While global markets are becoming more connected and correlated, a key factor that sets GCC stock markets apart from the rest of the world is that they are driven by oil price. Most GCC economies rely heavily on government spending, which in turn is closely related to their hydrocarbon revenues. Aside from the fact that hydrocarbon revenues make up over 70% of government revenues in Qatar and over 90% in Saudi, stock markets also have a significant correlation to the price of oil as can be seen from below chart.
Factors like global interest rates are important but only indirectly, through their effect on global growth and the price of oil. Given this central role that oil plays in the GCC, we analyze oil price outlook in this report as this is an important factor in our portfolio construction.
As with any global commodity, oil price is a function of global demand (hence global GDP growth) and supply. But looking at oil price in USD terms, as most investors do, is a misleading start as the US dollar has depreciated significantly. The chart below shows the USD trade-weighted against major currencies. Despite significant appreciation from 1995 to 2001, the dollar has still declined around 25% in the last 25 years.
Furthermore, during this period, global inflation has been 2.6% annually. Adjusting for both the USD decline and global inflation we get a very different trend for the real price of oil. Starting with a price of $18 per barrel 25 years back, today's adjusted oil price would be about $38 per barrel, rather than the $100. This is a 3.8% annual increase in real price, which (although not low) in the context of demand growth and constraining supply dynamics is more reasonable. We believe it is particularly important to adjust the price history to have a better base for analysis and predicting the future.
With OECD demand mostly flat in the past decade, oil demand growth has been driven by emerging markets. Demand forecasts are a derivative of global growth forecasts, assuming no major technological changes that materially reduce oil dependency or improve energy efficiency.
Most forecasters including the IMF are forecasting 2014 global GDP growth to be broadly in line with 2013. Recent monthly data confirms this with the exception of US ISM new orders which came in surprisingly low at the end of January. While we will be closely monitoring these, we believe US policy makers are committed to sustaining growth.
The more difficult task is predicting supply. Non-OPEC supply growth has fallen short of global demand growth in 8 of the last 10 years, explaining why OPEC (40% of global production) has seen resurgence in its leverage over the oil market in the past decade.
OPEC spare capacity, of which Saudi Arabia accounts for over 80% today (disregarding Iran), is the most important supply-side measure to follow for near term oil price outlook. Other OPEC producers have seen issues ranging from deteriorating security in Iraq and Libya, to sanctions on Iran and production constraints due to oil theft in Nigeria. Saudi Arabia's "swing" capacity gives the Kingdom unique influence over the spot price of oil, every time it announces production cuts or increases.
Over the longer term however, the picture gets more complicated. Could Iran strike a lasting nuclear deal lifting sanctions, which would not only add up to 1 million bpd to global supply, but also invest in new capacity? Could Iraq's ambitious plans to add 6 million bpd capacity by 2020 come to fruition? And finally, how much will unconventional sources like tight oil (shale) and other liquids (biofuels, GTL, etc) shake up the traditional crude oil market? It is worth noting that the US EIA has forecast a 6 million bpd increase in production from these unconventional sources in the current decade. These compare with total current production of about 90m bpd.
The chart below shows the historical oil price and the range of analyst forecasts along with the consensus average. The purpose of constructing this chart is to assess how well analysts have been able forecast oil price in the past, and to review what they are currently forecasting.
Our first observation is in volatile years (such as 2007 to 2010), no analysts were able to predict oil price with much accuracy. In recent years, when price was less volatile, predictions were closer. Our second observation is that excluding a crisis year like 2008, the price of oil in recent years has broadly been in the US$ 80-100 per barrel range.
From the "Adjusted Oil Price" on chart 3, we notice that oil was broadly in a close range in currency-adjusted real terms prior to 2003, and since than it has jumped to its new range of $80-100 per barrel (or $28-38 per barrel on an adjusted basis).
The key question is can price of oil drop significantly or whether it will stay at around current levels. Oil market commentators point out that King Abdullah called $75 per barrel a "fair price" in 2008, only to raise that target to $100 per barrel in 2012 when burgeoning public expenditure raised the Saudi government's budget break-even oil price.
In our view, unless there is any material addition to sustainable new capacity from Iran, Iraq or unconventional sources that challenge Saudi Arabia's "swing" capacity, there is unlikely to be a threat of a sharp drop in oil price.
If oil price stays around $100 per barrel as expected by analysts, this means GCC governments will continue to generate significant hydrocarbon revenues which will support strong public expenditure and economic growth. This will be supportive for sectors benefiting from government-spending both directly (such as banks, construction/real estate) and indirectly (consumer), and for the chemicals sector which is driven by oil prices. We closely follow the various factors mentioned in this report, to enable us to reposition our client portfolios if we see any significant changes that could affect the price outlook.