Finance as usual?

 

The impact of oil price volatility on the GCC financial sector.

By Richard Banks, Regional Director, Euromoney Conferences

 

 

If there is one thing that the return of volatility shows, then it is that predictions of future oil prices are dangerous. Only last July highly reputable research sources were confidently predicting oil at $110 or higher for the foreseeable future.  They were intrinsically predicting a continuation of the status quo.

 

You will note that I used the words ‘return of volatility’ not ‘oil price decline’. I choose my words carefully – we have not yet reached a new equilibrium in the oil price. That has significant implications for investment.

 

So, two highly relevant questions would seem to be: Where will the new equilibrium price be and when will it get there?  I don’t know. Nobody does.

 

However, we do need to understand what’s currently driving the headline price and how those factors may change in order to understand better where we might be heading and what bumps there could be on the road ahead.

 

I will not get too forensic, but I would like to look quickly at the factors that seem to be driving the market:

 

1.       A sustained and significant surge in non-OPEC output

2.       Continued supply despite potential geopolitical risks in oil producing regions

3.       A period of softer than expected global demand

4.       A strong dollar

5.       A strategy by the KSA to protect market share rather than headline prices.

 

When was the last time these factors combined and what happened?

 

Late 1985. Reagan & Gorbachev were meeting in Switzerland, the first version of Microsoft Windows had just been released, the hole in the Ozone layer had recently been discovered and Madonna was the latest chart sensation.

 

At that time, prices fell (peak to trough) by more than 70% - from around $30 in autumn 85 to below $10 in spring 1986 before recovering to trade up to $20 by spring 1987. The price then tracked in the $10-$20 range for the next 16 years. 

 

Let us not fall into the trap of assuming that history will repeat itself exactly. I just want to emphasize that there is precedent – and that precedent points to the price beginning to stabilize sometime around the Q2 2015. Giving a synthesis of current analysts’ predictions, we should be looking at an average of $60bbl for 2015 and $75bbl for 2016. However, a major change in any of the factors driving the market now could change that – and it seems for the better (from the perspective of producers, at least).

 

The point I am trying to make is this: combine the confluence of short-term factors with medium-term structural factors (environmental concerns and technological advances) and it is more likely than not that we are facing a sustained period of prices lower than those to which we have become accustomed in the last five years. 

 

It would be foolish to assume otherwise – even though future price volatility seems to be skewed to the upside.

 

Since 2008’s financial crisis, the GCC region has been an island of growth and financial stability in a sea of uncertainty. Now the GCC has re-coupled with uncertainty and must quickly adjust to that reality. It is no longer a special case.

 

I hope that the policy and business responses are appropriate. This is a good time (relatively speaking) to act on reform of subsidy systems – particularly energy and water and a good time to look at some real drivers of sustainable growth.

 

Some countries have already started taking steps – subsidies have been reduced, some marginal large projects have been postponed and there is an acceptance that further structural and legislative reforms are far more urgent than even six months ago.

 

Inevitably, the change in the market fundamentals will impact the financial sector and investment capital flows.  

 

Bond and equity markets are jittery but not panicked. Headline equity indices are off 2014 highs but CDS spreads and yields on regional sovereigns or sovereign proxy bonds have narrowed in early 2015 after widening in Q4 2014.

 

Jittery markets, however, are not beloved by new issuers. The volume of new bond issuance fell significantly in Q4 2014 and won’t pick up until the markets stabilise. Nor will IPOs be flooding into this market.  Investment banking revenues will be negatively affected as transactions stay in the pipeline.

 

Inevitably, bank profits will also face downward pressure in 2015 as NPL provisions rise. However, regional banks are well capitalized and therefore, any risk to the banking sector is not currently systemic.

 

Governments across the region have reiterated their commitment to current spending plans, which provides some comfort to those of us concerned with the dependence of banks and their clients on government largesse. However, the rate of growth of spending must be curtailed – and that, of course, affects the core growth projections for the financial and corporate sectors.

 

In short, then, GCC financial sector growth will slow.

 

Investment capital in the region will still be plentiful but attractive opportunities for the deployment of that capital will be even harder to find. With the exception of the USA and, perhaps, the UK – developed markets won’t return to significant growth in 2015. The emerging market commodity play is now done and the BRICs are all on a lower growth path permanently. Some riskier but interesting outliers (Egypt, for example) may provide opportunity to the courageous but they won’t move the needle on a global scale.

 

The advantage in these markets may go to two types of player – the very large and the niche.
And, as in markets like media, telecoms and, indeed, hydrocarbons, we could well see a squeeze on the middle ground.

 

Large regional or multi-national financial institutions have scale, depth and systemic importance. They have the market share and pricing power, which will ensure their survival (if not their growth). 

 

Conversely small, lean and nimble players with good management and innovative/disruptive business models will also prosper.

 

Those who will suffer are the players with neither scale nor speed. Customers (borrowers, depositors, investors and clients) will demand muscle or sinew – size or speed – and greater efficiency in both. Institutions will need to earn their positions not be content with replicating others whilst surfing on the back of a region-wide revenue boom.

 

There are too many banks and investment companies in the GCC with cookie-cutter business models. Just last week I had an extended series of meetings with investment companies and banks from across the region. I am not going to name names but there was a marked difference between those who put across non-specific plans to grow ‘retail banking’, ‘private equity’ or ‘fund management’ and those who presented tightly targeted and clearly delineated strategies.

 

The middle ground in the Middle East financial sector is due a shake out. One product of regional liquidity has been the creation of investment firms and other institutions without a clear business model. There was a similar boom in these companies leading up to the 2008 financial crisis. That didn’t end well and I don’t think we are facing a similar crash – we are looking now at a re-think, not a re-set.

 

There is plenty of room for high-quality banks with conventional business models. There are many opportunities for institutions that are truly innovators. It is the middle ground, which looks unattractive to me.

 

I am looking forward to putting this hypothesis to the test at the Euromoney Saudi Arabia conference in Riyadh on 5-6 May. You can join us there or online by going to www.euromoneyconferences.com

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