Monthly Bulletin. Feature: Oil market developments boost outlook. October 2007

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1 October 27 Monthly Bulletin Feature: Oil market developments boost outlook (WTI, $/b) Oil price hits new high Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Recent oil market developments have improved the economic outlook for Saudi Arabia. Oil prices hit all-time highs in late September despite Opec agreeing to increase production quotas earlier in the month. High prices and rising production will lift economic growth and the budget and external surpluses in Saudi Arabia to above the levels we forecast earlier this year. We now expect oil prices to average over $6 per barrel over the medium term, providing a very healthy backdrop for the non-oil sector. Concern about a continued imbalance between demand and supply has been the fundamental factor pushing oil prices up. Demand growth has remained solid despite rising prices, while new supply, mainly from non-opec sources, has not come on stream as fast as had been anticipated. A cut in US interest rates in September and the prospect of further reductions has allayed the concerns of many in the market about the health of US demand for oil; speculation has also contributed to the recent price rise. With the oil market likely to remain tight over the medium term, conditions are in place for Opec to calibrate how much quotas are increased, rather than reduced, over the next few years to keep prices roughly where it wants them. The revision to our outlook for the oil market has had a positive impact on our economic forecasts. Nominal GDP is now forecast to grow by 6.4 percent this year, compared our previous expectation that it would decline by 4.3 percent; in real terms, GDP is now expected to grow by 2.9 percent. While rising government spending and imports mean that the budget and external surpluses will still be down on their totals for 26, under our revised oil market outlook they will remain very strong over the next few years. Economy in brief: The exchange rate peg was put under pressure after SAMA decided not to change its interest rate following a cut in US interest rates on September 18. Although SAMA s move was understandable given the conditions within the Saudi economy, some foreign banks took it as a sign that SAMA was preparing to alter or drop the peg. Subsequently, the SAMA governor reaffirmed the government s commitment to the peg. For comments and queries please contact: Brad Bourland Chief Economist & Head of Research jadwaresearch@jadwa.com Head office: Phone Fax P.O. Box 6677, Riyadh 11 Kingdom of Saudi Arabia Elsewhere in the economy, inflation continued to surge, with the growth in rents reaching double-digits. In contrast, money supply growth eased. Stock Market in brief: The announcement of the imminent launch of a new operating system for the Saudi stock market that would enhance transparency has unnerved speculators, causing the share prices of many smaller companies to fall. Banking shares have been boosted by a decision to open them up to GCC investors, but in general, investors remain cautious. 1

2 October 27 Oil market developments lift economic outlook Recent oil market developments have improved the economic outlook for Saudi Arabia. Oil prices hit all time highs in late September. This was caused by oil market tightness, rather than the type of adverse global development (either geopolitical or weatherrelated) usually associated with oil price peaks, and happened even though Opec agreed to increase output earlier in the month. High prices and rising production will lift economic growth and the budget and external surpluses in Saudi Arabia to above the levels we forecast earlier this year. Oil prices averaging over $6 per barrel over the medium term will provide a very healthy backdrop for the non-oil sector. (WTI, $/b) At an all-time high WTI peaked at $83.9 per barrel on September 2 and has been above $8 per barrel for most of the period since mid-september, around one-third higher than it was at the start of this year. Concern about a continued imbalance between demand and supply has been the fundamental factor pushing oil prices up. Demand growth has remained solid despite rising prices, while new supply, mainly from non-opec sources, has not come on stream as fast as had been anticipated. Falling US inventories over the last few months have raised market expectations of a shortfall in supply in the final quarter, when demand peaks due to the northern hemisphere winter. Jan-86 Jan-88 Jan-9 Jan-92 Jan-94 Jan-96 Jan-98 Jan- Jan-2 Jan-4 Jan-6 Fallout from the woes in the US sub-prime mortgage market has so far had a surprisingly positive impact on oil prices. While a slowdown in the US economy would hit demand for oil and therefore lower oil prices, the larger than expected cut in US interest rates in September and the prospect of further reductions has allayed the concerns of many in the market about the health of the US economy (resulting in the Dow Jones share price index hitting a new high). In addition, with oil being perceived as safer than many other assets during the current period of financial market volatility, speculative money has helped to spur the recent run-up in oil prices. (WTI, $/b) A further spike is possible Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec There is very little geopolitical risk driving oil prices higher. During the summer spike in the price of oil in 26 there was greater concern than today about Iran s nuclear program, the upcoming hurricane season in the Gulf of Mexico, ethnic violence in Nigeria and other factors that could disrupt oil supply. With less attention being paid to these factors currently, despite continued risks, we believe there is a chance of a further spike in prices to $9 or even $1 per barrel. Such a spike based on geopolitical developments would be unhealthy for producers and consumers alike, and Opec would likely intervene to calm markets and bring prices down. At its regular meeting on September 11, Opec agreed to increase production by, barrels per day (b/d) from current levels to 27.2 million b/d (1.4 million b/d higher than the old quota see table). Saudi Arabia accounts for over 3, b/d of this production increase, its quota rising to 8.94 million b/d. It was not clear that Opec would raise quotas at the meeting as in the run up many Opec members stated that production should be left unchanged. However, the rise was ultimately insufficient for the market and did not prevent prices rising further. We have therefore revised up our oil price forecast for this year to $71 per barrel for WTI (equivalent to around $6 per barrel for Saudi crude) from $6 per barrel ($7 per barrel for Saudi crude). Our oil production forecast for 27 has also been raised slightly to take account of the new quota level. 2

3 October 27 Oil production (' b/d) Old quota August production New quota Algeria Indonesia Iran Kuwait Libya Nigeria Qatar Saudi Arabia UAE Venezuela (Thousand b/d) 3, 3, 2, 2, 1, 1, - Oil market set to remain tight Increase in Global Demand Increase in Non-Opec Supply Absent untoward global developments, the oil market is likely to remain tight over the medium term. According to a recent report from the International Energy Agency, despite four years of high oil prices, this report sees increasing market tightness beyond 21, with Opec spare capacity declining to minimal levels by 212. With global demand for crude oil likely to outpace growth in non-opec supply, conditions are in place for Opec to calibrate how much quotas are increased, rather than reduced, over the next few years to keep prices roughly where it wants them. Our sense of Saudi oil policy is that the Kingdom would like to see prices at a level that does not harm global economic growth or result in excessive worldwide investment in new oil production capacity. Currently, that price is probably in the area of $6-$6 per barrel. As a result of these likely oil market conditions, we have increased our price forecasts over the medium term. We now expect oil to average $6 per barrel in 28 and $7 per barrel in 29 and 21. We have also made slight adjustments to our oil production profile for Saudi Arabia over the years to 21, though the upward trend remains unchanged. Implications for Saudi Arabia The revision to our outlook for the oil market has had a positive impact on our economic forecasts. The combination of higher prices and production will raise economic growth and widen the already substantial current account and budget surpluses. Although not as strong as the exceptional performance of 26, the economy will remain very healthy in 27. With oil prices expected to stay high, the economic outlook to 21 remains healthy and in line with that described in our July 27 report, The Saudi Economy s Golden Era: Phase Two. We have revised up our forecast for real GDP growth in 27 to 2.9 percent from 2.7 percent (a table containing all our forecasts and historical data is on page 1). This is because we now forecast oil production to be.8 percent lower this year than in 26, compared with our earlier expectation that it would decline by 6.4 percent. Our outlook for elsewhere in the economy remains unchanged; 27 will be the year in which the dynamic of the current economic boom shifts from the oil sector to the non-oil private sector, with transport and communications, construction and finance the fastest growing sectors. 3

4 October 27 Nominal GDP is now forecast to grow by 6.4 percent, compared our previous expectation that it would decline by 4.3 percent. Over the five years to the end of 27 the size of the economy will have doubled to $371 billion. Increased oil revenues mean that our forecast for nominal growth in the oil sector has been revised from percent to 1.7 percent. In per capita terms, we project GDP to exceed $1, for the first time since (% of GDP) Outlook for budget has improved (budget balance) Oil revenue accounts for around 9 percent of total budget revenue, so the increase in our oil price and production forecasts produces a large jump in our projection for the budget surplus. Owing to concerns about the impact on inflation, government spending is not expected to grow to the same extent as the increase in revenue, though the continued escalation of project costs means that it will be hard to contain expenditure. Pressure for higher public-sector pay to counter rising inflation will further limit the government s ability to control spending growth. We therefore forecast that the budget surplus in 27 will be lower than last year s, although it will remain substantial, at $9 billion (16 percent of GDP) Exceptionally high current account surplus The revised oil forecasts have also improved our outlook for the current account. Oil exports are projected to reach an all-time high of $191 billion in 27, over treble the total of just five years earlier. As import spending has also risen (letters of credit opened for imports by the private sector are up by 18 percent over the first six months of 27, compared with the same period of last year), we still expect a decline in the overall trade balance. With foreign service payments expected to rise (owing to a lack of skilled employees in the Saudi labor market), we forecast that the current account surplus will still be down on the record total of last year, but at $84 billion (23 percent of GDP) it will be exceptionally high. (% of GDP) 1 1 Our current account projections are based on newly published revisions by SAMA to its estimates for 26. These revisions reveal some trends that are expected to grow in prominence over the next few years Higher imports: Imports were revised up by over $3 billion, to $63.8 billion, a 17 percent rise on the 2 level. Imports have grown at double-digit rates in each of the last four years. This trend is expected to continue, as large imports of capital goods are required for the megaprojects planned and underway in the Kingdom. Given the run-up in raw material prices, the growth in imports in volume terms is likely to have been modest. ($ billion) Growing reserves lift investment income Strong growth in investment income: Investment income is the return the government earns on its foreign assets. The old data had put investment income at $6.9 billion in 26, up 4 percent on the 2 total, the same rate of growth as that for SAMA s holdings of foreign assets. This implied a return of just 2. percent on SAMA s investment portfolio despite higher global interest rates (we believe that the bulk of SAMA s foreign assets are foreign government debt). The new data put investment income at $1.4 billion, implying a return of 3.8 percent. With foreign assets expected to continue to grow in line with sustained current account surpluses over the next few years, investment income will become an increasingly important source of foreign exchange. 4

5 October 27 Rising remittances: Rapid growth in the expatriate labor force will increase remittances, as many foreign workers transfer a large proportion of their income outside of Saudi Arabia. Revised data put the outflow of remittances at $1.6 billion in 26, up $1 billion from the previous estimate and $1. billion higher than the total for 2. Importing the skilled and unskilled labor necessary to implement the megaproject boom will add to the outflow of remittances in the years to come. There were two other notable revisions to the current account data. First, the growth in non-oil exports was lowered. Second, payments for other government services (mainly military goods) were revised down. In both cases, the revised numbers still represented large increases on the 2 totals. The upward revision to our current account forecast is reflected in a higher stock of foreign assets. We now forecast that official foreign assets will reach $34 billion by the end of 27. External sector ($ billion) actual provisional revised forecast Oil Exports Other Exports Imports Trade balance Receipts Investment Income Oil Sector (Bunker Oil) Other Payments Freight And Insurance Oil Sector Other Private Services Other Govt. Services Private Transfers Services & transfers balance Current account balance % GDP Inflation is climbing rapidly We have used this opportunity to look at our other forecasts. Our inflation projections have been nudged up for after a detailed examination of food prices (Why food prices are rising in Saudi Arabia, published earlier this month) has convinced us that they will be rising at above average rates for several years to come. The jump in rents in August (to 12.1 percent in year-on-year terms) and its possible impact on the prices of other goods as retailers pass on their higher costs, has also contributed to the rise in our inflation forecasts. Sharper than anticipated growth in rents and the prospect of lower interest rates have contributed to the slight deterioration in our outlook for inflation. We have also trimmed our interest rate forecast, but maintain our strongly held view that the riyal s peg to the dollar will remain unchanged.

6 October 27 Economy watch Interest rate moves put pressure on riyal Riyal hits 21-year high against US dollar Speculation on international markets about the sustainability of the exchange rate peg pushed the riyal to a 21-year high against the US dollar near the end of September. An affirmation of the government s commitment to the peg by the SAMA governor has stabilized the riyal, though it remains very slightly above the level of its formal peg. We remain confident that the exchange rate peg will remain unchanged over the medium term Jan-6 Mar-6 May-6 Jul-6 Sep-6 Nov-6 Jan-7 Mar-7 May-7 Jul-7 Sep-7 The speculation emerged after SAMA decided not to change its repo rate following a basis point (. percentage point) cut in the US Fed Funds rate on September 18. Some foreign banks took this as a sign that Saudi Arabia was preparing to alter or drop the exchange rate peg. This is because under a pegged exchange rate system without capital controls, the repo rate needs to broadly shadow the Fed Funds rate, as otherwise it could stimulate large capital flows into or out of Saudi Arabia (depending whether the repo rate was higher or lower). As a result, the riyal was pushed to its highest level against the dollar since the peg was introduced in 1986 (though the actual move was tiny; just.4 percent). (percentage points) Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May /1/1992 Inflationary pressures building 1/1/1993 Money supply 1/1/1994 1/1/199 1/1/1996 1/1/1997 1/1/1998 1/1/1999 1/1/2 1/1/21 1/1/22 Inflation (RHS) High interest rate differential not unusual (SAMA repo rate less Fed funds rate) 1/1/23 1/1/24 1/1/2 1/1/ /1/27 SAMA s interest rate decision is understandable given the conditions within the Saudi economy. Inflation and money supply growth had both jumped in July (the latest data available at the time of the interest rate decision). Although we do not think that interest rates are an effective way of controlling inflation in Saudi Arabia (as debt is low and generally not sensitive to interest rate changes) lower rates would certainly contribute to faster monetary growth and inflation. In addition, interest rates in the interbank market (which are the main determinant of commercial bank lending rates) were below those in the US owing to high liquidity within Saudi commercial banks. Immediately prior to the Fed s cut, Saudi three-month interbank rates were 49 basis points below corresponding US rates. Despite the change in the differential between the repo rate and the Fed Funds rate, Saudi three-month rates were at a 1-1 basis point discount to US ones in early October. SAMA has not always followed the Fed in changing interest rates in the past. It did not raise interest rates in March and May of last year owing to concerns about the stock market and ultimately only passed on some of the Fed rises in a 3 basis point hike this February. Nor is the differential between the SAMA repo rate and the Fed Funds rate of 7 basis points out of line with historical trends. As the chart to the left shows, the differential was at this level for most of the period from November 21 to March 24. As we outlined in our August report, The Riyal s Peg To The Dollar, there is no compelling economic argument to drop the exchange rate peg at present and the costs of doing so would greatly outweigh the benefits. The SAMA governor stated the government s commitment to the peg at a press conference in late September. However, his comments contained enough ambiguity to not entirely convince international investors (who are used to analyzing every word of policy statements) and as a result the riyal has yet to return to the 3.7:$ level it is formally pegged at. 6

7 October 27 In brief: Economy Inflation continues to rise Inflation surged to a 12-year high of 4.4 percent in August, from 3.8 percent in July. Rents remained the main driver behind rising inflation, with the component of the cost of living index that contains rents jumping by 12.1 percent in year-on-year terms. By increasing retailers costs, rising rents can stimulate broader prices rises across the economy. The jump in rents was much larger than we had anticipated and has contributed to an increase in our inflation forecast (see Feature).. Jan 23 May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Money supply growth off recent high Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Jan Jul Annual broad money (M3) growth slowed in August from a near three-year high of 21.4 percent in July. Nonetheless, at 18.8 percent it is not far from the recent high. A recovery in commercial bank lending to the private sector, which was hit by the plunge in the stock market last year, has combined with the continued conversion of foreign exchange into riyals by the government and Aramco for spending on locally-produced goods and services, to push up money supply growth since the middle of last year. The strong money supply growth supports SAMA s decision not to cut interest rates, as lower rates would stimulate more borrowing and add to inflationary pressures. Boom times for the construction sector (Growth in private sector letters of credit opened for building material, six-month moving average) The construction sector appears to be experiencing another year of extremely rapid growth according to data on letters of credit (guarantees of payments). Letters of credit opened for imports of building materials by the private sector are up by 76 percent over the first six months of 27, compared with the same period of last year. Building materials now account for 12 percent of total letters of credit opened, more than double their share in 24. Letters of credit for food imports grew by 44 percent over the same period, reflecting the jump in international food prices. 2 Jan May Sep Jan May Sep Jan May Sep Jan May Saudi Arabia Best in the region (ranking in World Bank Doing Business report) Kuwait Oman UAE Jordan Lebanon Yemen Doing business in Saudi Arabia has got easier. The Kingdom climbed 13 places in the 28 edition of the World Bank s Doing Business rankings to become the 23 rd easiest country in the world for companies to operate in. The Doing Business index is one of the benchmarks targeted by SAGIA as part of its goal to make Saudi Arabia one of the ten most competitive nations in the world by 21 (the 1 x 1 program). Policies toward foreign trade and obtaining credit combined with the elimination of the minimum capital requirement made the Kingdom the top reformer in the world last year with regard to starting a business. Overall, Saudi Arabia now ranks above Austria and France, but still has much to do to get into the top 1. Contract enforcement and closing a business are the most important areas to tackle. 7

8 October 27 Stock market watch New trading system unnerves speculators Share prices have been on a downward trend since the Capital Market Authority (CMA) announced that the long-awaited new operating system for the Saudi Stock Market (Tadawul) would be launched on October 2. The new system contains a variety of enhancements that will improve the operation of the exchange and provide greater transparency. We believe that the prospect of stricter oversight has worried many speculators, causing them to withdraw from the market and pushing down share prices. High among the advantages of the new system is its ability to significantly boost the capacity for processing trades. This will rise to two million transactions per day on October 2, from the current level of about 8,, and has the flexibility to be upgraded further. Additionally, the new system makes it possible to introduce trading in products such as bonds and sukuk and to offer entirely new products such as exchange traded funds. Three types of trading orders will be processed by the new system; market, limit (at which the purchase or sale price is predetermined) and hidden. Hidden orders are orders that are so large that if they are conducted in one go they would distort the market; they are typically placed by institutional investors. Hidden orders are broken down into tranches that can be a minimum of one-fourthousandth of the size of the total order. Once one tranche of the order has been executed, a new tranche with new terms would automatically be allowed by the system for processing. The system is linked with a host of peripheral electronic systems which handle other relevant processes such as market control and supervision, reconciliation and clearing and market information. It was developed with Nordic stock exchange operator OMX, a leading provider of information technology systems for financial markets. Investment subsidiaries of commercial banks, brokerages and providers of market information have taken part in a successful series of pre-run operating tests. Since the announcement on September 26 that the new system will be introduced, the TASI has fallen by nearly 3 percent. Accounts in the local press alluded to the lack of information about the new system as a contributory reason for the decline. We believe, however, that the new system should have come as no surprise to the investor community as both the CMA and Tadawul have been talking about it for more than a year. Moreover, both organizations announced the advent of the new trading system through local newspapers, television and their websites. Tadawul also produced and distributed (through trading halls and brokerages) two sets of brochures on this development. We think it is more likely that some speculators and day traders may have pulled out of the market as they believe that the new system is more capable of tracking down attempts to manipulate the market than the current one. Smaller capitalized stocks favored by speculators have performed far worse than large companies since the new system was announced. 8

9 October 27 In brief: Stock market Reform helping banks to outperform (August 27 = 1) Aug -Sep 14-Sep 23-Sep 2-Oct GCC investors were permitted to trade in shares in Saudi financial service companies on September 2. This removes the final restriction on the participation of investors from other GCC countries in the Saudi stock market. In anticipation of large inflows from the rest of the region, the banking sector share index climbed by 1. percent on September 2, before falling back in line with the rest of the market over subsequent days. Since the instruction from the Council of Ministers to the CMA to prepare the market for opening to GCC investors was made on August 27, the banking sector has outperformed the TASI all-share index by around 4 percent. The strength of the Saudi banks makes them attractive to GCC investors. TASI Banking sector TASI Insurance shares have been highly volatile May 19-May 2-Jun 16-Jun 3-Jun 14-Jul 28-Jul 11-Aug 2-Aug 8-Sep 22-Sep 6-Oct Insurance sector TASI all-share index Al-Ahlia became the fourteenth insurance company to be listed on the stock market this year on October 6. As with all the others, its shares recorded a substantial gain (of 67. percent) on the first day of trading. Insurance company shares have become favored by speculators and as a result their share prices have been highly volatile. The chart to the right shows that since the first of the new insurance companies was listed on May, volatility in TASI insurance index has been consistently higher than that for the whole market (we measure volatility by taking the difference between the intraday high and low as a percent of the closing value of the index). Excluding NCCI, which has by far the largest market capitalization in the sector, volatility is more extreme. 8,3 8, 7,8 7, 7,3 7, TASI pauses for third quarter results By October 8, only six out of 1 companies listed on the stock exchange had released their interim financial statements for the third quarter of this year. All except one show continued earnings growth for the third quarter and for the nine months ending September 3, albeit at a slower pace than in previous years. The one company that has reported a decline in earnings is Tabuk Cement. The company s CEO blamed the decline on poor sales, which is surprising, given that construction is one of the fastest growing sectors of the economy. 6,8 Jun-7 Jul-7 Aug-7 Sep-7 Oct-7 (numner of transactions) Lower turnover reflects investor caution Jan 26 Mar May Jul Sep Nov Jan 27 Mar May Jul Sep New data issued by Tadawul shows that investor confidence has yet to recover since the collapse in share prices last year. Despite 2 new listings over the first three quarters of this year and a similar number of share splits and rights issues increasing the number of shares available, the average daily volume of shares traded is down by nearly 19 percent compared to the same period of last year. The average daily number of transactions is down even further, at 2 percent. Agriculture and insurance were the only sectors that experienced an increase in trading volumes over the first nine months of this year. Both of these sectors are favored by speculators, though the bulk of increase in the insurance sector can be accounted for by the new IPOs. 9

10 October 27 Key data F 28F 29F 21F 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) $$EDVHOHQGLQJUDWH\HDU HQG 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 27 to 21. 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.

11 October 27 Disclaimer of Liability Unless otherwise stated, all information contained in this document (the Publication ) shall not be reproduced, in whole or in part, without the specific written permission of Jadwa Investment. Jadwa Investment makes its best effort to ensure that the content in the Publication is accurate and up to date at all times. Jadwa Investment makes no warranty, representation or undertaking whether expressed or implied, nor does it assume any legal liability, whether direct or indirect, or responsibility for the accuracy, completeness, or usefulness of any information that contain in the Publication. It is not the intention of the Publication to be used or deemed as recommendation, option or advice for any action (s) that may take place in future. 11