Destruction in demand
"It is too easy to be pessimistic," is how one senior financial executive from the Gulf put it over dinner in London. My accountant from New York is taking negativity to the extreme, saying he has only invested in land, having no faith in financial instruments.
It is challenging at best to see the glass half full at this juncture. Even with stimulus packages being cobbled together, two key ingredients -- confidence and capital -- are clearly missing. As a result, this slowdown is spreading far and wide.
During an exclusive interview with Marketplace Middle East this week in London, the Secretary General of OPEC Abdalla Salem El-Badri pointed to the challenge ahead, "There is destruction in demand; there is no doubt about it."
The Secretary General says the worst case scenario is that demand drops by up to a half million barrels a day this year. The International Energy Agency is projecting consumption will drop by double that amount -- or a million barrels a day. If that is the case, daily demand will be below 85 million barrels a day, and holding onto $40 a barrel will be difficult.
El-Badri, as the great equalizer in the organization, is trying to prod producers inside the 12-member group and outside, amongst the key Non-OPEC players, to trim their sails. "We really need more from our member countries," says El-Badri, noting that 800,000-900,000 barrels still need to come off the market to hit the promised cuts of 4.2 million barrels a day, announced back in December.
Once those cuts are delivered, "if the market did not react, I think we have to balance the market,” said El-Badri. He pointed to the amount of stock, which today is floating on the sea or sitting in bunkers. "The stock at this time is about 57 days. This is five days above the 52 day average; if we want to take the five days out of the stock, then we have to cut more." That is as clear as it gets, whether the group that controls 40 percent of the world’s supplies is prepared to do more.
At this juncture, they are the only players doing so. The IEA still believes that non-OPEC production will go up by 400,000 barrels a day this year. OPEC is not keen to play the role of swing producer all the time or in this case of "swing reducer."
"I am taking this opportunity to ask Norway and Mexico to join us, because if the market collapses, it is not to the benefit of anybody," said El-Badri. This follows consultations with Russia’s President, Dmitry Medvedev, to do the same. This is a case where market share may override near term revenue shortfalls.
The International Monetary Fund, in a special regional report, notes that Middle East producers could see their revenues drop by $400 billion in 2009 due to demand destruction. The IMF urged oil producers to spend their way through the downturn so that the infrastructure build-out continues and confidence remains. The Fund sees regional growth at 3.6 percent this year, down from 6.3 percent in 2008. That is certainly not bad, and is a dream-like scenario compared to Europe or the United States right now.
The Secretary General, like many others, is hoping that the emergency actions taken today will mark the bottom of the cycle by mid-year, with the first hints of recovery by the close of 2009. I believe that is the best case scenario.
Lower interest rates, stimulus plans and tax cuts don’t do a whole lot if businesses cannot get access to capital. That is the quandary today. In the meantime, medium and long term planning and investments are being shelved.
"Because of demand destruction, and also because of financial problems, we are postponing about 35 of our projects from 150 projects, and I think that if this price continues, more projects will be delayed," said El-Badri. The reality is that no one seems willing to pony up more money if they don’t see revenues bouncing back to justify it. That is why there seems to be a building consensus to find what we have talked about on our programme, "The Goldilocks Scenario."
"I think that $40 will not permit us to invest to have a reasonable price where you can invest, where you can have another source of energy then from $70-$80 a barrel, is fair," said El-Badri.
There was a hint of disagreement within the Organization on this point. The President of the group Chakib Khelil thought that $40 was a "good price for the moment." Privately others said it is too painful for those desperate for revenues and probably counting on $60 or more.
As El-Badri noted we should be thinking a few years down the road, "There will be no additional capacity when the economy will pick up. Then you will not find additional capacity."
A Nasty Economic Virus
Making the right bold decision is an art. During this severe global economic downturn, which is spreading around like a bad virus we tend to become numb to big announcements -- from record investment fund fraud in New York of $50 billion to record interest rate cuts.
It is within this context that the members of OPEC followed right on the heels of the members of the U.S. Federal Reserve Board with a historic move. As their policy counterparts at the Fed know, chasing the market is proving difficult, because consumer sentiment and therefore demand is plummeting so fast.
A cut of 2.2 million barrels a day is dramatic, especially in the context of a $100 drop in a barrel of crude in the last six months. By OPEC standards this was managed in a measured way.
After convening an emergency meeting in late November in Cairo, the group gathered in the home country of the cartel’s president, Chakib Khalil. They were joined by four non-OPEC counterparts as observers from Azerbaijan, Oman, Russia and Syria. They, too, sent signals that cuts in January 2009 would hit the market. Some production was scheduled to come off anyway, but in this case producers wanted to illustrate unity.
The reason for this sudden cosiness in the oil business is simple, a sharp drop in revenues. OPEC nations have lost nearly $3 billion a day since the peak in July; they lost half their daily revenue since the start of the year. Forty to fifty dollars a barrel is not what this group has in mind especially when there is more than $1 trillion of projects either under construction or on the drawing board in the Middle East.
The reality is OPEC members were left with little choice than to take action. Prices dropped a record $28 in the month of October. It was like the global economy was walking tentatively along with concerns about recession, and then plunged off the cliff into crisis. This rings true in nearly every sector: oil, autos, housing and shipping.
I spoke to a representative of one of the largest oil and gas shipping groups who noted tanker rates plummeted 80 percent for shipments since July. No one can remember that happening in recent memory.
As a twenty year veteran of covering OPEC meetings, it also strikes me as rather extraordinary that the dramatic action was taken right in the midst of winter when demand is about to hit its peak. Respected energy consultant, Mehdi Varzi, is one who believes OPEC is acting in a near-sighted way. He sees the global economy right now as a very ill patient and higher prices will only prolong the illness or extend the recession in this case.
Varzi for one believes we could see $60 to $70 oil by the spring. This is in line with the aspirations of Saudi Arabia, Kuwait and Qatar but not high enough to prompt companies to invest in marginal fields or fund alternative energy projects either. It is the “Goldilocks scenario” we talked about recently on our program and in this column.
When that OPEC target price will be reached is a subject of great debate within the corridors of oil companies, investment houses, buyers of energy and the analyst community. Fareed Mohamedi of consulting group PFC Energy in Washington believes a price around $70 a barrel will be postponed until 2010, due to a mix of poor market sentiment and a real drop in demand. “People think we are going to go down before we go up,” says Mohamedi, and there is a “lack of trust they will deliver.”
After a full day of reporting on OPEC’s historic cut on paper, I was called by a friend who has worked in the Middle East for 20 years and was eager to mull over the action taken by oil producers. He correctly pointed out that OPEC never manages what he calls a falling market. If downward momentum begins to build, it is very difficult to turn the tide or even set a floor underneath prices. This was true in the late 1980’s (I can remember seeing for myself the rusting oil rigs in Texas fields) and again earlier this decade when recession set in.
This sell off as both Varzi and Mohamedi discussed during our interviews is more severe than anything we have witnessed in the past two decades. The market went from a period of great exuberance to great concern in a span of just three months.
The oil market and the cloud of negative sentiment that persists is a reflection of the global economy today as a whole -- it just took much longer to hit this sector. A year and a half ago the U.S. housing market started to expose real cracks of concern, followed by the sub-prime crisis during the late summer of 2007. Six months ago we were still witnessing record oil prices, which lulled ministers into believing that demand from the East would outweigh problems out West.
A full year later after the financial crisis everyone, including those who sat around the table in Algeria, found out the hard way that no one or nothing is immune from this persistent, nasty economic virus.
In search of Goldilocks
The story of Goldilocks and the three bears has a little girl rummaging through a house uninvited to try all three bowls of porridge until she finds one that is not too hot and not too cold. The OPEC cartel -- producers of about 40 percent of the world’s oil -- is not living through a fairy tale, but in reality is finding it difficult to secure the right price for its crude as economies tumble into recession.
After choosing not to take action at an emergency meeting in Cairo, energy ministers have made their opinions known about what is the Goldilocks price for their product. Saudi Arabia’s Oil Minister, Ali al-Naimi, the swing producer of the group, surprised those who follow this business by declaring $75 a barrel as a “fair price” for crude today.
His Qatari counterpart Abdullah bin Hamad al-Attiyah was hot on his heels saying that colleagues were searching to stabilize prices of $70 to $80 because it is a level which will lead to investment in future production.
During the last quarter, oil has fallen more than $100 a barrel. Formal cuts of one and a half million barrels a day were announced in September and October, but it is taking a while to get those reductions implemented. In the meantime, the only thing related to oil that is going up is the amount of storage.
From his office tower overlooking the waterfront in Sharjah, Hamid Jafar, the polished Executive Chairman of Dana Gas, talks about the need for less volatility: “The worst thing for the industry and for investments is wide fluctuations, because it creates uncertainty,” says Jafar, “That’s not healthy because a lack of investment today will create a bigger spike for the medium term.”
From his headquarters in the United Arab Emirates, Jafar has fanned out in the region to develop fields in Egypt and the Kurdish Region of Iraq. Dana Gas and another company he owns, Crescent Petroleum have invested two-thirds of a billion dollars in the Kurdish gas project. Jafar is keen to see state-run oil companies accelerate their investments in partnerships with private sector firms like his. The trend in the business is the opposite. State run oil companies have been eager to control as much of their production as possible in an effort to maximize profits.
Oil industry insiders say Saudi Aramco is one of the exceptions. Neil Fleming of Platts put it bluntly on the sidelines of a London conference, “What tended to happen with other OPEC producers is they’ve milked what they had in terms of resources and revenue. The impetus to really invest in increased production was not there.”
With oil hovering around $50 a barrel, it is difficult to fully embrace the recent report from the International Energy Agency that predicts oil will average double the current amount between now and 2015. The Paris-based agency notes that a half billion dollars a year needs to be invested to compensate for the drop in production in countries like Mexico, Norway and Russia. Yes, the second largest exporter today, Russia, is seeing its fields drop by an estimated six to eight percent a year. The bulk of those investments need to go into Middle Eastern fields, where reserves are plentiful.
Kuwait Petroleum Company, for example, wants to expand production by one million barrels a day to 3.5 million in the next seven years. To do so, their Managing Director of Planning, Jamal Al Nouri said during an interview in Dubai that $60 to $70 would suffice in terms of his production pipeline.
“It is a complex combination of projects in terms of exploration, infrastructure, drilling and facilities for export and maybe securing markets outside,” Al Nouri said. KPC for example is a joint venture partner on a $6 billion dollar refinery in Vietnam.
Here is the rub. Despite their coffers overflowing when oil was over $100, the Middle East can have too much of a good thing. When prices are sustained above $90, it prompts owners of more expensive projects such as tar sands in Canada for example to go into production. That might be good for balancing supplies, but at the same time the trend reduces the influence of regional oil producers. Also, high prices push consumer nations to accelerate their investments into alternative sources of fuel.
Peter Barker-Homek is Chief Executive of Abu National Energy Company, better known as Taqa. His group owns oil and gas assets, plus clean burning power generation projects.
With a broader portfolio he is advocating that a higher price will prompt smarter investments: “I think the dialogue is moving from simply oil demand and supply balance to what is the whole global energy mix. And we have to change ourselves to a low carbon society, a low carbon planet. The only way to do that is to have relatively high pricing over the next five to ten years which will cause a migration from fossil fuel in transportation and cause us to switch to more efficient power-generation.”
So, while this blueprint for future energy is still being drawn up, OPEC finds itself only a quarter of the way through a story it was hoping not to be part of. It is called a deep correction in the West and falling demand for their number one asset. Oil producers are searching for Goldilocks, but like in the fairy tale, she remains elusive.
Beware of falling BRICS
The attacks on Mumbai underscored the frailty of the world today. It is complex enough with the financial crisis at hand, but unduly challenging if you throw terrorist attacks on top. Strike while the enemy is weak seems to be the rule of thumb here.
India, one of four BRIC countries -- Brazil, Russia, India and China -- has come a long way since the 9/11 terrorist attacks which shook the world. India’s main market index surged 390 percent since 2001 through September of this year and that is factoring in the sizable correction in 2008. Economic growth has averaged eight percent in that timeframe. Brazil, Russia and China posted equally impressive gains of 345 percent, 639 percent and 500 percent in the same period.
All four of these BRIC countries have been forced to take a big pause or as Florence Eid, Managing Director of Passport Capital noted during a speech with business executives this week, “The train may be stopped, but it is still steaming.”
This is not dissimilar to the story throughout the Middle East. Stock markets in the region are down between 30 and 70 percent in 2008. That is not insignificant because an estimated $1 trillion of market capitalization was wiped out in short order.
The concern through the first half was too much liquidity chasing too few products. The story almost put to bed in the second half of the year is all about a lack of liquidity to fund the $1 trillion of projects now on the books in the region.
It is in that spirit that Saudi Arabia’s central bank decided to move decisively with a cut of one percent to its main lending rate.
“This is no time for inching right? We have seen 100 basis point cuts right around the world,” said Eid, “The Saudi Central Bank is acting in the very same manner. There is no time to wait. There is no time to reflect what is going on. It is time to move and they moved fast.”
It is the same reason Abu Dhabi stepped up support for Dubai’s property sector. The federal government provided $13 billion to form the Emirates Development Bank and absorb the assets of lenders Amlak and Tamweel. This was quickly followed by the creation of a new national entity Abu Dhabi Finance. No one wanted to see this train parked in the station too long -- with or without steam. Some noted this might mark the beginning of the end to the property drops we have witnessed over the past two months. Let’s see if the risk premium of two percentage points above LIBOR will come down as a result.
While some may be writing clever headlines about “Crumbling BRICS” or “BRICS on shaky ground,” one should definitely rollout the master blueprint. The Paris-based think tank of the industrialized world, the OECD put it into context recently, projecting that the 30 member countries will contract by 0.3 percent next year. In sum, all, ALL of the growth for 2009 will come from the BRIC countries and their faster growing brethren. China, India and the Middle East may be lucky to eek out six percent economic growth next year, but that is six percent better than we are seeing elsewhere right now.
Earlier this year at the World Economic Forum annual meeting in Davos, there was a great deal of buzz around the concept of de-coupling, that the fast growing economies would break free from the shackles of their slower growing counterparts in the G7. That theory was given far too much airtime, since countries like Saudi Arabia, China and India are still very dependent on Western demand and Western investment. This co-dependency was enough to knock at least two percentage points of growth off for each country this year.
Tony Angel, Managing Director of EMEA for Standard & Poors, at the same gathering of business executives said the relationship between the G7 and the rest of the world is tighter than ever. One lesson we learned from this mammoth downturn is that emerging markets are “embedded in the world economy.” That too, said Angel, is a good thing since it is “time to move on from a uni-polar world.”
Companies of the emerging market countries have moved well down the track this decade. The names of SABIC (Saudi Arabia), Lenovo, Haier (Chinese), Tata, Ranbaxy (Indian) and Embraer (Brazil) should all sound familiar to those of us in the business. All six have emerged as major players either through their global growth or by acquisition of global counterparts.
With a bit of research, I found that the term “emerging markets” was coined in 1981 by World Bank economist Antoine van Agtmael. So, in less than three decades these economies have become not only magnets for foreign direct investment but as capital generators in their own right.
They have their own set of challenges; the risk of a harder economic landing is there and the train may be paused at the station, but demographics and growth are on their side.
Barrels of Concern
When we were in school doing our maths, our teachers always instructed us to use a pencil and not a pen in case we made mistakes. It was impossible to erase a miscalculation back then. Those who are making economic and energy forecasts right now might be wise to do the same.
With as much exuberance on the way up to $147 in July, we are witnessing equal pessimism on the way down to $55 a barrel. The internal tussle within OPEC back in July was supplying more oil to meet demand. Today, the 13 members cannot scale back fast enough. After trimming production by one and a half million barrels a day since September, they are looking at another emergency meeting for the end of November in Cairo. Playing catch up with the markets is always a frustrating game, and that is the one being played out today.
If we continue along this path, don’t be surprised if the six and a half percent growth earmarked by the International Monetary Fund for the Middle East gets crossed out shortly for a lower number. That will spill over to the property sector where we are starting to see 10-20 percent falls for villas and flats in Dubai. Officially we don’t know how leveraged some of these companies are, but there is a lot of discussion off-line that provides a pretty good indication.
In the meantime, OPEC members will do their level best to find the middle ground. While on a trip to Cyprus for bi-lateral meetings, the Prime Minister of Qatar, Sheikh Hamad Bin Jassim Bin Jabr Al-Thani reiterated his call for a trading band, "We think that $70 to $90 is a fair price because you need to keep new exploration to go on and as you know, the investment in the oil is expensive.”
That appears to be the Goldilocks scenario for OPEC: not too hot, not too cold, but just right. Right now, regional producers still make plenty of money at $55, but they are losing $2 billion dollars a day from the go-go times of July -- that’s three quarters of a trillion dollars a year.
Power in Reserves
In their World Energy Outlook, the IEA projected spending of $24 trillion in energy between now and 2030 to meet the demands of the fast developing countries from Asia to Latin America. I found it interesting that only a quarter of that (he says lightly) is forecasted to be spent on oil and gas. Half is forecasted to be spent on power generation and a good slice of the total on conservation.
The IEA sees demand growing from 86 million barrels a day to over 100 million in that time frame. Make no doubt about it, with 78 percent of the proven reserves today, OPEC will be in the driver’s seat once the doom and gloom clears -- whether it is in 2010 or a tad later. Non-OPEC oil fields are reportedly depleting by six percent a year now. That is expected to jump to eight percent in the next two decades.
If that is the case and this forecast holds up, the IEA believes oil will average $100 a barrel between now and 2015. By 2030, the agency is expecting today’s barrel of oil to be priced at $200.
In the meantime, a projected $450 billion is needed to develop reserves that have been identified and even more to find those which have not. At today’s prices that is a tall order. Let’s hope that the Goldilocks scenario returns fast so forecasters can rework their numbers up, rather than down yet again.
That Slippery Feeling
A fifty percent correction in four months! At first glance you probably think I am referring to regional equity markets. Think again.
Before one can say West Texas Intermediate, crude prices have gone from a hefty record of $147 a barrel way down to the $70 range. It may have taken too long for the G7 countries and their new partners to come together with a defined rescue package. That is on the books. The world has now decided to focus on a new chapter titled "Recession 101".
The gathering of 185 countries at the International Monetary Fund and World Bank meetings in Washington provided the outline for this new chapter. Take note of the tone by Olivier Blanchard, Director of Research for the IMF.
"Growth in advanced countries will be very close to zero or even negative until at least the middle of 2009," says Blanchard, "We predict that even the fast developing countries will grow at a substantially lower rate than they have in the recent past, 7 percent in 2008, and 6 percent in 2009."
Slower growth is not the surprise; the speed of the fall and depth of the drop are. Blanchard’s ultimate boss at the IMF, Dominique Strauss-Khan, says the institution was quick to dispel the concept of de-coupling, that no part of the world was immune to the downturn. I think most would admit today in fairness, that no one really thought that this banking crisis would be so horrific.
It has Middle Eastern central bankers cutting interest rates. Saudi Arabia lowered its benchmark rate by a half percentage point after the likes of the UAE, Bahrain and Kuwait pulled the trigger the week before. Enemy number one was inflation at the peak of summer, which was replaced by slower growth. Both surely have been substituted by lower oil revenues.
Let’s take the largest producer; Saudi Arabia. At $147 a barrel, the Kingdom brought in oil revenues of more than $1.3 billion. At $70, that quickly becomes $637 million. That is a lot of money; more than a population of 28 million can spend of course, but a great deal less than a quarter ago.
According to Saeb Eigner, founder of investment group Lonworld and author of "Sand to Silicon", most Middle Eastern oil producers have been prudent with their revenue targets. In five short years they wiped out budget deficits accumulated, in part, by financing the first Gulf War. In most cases, $40-$50 has been the yardstick. It would be more interesting to discover what targets they penciled in on the margins after seeing prices trade well over $100 for a half year.
Oil ministers representing13 members of the OPEC cartel will hold what they call an extraordinary meeting in Vienna this Friday. They already agreed in September to trim production by a half million barrels a day. Not long before that, swing producer Saudi Arabia agreed to boost production in June to cap prices that were on their way to $147 in July. Back then, oil minister Ali al-Naimi said there was not an oil shortage, but the market was not factoring in a slowdown in demand. Not surprisingly, he was correct.
This leads us to the old debate within OPEC between the price hawks and doves. Saudi Arabia has always tried to counter balance members Iran and Venezuela, who have sought maximum revenues per barrel. The Kingdom has taken the view there is a breaking point where price undercuts demand. After we have witnessed the first hint of recession, one sees what the slippery slope looks like. OPEC has already cut its 2009 forecast for daily demand by a half million barrels a day.
This crisis did start in America. It has crossed the Atlantic hitting Britain and the European Union with full force. Export driven markets from China to Southeast Asia are feeling the pinch, with growth off one to two percentage points depending on the economy.
The real fear it seems is not $70, but what many privately say could be just around the corner. If one can see prices tumble by 50 percent, then another 20 percent is not outside the realm of possibility with investors still climbing a wall of worry.
ABOUT THIS BLOGJohn Defterios’ blog accompanies the weekly business program, Marketplace Middle East (MME) that is dedicated to the latest financial news from the Middle East. As MME anchor, John Defterios talks to the people in the know, finding out their opinions on the big business moves in the region, he provides his views via this weekly blog. We hope you will join the discussion around the issues raised.
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