Adjusting to the oil price shock

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1. N February 2016 This and can be Downloaded from www .samba.com GCC Chart Book Adjusting to the oil price shock GCC Chart Book: Update Executive ExecutiveSummary Summary Office of the Chief Economist Economics Department Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia ChiefEconomist@samba.com +9661-477-4770; Ext. 1820 (Riyadh) +4420-7659-8200 (London)  Oil prices appear to have found a floor at around $30/b for Brent. This is way below levels expected by GCC states when prices first started to fall from $100/b back in mid-2014. Average prices fell 43 percent in 2015 to $57/b, and are projected to be down another 25-30 percent this year. With prices below the full cycle cost of production for many, there will be a recovery in due course. But in the meantime GCC states are having to make sharp fiscal and structural adjustments.  Perhaps against expectations, GCC governments have been quick to react to the new oil price environment by pressing ahead with much needed reforms to their generous welfare systems, most visibly by cutting back on energy subsidies. To varying degrees, there has also been sharp cuts in fiscal spending, and concerted efforts to raise nonoil revenues. These are expected to lead to the introduction of a value added tax (VAT) throughout the region by 2018, and the sale of state assets.  Despite these moves, the speed and extent of the oil price decline has pushed many into large fiscal deficits (15 percent of GDP in 2015), which will persist this year, before coming under control as prices pick up and fiscal consolidation measures take effect. Low levels of government debt and large external savings provide scope to fund these deficits to varying degrees. Most notable has been the resumption of domestic debt issuance by Saudi Arabia last year, with a first sovereign international bond issue planned for later this year.  Reduced public spending; a shift to current account deficits, and a challenging external environment have weighed on growth, confidence, and GCC stock markets. More frequent PMI data confirm that private non-oil activity has continued to slow through January.  Despite a deteriorating operating environment GCC banks weathered through 2015 reasonably well, and remain well capitalised. However, deposit growth is clearly slowing, NPLS rising, and liquidity tightening, which will constrain future credit growth. Rising government borrowing will also reduce the amount of liquidity available for private sector lending, and financing costs are rising.  GCC exchange rate pegs have come under speculative pressure in forward markets, particularly in Saudi where foreign exchange reserves have fallen sharply. However, GCC states would gain little from a devaluation, and are expected to draw on their large external savings to support their pegs as necessary while pressing ahead with fiscal consolidation. PUBLIC 1
2. February 2016 Oil prices may finally have found a floor at around $30/b for Brent. However, this is way below levels expected by most when prices first started to fall in mid-2014. Average prices fell 43 percent in 2015 to $57/b, and are projected to be down over 20 percent again this year. The surprising resilience of US shale has been a major driver of lower prices. Despite plunging rig counts, output has remained stubbornly high as companies have cut costs, improved efficiency, and focused on their most productive wells. At the same time OPEC has adopted a “market share” strategy, and Iranian oil has returned to the market following the lifting of sanctions. PUBLIC 2
3. February 2016 140 90 J … F… M… A… M… J… J… A… S… O… N… D… J… World… Although global oil demand grew strongly last year at around 1.6mb/d, excess supply continues to result in record stock builds which will prolong price weakness, especially as global demand looks set to soften this year. MSCI EM Given the lack of a supply response from either OPEC or US shale oil, oil futures have adjusted down dramatically, and are now below the full cycle cost of production for many. This suggests they will eventually recover, but perhaps not until early next year. In the meantime GCC producers will need to adjust to a major oil price shock. After years of large surpluses, this oil price shock has pushed GCC fiscal accounts into deficit. These are around 15% of GDP for Saudi, Bahrain and Oman, and are projected to worsen in 2016. Hopes for an improvement hinge on both a recovery in oil prices as well as sustained efforts at fiscal consolidation. PUBLIC 3
4. February 2016 Public spending has already been reined in and further cuts are in prospect over 2016 . In addition, all GCC states have moved to reform their energy and utilities subsidies, and are preparing to introduce VAT by 2018. Generous welfare systems are likely to be rolled back and Saudi Arabia is also looking to privatise state assets and intensify diversification efforts. GCC Opportunity Cost of Energy Subsidies US$bn % GDP 2014 2015 2014 2015 KSA 69.9 47.3 9.4 7.4 Kuwait 12.7 9.3 7.4 7.2 Qatar 10.6 7.7 5.0 4.0 UAE 9.6 3.8 2.4 1.1 Oman 5.8 2.8 7.5 4.6 Bahrain 2.6 1.6 7.3 5.1 Benchmark:USA pre-tax prices Source: IMF Generally low public debt levels leave plenty of scope for new debt issuance to help fund fiscal deficits, although governments will also look to draw on their own savings. Last year saw a surge in GCC bond and sukuk issuance. However, this largely reflected the resumption of domestic government bond issuance in Saudi Arabia for the first time since 2007. GCC corporates were less active, although banks continued to raise funds in capital markets. PUBLIC 4
5. N February 2016 Saudi Arabia issued $30bn in domestic Rating bondsAgencies in 2015, and is Moody's S&P Fitch looking to issue a similar amount Saudi Arabia AA3 this year, augmented Aaby its AA first Oman A1 A international sovereign bondNR Qatar AA NR issuance. GCC Aa2 sovereign issuance UAE Aa2 NR in general is expected to riseNRthis Bahrain Baa2 BBB BBB year, and banks may also be Kuwait Aa2 AA AA pushed to raise more funds. All GCC central banks except Qatar and Oman, have followed the US Fed in raising policy rates 25 bps. In contrast, Qatar is expected to lower its repo rate from 4.5 percent to 2.5 percent to help banks dealing with strained liquidity conditions. Reflecting both an increase in policy rates as well as tightening liquidity as oil revenues decline, GCC interbank rates have surged. PUBLIC 5
6. N February 2016 Bank deposit growth has slowed markedly leading to an increase in aggregate loan-to-deposit ratios . This will curtail banks’ ability to fund both private sector activity, but also to absorb expected government bond issuance. Public sector deposits account for a third of total bank deposits in Qatar and Oman, making them particularly vulnerable to declining government revenues. Recent data confirm that public sector deposits with banks have fallen in Qatar, while they remain essentially stagnant in Oman. PUBLIC 6
7. N February 2016 Similarly public deposits are down in Saudi Arabia and Bahrain , while they have only recently reversed in Kuwait, to grow by around 10 percent y-o-y. Government deposits have also been declining in the UAE contributing to a tightening of bank liquidity. This prompted UAE banks to aggressively seek new deposits, including from abroad, and in December there was a strong improvement in liquidity reflected in a surge in bank excess deposits with the central bank. In contrast, bank excess reserves continue to be drawn down in Qatar and Saudi Arabia. PUBLIC 7
8. N February 2016 The late year increase in nonresident and GRE deposits has helped stem the sharp slowdown in total UAE bank deposits . In the rest of the GCC the drag from slowing/falling public sector deposits has been mirrored in a slowdown in total deposit growth at banks. GCC bank deposit growth rates have now slipped to around 5 percent. PUBLIC 8
9. N February 2016 Despite the deposit slowdown , credit growth in the GCC has held up. However, to some extent this reflects increased demand from companies to cover increasing public sector payment delays. Clearly the operating environment for banks has deteriorated, and this will stifle credit growth. Rising government borrowing will also reduce the amount of liquidity available for private sector lending. GCC banks remain in relatively good shape to weather the expected increases in impaired assets, and continue to hold healthy capital buffers. However, profitability is expected to decline. PUBLIC 9
10. February 2016 The US dollar strengthened GCCagainst current most account balances have major currencies mirrored the fiscal accounts by last year except the euro , but moving deficit asthis oil year revenues has into lost ground in the slumped. Only Kuwait looks likely to face of further euro strength manage smallhaven surplus this year. and aa safe bounce in the Yen Rising US yields have pushed up GCC yields, although the strength of major issuers has the increase GCClimited states have built up large external savings which growth can be drawn hinese oil demand last on to help finance the twin deficits, year. although these are considerably more limited in Oman. Little official data is available, but reports suggest theSWFs US, the that oil thatInGCC arenotion already demandsome might liquidating ofhave their reached assets. some sort of structural peak is having to be revised. The abundance of cheap shale oil, along with decent population growth, has revived oil demand. Mixed signals on the demand side are matched by a confused supply picture. The Libya’s shift to output currentremains account deficits amid a outflows chaotic have and depressed sustained capital political though there resulted in a scene, large drawdown of Saudi central bank Others are reports thatreserves. recent tanker haveloadings fared better, and theupUAE has have picked seenmarkedly. a notableIraq’s increase in late in output remains 2015. volatile—dogged as it is by security and technical issues— but has not been able to recapture the highs registered in mid-2012. Sudan’s production has collapsed again PUBLIC 10
11. February 2016 The extent of the oil price slump and expectations that it will be . prolonged have raised questions over GCC exchange rate pegs, leading to pressure in forward markets. We do not expect them to break, but to deter speculation SAMA has advised Saudi banks not to issue option contracts in forward markets. There are few clear advantages to breaking the dollar pegs as exports are largely priced in US$ and GCC economies are heavily import dependent. Policy adjustments will need to focus on fiscal measures, with temporary recourse to government savings. Nonetheless, markets view Oman’s peg as the most vulnerable given its more limited external savings. Although Bahrain, Oman and Saudi have been downgraded by ratings agencies in recent months, all GCC states currently retain their investment grades. These may be at risk for Oman and Bahrain, while as recently as February, Moody’s affirmed Saudi’s Aa3 rating with stable outlook. Rating Agencies Moody's S&P Fitch Saudi Arabia Aa3 A+* AA* Oman A1* BBB+* NR Qatar Aa2 AA AA UAE Aa2 AA AA Abu Dhabi Aa2 AA AA Sharjah A3 A NR Bahrain Baa3* BBB-* BBB-* Kuwait Aa2 AA AA *placed on negative watch denotes downgrade since last chart book PUBLIC 11
12. February 2016 Although ratings agency downgrades have been limited , markets have taken fright at the latest step down in oil prices. Having held relatively stable, CDS spreads have risen sharply this year. Despite widening CDS spreads and the first hike in US policy rates, GCC international bond yields have risen only modestly. However, GCC stock markets have seen large sell-offs continuing the trend that started in 2015. PUBLIC PUBLIC 12
13. N February 2016 Slowing public spending , tightening liquidity and a challenging external environment have all begun to weigh on growth. High frequency PMI data confirm the downward trend with the KSA index dropping to a new low in January. While still in expansion territory (above 50), the suggestion is that nonoil growth is likely to be weak this year. ` Despite a much more diversified economy, the non-oil private sector is also slowing in the UAE where the PMI has dropped to 52.7 in January. PUBLIC 13
14. N February 2016 That said , there remain bright spots, and region wide air traffic numbers continue to grow healthily. Despite new hotels coming on stream hotel occupancy rates in the GCC are also holding up, and tourism sectors continue to perform reasonably well. Underlying inflation pressures remain subdued, but indices are being affected by subsidy reforms which are likely to generate increases in average inflation rates. PUBLIC 14
15. N February 2016 Meanwhile , real estate prices remain on the retreat in Dubai, and are likely to stay weak as new supply come on stream. Although, the lifting of sanctions on Iran may provide some support from that source. The long rally in Qatar real estate prices also looks to be drawing to an end as growth prospects weaken – despite continued investment momentum from the world cup preparations and sustained population growth. PUBLIC 15
16. N February 2016 GCC Key Macro Indicators and Forecasts GCC Real GDP (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account (% GDP) Oil production (mb/d) Oil price (US$/b) Population (million) 2011 8.4 1,437 2.9 12.7 22.7 16.08 110.0 43.8 2012 2013 2014 2015e 2016f 5.2 3.5 3.3 2.9 1.3 1,583 1,623 1,647 1,421 1,373 2.2 2.8 2.6 2.5 2.6 13.0 10.1 2.5 -9.0 -11.2 24.9 21.4 15.8 -1.0 -7.8 16.96 16.71 16.95 17.56 17.55 111.0 107.0 107.0 58.0 40.0 45.7 47.7 49.5 51.3 53.0 Saudi Arabia Real GDP (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account (% GDP) Oil production (mb/d) Population (million) 2011 2012 2013 2014 2015e 2016f 9.9 5.3 2.7 3.5 3.4 0.6 669.5 733.9 744.3 746.2 653.3 608.8 3.7 2.9 3.5 2.7 2.1 2.8 11.1 12.0 5.8 -3.5 -15.9 -17.0 23.7 22.4 17.8 12.4 -6.3 -13.4 9.3 9.8 9.4 9.7 10.2 10.2 28.4 29.2 30.0 30.6 31.5 32.5 Qatar Real GDP (% change) Nominal GDP ($ billion) CPI (ave. % change) Budget Balance (% GDP) Current Account (% GDP) Oil production (mb/d) Population (million) 2011 13.0 169.8 1.9 6.4 28.4 0.74 1.7 2012 2013 2014 2015e 2016f 6.0 6.3 4.0 4.2 3.9 189.9 201.9 210.1 188.5 186.8 1.9 3.1 3.0 1.5 2.5 8.9 14.4 9.6 1.8 -5.3 32.6 30.9 26.3 1.6 -6.8 0.73 0.70 0.67 0.66 0.61 1.8 2 2.2 2.4 2.5 PUBLIC 16
17. N February 2016 James Reeve Deputy Chief Economist James .Reeve@samba.com Andrew Gilmour Deputy Chief Economist Andrew.Gilmour@samba.com Thomas Simmons Economist Thomas.Simmons@samba.com Disclaimer This publication is based on information generally available to the public from sources believed to be reliable and up to date at the time of publication. However, SAMBA is unable to accept any liability whatsoever for the accuracy or completeness of its contents or for the consequences of any reliance which may be place upon the information it contains. Additionally, the information and opinions contained herein: 1. 2. 3. Are not intended to be a complete or comprehensive study or to provide advice and should not be treated as a substitute for specific advice and due diligence concerning individual situations; Are not intended to constitute any solicitation to buy or sell any instrument or engage in any trading strategy; and/or Are not intended to constitute a guarantee of future performance. Accordingly, no representation or warranty is made or implied, in fact or in law, including but not limited to the implied warranties of merchantability and fitness for a particular purpose notwithstanding the form (e.g., contract, negligence or otherwise), in which any legal or equitable action may be brought against SAMBA. Samba Financial Group P.O. Box 833, Riyadh 11421 Saudi Arabia PUBLIC 17