent low of 2.14 percent on May 4 and 142 basis points above the corresponding US interest rate. It appears that some banks are more anxious to secure funding than others because non-statutory commercial bank deposits at SAMA are SR26 billion, implying reasonably healthy liquidity for the sector as a whole. 7

8 Stock market watch Market opened up to foreigners The Capital Market Authority (CMA) has issued regulations that give foreign investors access to the stock market. While some details need to be clarified, this decision has profound implications for the market. It has further buoyed share prices that were rallying following the implementation of new disclosure rules earlier this month and we expect the market to rise further over the remainder of the year. Foreign investors will be able to access Saudi shares through swap agreements with companies that have a license from the CMA to deal as a principal. The Saudi partner will retain the legal ownership of the shares, but the foreign investor will be entitled to capital gains and losses made in trading the shares. Voting rights will be held by the Saudi partner, but they are prohibited from exercising them. Currently 9 investment companies hold the appropriate license (though 1 of these have yet to commence operations). By taking this approach the CMA hopes for the greater stability that foreign investors bring to stock markets while avoiding potential pitfalls over the transfer of ownership of local assets to foreign investors. The vast majority of foreign inflows will come from institutional investors, who base their decisions on company fundamentals and are not influenced by the rumors and speculation that drive many local investors. The CMA will monitor transactions to try to prevent inflows of foreign speculative capital TASI has rebounded There will not be an immediate influx of foreign funds. Swap agreements need to be drawn up and approved by the CMA and various technical issues need to be clarified. Nonetheless, there is strong demand for Saudi shares from foreign institutional investors and once there is comfort in the new regulations we expect a healthy inflow of funds. The announcement of the opening of the market to foreign investors triggered a.2 percent jump in TASI, largest one-day gain since April 7. This followed a rebound in the TASI over the previous week after it lost 13 percent in the preceding last two weeks as some investors sold in advance of new disclosure rules Jan-7 Mar-7 Jul-7 Nov-7 Mar-8 Jul-8 It was announced on July 3 that from August 16, the names of all shareholders with a percent or greater stake in a listed company will be published on the Tadawul website every day after the market closes. The aim of this is to increase transparency and reduce manipulation (some investors have bought up large stakes in small companies to drive the price up before selling at a large profit). In response, some large investors are cut their holdings to below five percent in order to protect their privacy (both in terms of the companies they own and the value of their portfolios). The sell off was not driven by market fundamentals. We believe these are strong, with earnings growth averaging over percent in the second quarter and a healthy economic outlook underpinning a generally robust environment for corporate profits. The expectation of, and actual receipt of, inflows from foreign investors further bolsters the outlook for the market and we expect healthy gains in share prices over the remainder of the year. 8

9 Investors corner Jadwa s approach to DCF valuation The increase in equity research reports on companies listed on the Saudi stock market has made an important contribution to increasing investor awareness. It has also caused some confusion as to how analysts looking at the same company can come up with different recommendations. While it is natural that opinions vary, much divergence can be caused by differences in core inputs used in the valuation model. The most common approach to equity valuation is the discounted cash flow (DCF) method, in which the estimated fair value of a stock is based upon the present value of projected cash flows discounted by a rate that reflects the related risks. DCF models are heavy dependent on two inputs; the cash flow measure used and the estimate of the discount rate. A small change in either of these values can have a significant impact on the estimated fair value of the stock. The cash flow measure we use in our valuation model is the free cash flow to equity (FCFE). Free cash flow to equity is cash flows after the firm has met interest and capital payments and provided for capital expenditure needs. These cash flows will ultimately find their way back to the investor in the form of dividends or share price appreciation. An alternative measure is free cash flow to firm, which is the sum of the cash flows to all claimants on the firm, including holders of debt. Free cash flow to firm is always higher than free cash flow to equity for any firm with debt and using it inflates the value of the firm, resulting in a higher fair value share price. As equity investors are buying an equity stake in the business we believe that free cash flow to equity is the more appropriate method for equity valuation. The discount rate is the rate at which the projected cash flows are discounted back to the present day; the lower the discount rate used, the higher the fair value share price. The discount rate is supposed to reflect the investor s required rate of return. To calculate the required rate of return, an equity risk premium is used to measure the risk of holding shares. We believe that historic market returns (rather than an arbitrary number) are the best estimate of the equity risk premium. There is no consensus among analysts about the appropriate way to calculate the equity risk premium. In previous equity research reports we used the arithmetic average of annual historical returns since the market inception. Using the arithmetic mean tends to accurately capture volatility and is considered consistent with the underlying valuation approach. However, the arithmetic mean is always larger than the geometric mean, which takes into account the compounding effect. We see merits in both approaches and now use an average of the two for our estimation of the equity risk premium. 9

10 September Key data F 9F 1F Nominal GDP (SR billion) ($ billion) (% change) Real GDP (% change) Oil Non-oil private sector Government Total Oil indicators (average) WTI ($/b) Saudi ($/b) Production (million b/d) Budgetary indicators (SR billion) Government revenue Government expenditure Budget balance (% GDP) Domestic debt (% GDP) Monetary indicators (average) Inflation (% change) SAMA base lending rate (%, year end) External trade indicators ($ billion) Oil export revenues Total export revenues Imports Trade balance Current account balance (% GDP) Official foreign assets Social and demographic indicators Population (million) Unemployment (male, 1+, %) GDP per capita ($) Sources: Jadwa forecasts for 7 to 1. Saudi Arabian Monetary Agency for GDP, monetary and external trade indicators. Ministry of Finance for budgetary indicators. Central Department of Statistics and Jadwa estimates for oil, social and demographic indicators. 1

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