In an exclusive, Ehsan Khoman, Head of Research and Strategist for MENA at MUFG, projects market movements for the region
If one thing is certain, it is that the Middle East never fails to keep investors on their toes. The first half of 2018 has seen geopolitical tensions intensify and then retreat, nuclear pacts tear apart as well as oil price oscillations. However, underneath the surface, it’s not all strife and turmoil. 2018 has also offered—so far—some relief from the economic stresses and disappointments that have characterised the region in recent years.
As the global economy strengthens, regional countries are likely to take advantage by accelerating structural reforms. There are also hopes that an easing of geopolitical conflicts will bolster the prospects for MENA oil importers.
Three developments in particular have shaped the financial and economic landscape of 2018: President Trump’s withdrawal from the Iranian nuclear agreement, Saudi Arabia’s noticeable progress with Vision 2030 and the OPEC+ meeting in June. They have all dominated the agenda over recent months and are undoubtedly set to further impact the region as we head into the second half of the year.
IRANIAN NUCLEAR DEAL
President Trump’s decision on 8 May to withdraw from the Joint Comprehensive Plan of Action (JCPOA) was a landmark moment. Given the state of geopolitical tensions between the two countries, there had been whispers that Trump was leaning towards a hard US exit. Despite Trump’s announcement, markets have still not fully priced in the willingness of Iran’s crude importing countries to comply with the US restrictions. Indeed, while the reinstatement of US sanctions on Iranian crude will undoubtedly curb Iranian exports, the size and scope of the impact is still unknown. This will depend on the extent to which those countries who previously received Iranian imports adhering with the sanctions, as well as whether they will be a reinstatement of sanctions on shipping insurance which were critical in disrupting Iranian crude exports between 2012-16.
Countries across the globe have been swift to choose their sides. European governments are working assiduously to safeguard business links with Iran. In early June, France, Germany and Britain pleaded in a public letter to the Trump administration to exempt European companies from sanctions on Iran. However, with the US viewing its new Iran strategy as both necessary and inevitable, European allies are already preparing for the US to proceed with wide-ranging sanctions irrespective of their wishes. Entities with significant operations in the US seem to be prioritising those relationships; Total, AP Moller-Maersk, MSC (world’s second biggest container shipping group), Allianz, Siemens and Maersk Tankers have all warned that they would wind down business in Iran.
One such example was Iranian delegates being barred from a S&P Global Platts meeting in London due to fears of breaching the US’s strict measures. Furthermore, if Europe does not deliver a credible compensation package, Iran may follow through on its threat to exit the nuclear non-proliferation treaty (NPT)—the only binding multilateral treaty aimed at achieving disarmament. This would severely degrade global security and increase the risk of war and a nuclear arms race in the region. Europe’s next steps will have serious consequences for not only its alliance with the US, but also for security in the region and perhaps the wider world. The next six months will be a crucial test of international diplomacy.
SAUDI MARKET REFORMS
In the past six months, the world has watched Saudi Arabia take significant steps towards achieving economic reform. Notably, there is a sense among those close to the Kingdom that recent activity is genuinely different to previous rhetoric and that, under the leadership of Mohammad Bin Salman, the country may be moving towards a period of meaningful structural change. This has been highlighted by the Kingdom’s mandate under Vision 2030 to reduce its reliance on the cyclical nature of hydrocarbon revenues, which has previously held the economy back. The Kingdom won classification as an emerging market by the FTSE and MSCI indices earlier this year; a huge step towards its goal of attracting more in foreign investment. The watershed announcements were a resounding endorsement for Saudi Arabia’s success so far with Vision 2030 and other market reforms aimed at transforming the nation’s economy.
Investors are also looking forward to privatisation plans, which are coming to fruition in 2019. If successful, these should further propel the rise of foreign exchange reserves over the medium-term. The Crown Prince’s Vision 2030 targets are undoubtedly ambitious. It is inevitable that the Kingdom will face challenges consolidating its finances—highlighted by the widening fiscal deficit in the first quarter to $9.2 billion compared to $7 billion in Q1 2017. Given the ambitiousness of the transformation programme, the pace is likely to be modest with many of the pledges taking years to achieve, but investors should not be put off by short-term challenges. On the contrary, investors should look ahead to the Kingdom’s long-term success. The authorities’ determination to support economic growth by adjusting policies in line with changing oil market dynamics, while sticking to the 2018 Budget path, have thus far provided encouraging signals.
One core part of Saudi’s diversification efforts is of course, the corporatisation of Saudi Aramco and its upcoming IPO. As we approach the two-year mark since the Crown Prince’s announcement, the listing continues to draw widespread speculation, despite the recent announcement that it will be delayed to early 2019. A likely explanation for the prolonged delay is the complexity of the transaction and the work required to disentangle Aramco from the rest of the Saudi state. However, one must not lose hope: these challenges are surmountable.
Further clarity to key disclosure guidelines in the second half of this year should go some way in assuaging any concerns. The next step for the Kingdom is to decide whether it will go ahead with an international listing. Though we know that the Saudi local Tadawul stock exchange will serve as the anchor market, investors eagerly await further guidance of additional locations. Countries across the globe are still jostling for the Kingdom’s attention, with the UK’s financial watchdog announcing only a few weeks ago that it will overhaul its entire regime (which currently entails strict adherence to rigorous governance standards) for IPOs of sovereign-controlled companies to create a ‘premium regime’ which would accommodate listings like Aramco.
If governments are prepared to reassess their own legal codes, the IPO is clearly a prize worth winning. Politically speaking, a listing on a Western stock exchange could help the Kingdom strengthen ties with the US and Europe. As long as regulatory concerns do not complicate efforts, the Kingdom could reap the benefits of strengthened Western ties. Meanwhile, an Eastern stock exchange could be less challenging from a legal and regulatory perspective but might come with less geopolitical benefits. OPEC As we enter the second half the year, developments in OPEC+ are currently the centre of attention for oil markets.
Prior to the OPEC meeting on 22 June, the key concern for OPEC members was that oil prices were approaching a concerningly high level for consumers and producers alike, leading to weakening demand and a slowdown in global economy. Output had fallen far further than the group initially intended (OPEC and non-OPEC compliance rates were at 172 per cent and 80 per cent respectively in April 2018), primarily due to involuntary production cuts by Venezuela, natural decline rates in other members such as Angola, as well as heightened geopolitical tensions surrounding the re-imposition of Iranian sanctions. Whilst OPEC+ member agreed in principle to raise production by up to one million barrels per day (b/d) on a coordinated basis at the latest meeting, there still remains a lack of clarity on the allocation by country.
Rather than increasing each country’s production allocations, OPEC+ will instead strive for 100 per cent compliance with the overall production ceiling agreed in November 2016. The central takeaway is that the 100 per cent compliance target is for the group as a whole, and not for individual members. Indeed, the only approach that OPEC+ as a group can bring compliance with the deal agreed back in November 2016 to 100 per cent (as of April 2018 it was 172 per cent), is for countries with spare production capacity to raise output at the expense of others.
Thus, without explicitly stating, OPEC+ members are in effect giving tacit approval for countries with spare capacity to produce over their allocation numbers. Several OPEC+ energy ministers appear to provide their own interpretation of what the output revival meant for the market. Iran saw no more than 500,000 b/d of additional output whilst Nigeria forecasted 700,000 b/d and Iraq said it could be as much as 800,000 b/d. Whilst the magnitude of the proposed oil production increase is negligible, at around one per cent of total global oil supply, it does mark a major shift in OPEC+ strategy to raise market share and away from supporting prices.
They are in effect articulating that they have won the battle to eliminate global inventories and now must move on to the next stage to demonstrate that they can manage market rebalancing in an uncertain future in which (i) global economic and demand growth are at risk; (ii) the robustness of non-OPEC production (particularly shale) could be a challenge and (iii) there remains uncertainties surrounding the production of Venezuela, Iran, Iraq, Libya and Nigeria.
Looking ahead, this production increase marks the first step and opens the door to further potential increases if OPEC+ members consider such an additional increase as necessary for market rebalancing. Whilst the consensus agreement by OPEC+ will offer a clarity on the global supply/demand balance in the near term, we view that considerable risks remain in relation to the oil price trajectory. In this regard, compliance adherence will be central to the determination of the frontend of the oil price curve, especially given the deviations in interpretations of the real production increase that is expected by OPEC+ members vis-à-vis the nominal articulation of the one million b/d revival in production. In addition, if all members are to participate in the production rampup, some countries’ capacity to meet their targets will be questionable.
Prices will also be susceptible to headline risks throughout the summer, should OPEC agree to reconvene and assess market conditions in September. A critical issue surrounds the US-China trade war which is diminishing energy cooperation. The threat of retaliatory Chinese tariffs on US exports of oil—US share of oil exports to China has sharply from 3.8 per cent in mid-2017 to 8.4 per cent in Q1 2018—would increase uncertainty surrounding the energy cooperation between the two countries, with Chinese oil corporates potentially becoming reluctant to sign long-term contracts with US oil exporters going forward.
This has already had an impact on oil prices, and an escalation in the trade tensions between the US and China could create further jitters. A rollercoaster region, the Middle East never fails to surprise and excite. Geopolitical activities will undoubtedly rumble on throughout 2018, with all eyes focused on how the region will react to the contentious OPEC+ meeting and Trump’s abandonment of the Iranian nuclear deal. Investors should expect a bumpy ride for the rest of 2018, but it could be one worth holding on for.