Vol 6 No 1-2, Jan-Feb 2011
APICORP’s Annual Review of the Arab Economic and Energy Investment Outlook
Still‐strong Fundamentals Despite Heightened Uncertainty This commentary has been prepared by Ali Aissaoui, Senior Consultant at APICORP, to serve as a review of business environment for the Corporation’s 2010 Annual Report. 2015
2014
2013
2012
2011
2010
4. Hence, growth for 2010 is put at 2.7% in advanced economies and 7.1% in emerging markets and developing countries. This translates into a robust growth of 4.8% for the world as a whole. For 2011, growth is projected to be slower as most countries have planned to exit or moderate their fiscal stimulus and shift their focus on fiscal consolidation (Figure 1). For the recovery to be sustained, conventional drivers of growth, i.e. consumption and investment, have to substitute for the temporary effect of inventory accumulation and fiscal stimuli. Expectations are that in most advanced countries consumption and parts of investment are likely to remain weak in the short to medium term. By contrast, in most emerging economies, consumption and investment may stay strong, therefore supporting growth
and expansion. 2009
2008
3. The process of recovery witnessed by the global economy in 2010 was largely attributed to the stabilization of the financial system, the effects of coordinated expansionary monetary and fiscal policies, and increased industrial production to rebuild depleted inventories. However, according to the latest IMF’s World Economic Outlook, which was released under the theme “Recovery, Risk, and Rebalancing”, 1 the recovery has been uneven across the world. While growth was sluggish in most advanced countries, it was much stronger in emerging and developing economies. 2007
2006
Global and Arab Economies 2005
APICORP Research Source: IMF, WEO update, Oct 2010
and own compilation and forecast for the Arab world ‐5
2004
The Economy and Markets 0
2003
5
2002
2. Against this unfolding backdrop, our commentary reviews the Arab economic and energy Investment outlook. To the extent that energy demand, interest rates and oil prices are key determinants of investment activity, the global and regional economies combine with the credit and energy markets to shape the outlook. Accordingly, the commentary is in three main parts: the first explores the state of the economy and markets; the second reviews the region’s inferred energy investment outlook; the third reassesses the energy investment climate in the wake of current events. Emerging and DCs
Arab world
Advanced countries
2001
10
2000
1. Coming in the aftermath of a major financial crisis, deep recession and high unemployment, 2010 was a year of mixed fortunes. Despite remaining weaknesses in the financial system, which are still constraining credit and investment, the global economy is surely mending. However, wherever socio‐economic imbalances could not be prevented, they spilled over into the political arena slowing down painfully the process of recovery. More dramatically in parts of the Arab world, discontent arising from exacerbated socio‐economic inequities has developed into political turmoil, creating as much uncertainty as hope. Figure 1: Overview of Global and Regional Growths % Real GDP Growth
APICORP Research
Economic Commentary
5. While the global economy is mending, the Arab world faces greater uncertainties. To be sure, the region fared well in 2010. Growth accelerated to 4.2% as most countries managed to build enough fiscal space to weather the global recession. However, ongoing social and political upheavals in parts of the region do not augur well. Whether or not growth can be sustained to the pre‐crisis trend shown in Figure 1 now depends on a number of countries maintaining social and political stability. This is a major challenge, which hinges on the capacity of governments to develop fresh policy reforms to tackle the socio‐economic problems that have been besetting them. The most pressing challenge is creating enough jobs for a rapidly expanding population and warding off renewed threat of inflation. The Credit Markets 6. In an effort to stimulate the US economy, the Federal Reserve has been reducing, since December 2008, its benchmark interest rate – the fed funds rate – towards zero. At the same time it signaled that US economic conditions might justify prolonging the near‐zero rate policy. The implication is that further efforts to support recovery had to be backed by additional monetary accommodation. But because the Fed’s low interest rate policy had already reached its bound, the Federal Reserve had to turn to unconventional policy tools to provide that extra accommodation. The adoption of “quantitative easing” means creating money to purchase long‐term securities on the open market with the aim of lowering longer‐term interest rates. As these purchases are settled through the banking system, they result in a significant augmentation in banks’ reserves. 7. The risk is that rather than lending these reserves, banks would instead use them to shore up their balance sheets. Nonetheless, at least excess reserves have been associated with improved interbank markets. This is illustrated in Figure 2 by the evolution of the dollar spread between LIBOR and the overnight index swap (OIS), a conventional measure of liquidity stress in these markets. The spread jumped to more than 35 bps in the wake of heightened sovereign risks in parts of the Eurozone, which undermined confidence in the soundness of some banks during the summer of 2010. It has since resettled near its pre‐
crisis levels of 10 bps. © Arab Petroleum Investments Corporation Page 1/5 Comments or feedback to: aaissaoui@apicorp‐arabia.com Economic Commentary
Vol 6 No 1-2, Jan-Feb 2011
Figure 2: Pre‐ and post‐crisis evolution of Libor‐OIS spreads 6‐month Libor‐OIS spread (basis points)
400
APICORP Research Using Bloomberg database
(as of 31 Jan 2011)
Lehman's
bankruptcy
(Sep 2008)
300
200
100
Onset of the
credit crisis
(Aug 2007)
Eurozone's sovereign debt troubles
(May‐Aug 2010)
10. By contrast to the tightening oil market, natural gas markets have, in the wake of the so‐called ‘shale gas revolution’, witnessed a significant and disruptive oversupply. Fast growing production from shale gas formations in the U.S. has deeply affected global supply fundamentals. As a result, natural gas prices have not only greatly deviated from oil price‐parity, but they have significantly diverged between regional markets. We expect prices to evolve in a range of $4‐5/MBtu in the fully liberalized, well supplied US market, and in a range of $8‐
10/MBtu in markets where oil‐linked prices still prevail. 0
Overview of Key trends 12. On this basis, we expect growth in energy capital investments to continue recovering from the contraction that occurred during the crisis (Figure 4). Current review for the period 2011‐15 points to a higher potential investment of $530 billion, compared to $470 billion in the last review.3 Furthermore, the total amount of investments shelved or postponed is expected to drop to 19% of potential, compared to 29% in the last review. As a result, actual capital requirements should amount to $430 billion for the period 2011‐15, compared to $335 billion in the last review. Figure 4: Rolling 5‐year reviews of Arab energy investments 600
500
400
300
Arab apparently shelved (LS)
Arab actual requirements (LS)
250
"Average project cost" index (RS)
200
300
150
200
100
100
50
Figure 3: 2010 Oil Prices Stabilization Within $79‐90/bbl Summer 2008:
Bursting of the
oil market bubble
APICORP Research, using OPEC database,as of Jan 2011
130
2011‐15 Review
2010‐14 Review
2009‐13 Review
Geographical Pattern 0.5
1.5
2008‐12 Review
50
2007‐11 Review
70
2010: Stabilization within APICORP's
$70‐90/bbl band
Winter 2008‐09
OPEC's output cut totaling 4.2 mmb/d
0
2006‐10 Review
90
0
2005‐09 Review
110
2004‐08 Review
OPEC Reference Basket Price ($/bbl)
150
Average project cost index
Oil and Gas Markets 9. Despite a strengthening of the global economy in 2010 oil prices remained within the band of $70‐90/bbl we anticipated 2
and advocated for OPEC basket price (Figure 3). However, recent data and forecasts, pointing to stronger than anticipated demand in fast‐growing emerging economies, have unanchored expectations for prices. When the IEA reported, in February 2011, that global demand grew at a staggering 2.8 mb/d in 2010, the strongest annual increment since 2004, prices had already unhooked from the band. Although the IEA is at variance with OPEC on the near‐term outlook, market conditions appear reminiscent of the steep upward drift experienced before July 2008. Therefore, instead of indulging once more in a sterile speculation vs. fundamentals debate, we should call on OPEC and the commodity futures regulating agencies to act more sensibly. The former by adjusting output to balance a tightening physical market, the latter by setting and enforcing position limits to dampen speculative trading in the futures market. 11. Our review of energy investment in the Arab world, which is project‐based, is underpinned by the above developments in three main ways. First, global energy demand is recovering. Second, despite current uptrend, we continue to assume that crude oil prices would stabilize again within the anchor price range mentioned before. Reports of higher than anticipated demand will encourage investors to bring back in line some of the oil‐based projects they had previously shelved or postponed and to slate for development new ones. Third, and by contrast, gas investors, which face a more challenging market, may put higher value on the option to wait. APICORP Research - Oct. 2010
US$ billion
Jan‐11
Oct‐10
Jul‐10
Apr‐10
Jan‐10
Oct‐09
Jul‐09
Apr‐09
Jan‐09
Oct‐08
Jul‐08
Apr‐08
Jan‐08
Oct‐07
Jul‐07
Apr‐07
Jan‐07
The Arab energy investment outlook 8. Reduced concerns about counterparty and liquidity risks in the interbank markets have somewhat improved funding for business. However, dollar credit markets remain tight and margins over LIBOR is still high. In this context, capital inflows to the Arab world, the bulk in the form of loans, slightly recovered from the trough of 2009. But, with a little less than $100 billion in 2010 these flows were far below the 2007 peak of some $180 billion. Furthermore, the average loan margin, although having decreased from the 2009 peak of 285 bps to about 210 bps in 2010, is still three times the pre‐crisis level of some 70 bps. As touched upon in the last section when discussing the investment climate in the region, we should expect unfolding events to affect both the size and cost of capital inflows. 2.2
30
Jan‐11
Oct‐10
Jul‐10
Apr‐10
Jan‐10
Oct‐09
Jul‐09
Apr‐09
Jan‐09
Oct‐08
Jul‐08
Apr‐08
Jan‐08
13. Closely reflecting the distribution pattern of crude oil and natural gas reserves in the region, 70% of the energy investment potential continues to be located in five countries namely Saudi Arabia, the UAE, Qatar, Algeria and Egypt. In the same vein, the GCC area accounts for nearly two thirds of the region's potential. © Arab Petroleum Investments Corporation Page 2/5 Comments or feedback to: aaissaoui@apicorp‐arabia.com Economic Commentary
Vol 6 No 1-2, Jan-Feb 2011
Within it, the UAE takes over Qatar as the second biggest potential energy investor (Figure 5). Sectoral Pattern 16. Of the $430 billion of actual capital requirements in the Arab world, the oil supply chain accounts for 42%. This will be needed to develop new production and transportation capacity, sustain current production through enhanced oil recovery (EOR) programs, and finalize the expansion program of the refining and oil‐based refining/petrochemical sectors. The gas supply chain accounts for 36%. This amount will be needed to develop new production and transportation capacity for both natural gas and the associated NGLs, expand capacity to meet domestic requirements and finalize ongoing export based projects, including gas based petrochemicals and fertilizers. Figure 5: Geographical pattern of energy investment Saudi Arabia
UAE
Qatar
Algeria
Egypt
Kuwait
Iraq
Libya
Oman
Syria
Sudan
Tunisia
Bahrain
Jordan
Yemen
Morocco
Lebanon
Mauritania
Actual requirements
Apparently Shelved
APICORP Research ‐ Oct 2010
0
20
40
60
80
100
120
140
14. In Saudi Arabia, potential capital investment is estimated at $130 billion. With Saudi Aramco and SABIC reaffirming their commitment to implement their investment programs, shelved or postponed projects are expected to decline to 6% of potential, compared to 21% in the previous review. In the UAE, revised potential investment totals $74 billion with projects made redundant amounting to 20%. Potential capital investment in Qatar is estimated at $70 billion. In this country, we continue to assume that the moratorium on further development of the North Field gas reserves (beyond the Pearl and Barzan projects) will not be lifted during the review period. Accordingly, shelved and postponed projects, even though much less than the 36% found in the last review, are likely to remain relatively high at 32% of potential. In Algeria, Sonatrach is anticipated to recover fully from its 2010 paralysis and resume normal investment activities. Hence, potential investment has been revised upward to $57 billion, while postponed projects are expected to drop to 19% of potential, compared to 31% in the last review. Finally, in Egypt, we keep to the revised potential investment of $42 billion with the hope that, despite current turmoil, project redundancy will be contained to 17% of potential. 15. Although similar trends are evident in the rest of the key petroleum producing countries, the below‐potential Kuwait and Iraq deserve some explanation. Kuwait has the highest rate of postponed and shelved projects. This, however, has more to do with the dynamics of domestic politics and policy than the effect of global and regional uncertainties. In this context, it is difficult to estimate the country’s actual capital requirements as long as major components of the upstream program remain at a standstill, or key downstream projects such as the al‐Zour refinery are undecided. Iraq, where the ambitions to achieve the full development of the oil sector have been revived, the extent of foreign investors’ contribution will depend on the ability of the Iraqi authorities to provide an ultimate solution to recurrent security problems. 17. Capital requirements in the oil‐, gas‐ and nuclear‐fuelled power generation sector represent the remaining 22% (capital expenditures for nuclear based power generation is implicit in 4
the UAE’s case). It should be noted that contrary to other links of the energy supply chains, where future investment is project‐
based, investment in the power sector is growth‐based. Therefore, no assumption of shelved or postponed projects is made. The resulting prospect of this chronically under‐
developed sector is highlighted in the Box. Contraction of Arab economies, and the apparently lesser demand for electricity, may provide temporary respite to a constrained capacity. Yet, this sector needs to catch up with an unmet potential demand. Box: Investments in the Power Generation Sector a B1. As a result of high population growth rates and fast expanding urban and industrial sectors, many countries in the Arab world have been struggling to meet rapidly increasing demand for power. However, compared to recent trends, projected demand is expected to be slightly curbed as a result of current economic contraction. Also, expectation of better load management and gradual phasing out of price subsidies could help rein in excess demand growth. B2. Accordingly, power generation capacity is projected to grow at a relatively subdued rate of 7.7% for the period 2011‐15, resulting in an additional capacity of 80.4 GW over that period. This increment, which represents 46% of the 2010 estimated aggregate capacity of 175 GW, justifies the huge capital investment of $92.9 billion found in the present review. A regional breakdown of these projections (Table below) shows that 60% of that expansion is expected in the GCC, which remains the fastest growing area. This should come as no surprise, taking into account its record rates of urbanization and the massive requirements for water desalination and air conditioning. 1
Maghreb Mashreq 2
GCC 3
Other Arab countries 4
Arab world
2009
capacity generation (GW)
27.5
43.1
87.8
2.9
161.3
2009 electricity production (TWh) 111.6 231.6 391.5 12.6 747.3 Medium‐
term annual growth (percent)
6.5 7.5 8.5 7.2 7.7 2010‐14 capacity addition (GW)
10.9
20.2
48.0
1.3
80.4
Corresponding capital requirements (G$)
13.1
25.1
53.0
1.7
92.9
1
Maghreb: Algeria, Libya, Mauritania, Morocco and Tunisia. Mashreq: Egypt, Iraq, Jordan, Lebanon, PT and Syria. GCC: Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. 4 Other Arab ciountries include Sudan and Yemen, but exclude Comoros, Djibouti and Somalia for lack of data.
Compilations and projections by APICORP Research 2 3
B3. In implementing their investment programs, power generators will be facing the same challenges as the rest of the industry. As discussed in the main text, these pertain to cost, feedstock and funding. a
See Ali Aissaoui, ‘Powering The Arab Economies in a New, More Challenging Environment’ (MEES, 25 January 2010). © Arab Petroleum Investments Corporation Page 3/5 Comments or feedback to: aaissaoui@apicorp‐arabia.com Economic Commentary
Vol 6 No 1-2, Jan-Feb 2011
The Investment Climate Cost Uncertainties 18. As indicated by the evolution of our index (Figure 4), the cost of an ‘average energy project’, which has risen almost three times between 2003 and 2008, is expected to increase again, after having slightly dropped in the last review. The 25% upward trend underpinning the current review may be explained by two factors. The first is that project sponsors will be focusing on important projects, which mostly entail higher costs. The second factor is related to anticipated cost inflation, which is still tentative. The extent the latter factor is predictable is examined next by analyzing a typical project cost structure. 19. The most preponderant element in a project cost is the price of engineering, procurement and construction (EPC), which represents 70‐80% of the total cost of a typical large scale energy project. Using the criteria outlined by the Independent Project Analysis, the key contributing cost factors to EPC are the prices of factor inputs, contractors’ margins, and project risk premiums when assumed by contractors, as is the case of lump sum turnkey (LSTK) contacts. To these three factors we have added our own, which is the cost of ‘excessive largeness’. In order to cope with unrelentingly rising costs, the major Arab project sponsors have sought to increase the scope and/or scale of their projects in order to lower unit costs and maintain an adequate return on invested capital. Anecdotal evidence suggests, however, that the economies of scope and scale of some large projects in the region have been offset by the diseconomies of the resulting complexities. Feedstock Availability 21. Although a great number of Arab countries are endowed with substantial gas reserves, their supply situation is difficult to gauge. Among the different metrics we have developed to provide a clearer supply picture, our preference is for the one measuring the trend towards an optimal supply threshold (OST), which is explained next.5 22. Reflecting the structure and use of petroleum reserves (crude oil, NGLs and natural gas), OST is defined as the one set of solutions that equalizes the share of natural gas production in total petroleum production with that of natural gas reserves in total petroleum reserves. A simple Euclidean distance, expressed in percent, shows how far or near different countries are from that threshold. This is illustrated by the 2010 cross section in Figure 7. Keeping progress towards the OST line should normally be encouraged; unless such a move is perceived too expeditious as a result of demand growing faster than additions to reserves. This appears to be the case of Iraq, the UAE, Libya, Saudi Arabia and Kuwait, whose distances to OST are lower than 5%. Therefore, each of these countries now runs the risk of not being able to keep its position once there. This is already the case of Bahrain, whose negative distance suggests that it is using more gas than it would possibly manage to supply in some future. Figure 7: Distance to the Op mal Gas Supply Threshold Bahrain
Kuwait
Saudi Arabia
20. Reflecting the above components, Figure 6 shows a typical cost structure of a large scale energy project. Prices of factor inputs (steel, copper, cement, and so on), which represent some 45% of total project cost, are expected to rise again after having softened during the recession, but at a pace more in line with that of major industrial materials and equipments than of raw commodities. Contractors’ margins are also likely to increase with the number of projects on the rise again. Furthermore, as the global credit crisis has forced an up‐pricing of risk, we should expect project risk premiums to remain relatively high. ‘Others’ denotes a miscellaneous component that tends to mirror the again rising general price inflation in the region. Hence it is hard to infer how up and for how long the overall cost trend is likely to be again, when combining all cost components. UAE
Iraq
Tunisia
Egypt
Oman
Syria
Iran
Algeria
Qatar
Yemen
Figure 6: Typical cost structure of a large‐scale energy project ‐10%
15%
Factor inputs
Excessive
largeness
20%
45%
‐5%
0%
5%
10%
15%
20%
25%
23. OST metric can be seen as a rather mechanistic interpretation of reality, which needs to be balanced with market and economic considerations. It may indeed be perfectly rational to under‐produce commercial gas if markets are not there or, taking account of the heavily subsidized domestic prices, the returns from investment are lower than can be obtained from other uses. The alternatives may include recycling more field gas to increase the supply of high export value NGLs or injecting gas into depleting oil fields to enhance their recovery. Others
10%
Distance to Optimal Supply Threshold
Libya
10%
Risk premiums
Contractors'
margins
APICORP Research
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Vol 6 No 1-2, Jan-Feb 2011
Funding Accessibility 24. Cost uncertainties and feedstock availability are compounded by a marked shift in projects’ capital structure. In a context of a continuing tight credit environment, we have witnessed a trend towards a more equity‐weighted capital structure. Based on most recent deals, the average equity‐debt ratio in the oil‐based refining/petrochemical sectors has been 35:65. The ratio in the gas‐based downstream sector has been 40:60 to factor in higher feedstock risks. In the power sector, the ratio has been reset to 30:70 to reflect lower leverage in independent power/water projects. On this basis, the resulting average capital structure for the whole oil and gas supply chain is likely to be 57% equity and 43% debt for the period 2011‐15. This compares with the equity‐debt ratios of 54:46 found in the 2009‐13 review and 50:50 in the 2008‐12 review. 25. This trend poses new challenges for achieving the needed amount and mix of equity and debt . On the one hand, we have estimated that any prolonged period of low oil prices below $70/bbl will affect project sponsors’ ability to self‐finance upstream investments. On the other hand, funding prospects for the still highly leveraged downstream will be even more daunting. The annual volume of debt would be in the range of $37 billion to $46 billion for the next five years. The lower bound of debt results from the actual capital requirements found in the current review and the likely capital structure highlighted above. The higher bound corresponds to the potential requirement and the speed at which remaining redundant projects will be brought back when the business climate fully improves. The lower bound compares to the all‐time annual record of $38 billion achieved in the loan market prior to the credit crisis. Nowadays, such amounts of debt can hardly be raised owing to lesser credit availability, higher costs of borrowing and tighter lending conditions. And this is despite the move by some Arab public investment funds to tap governments’ net savings and step up their lending and involvement in the local debt market. Re‐mapping the Energy Investment Climate 26. In the context of unfolding socio‐political developments in parts of the region, projects’ and companies’ credit ratings, which are almost always capped by sovereign ceilings, will be closely scrutinized. As an immediate consequence of current events, Tunisia and Egypt have seen their rating downgraded: Tunisia to a lower investment‐grade and Egypt to a lower speculative‐grade. While others might be placed on a negative credit outlook, we expect a fewer number of countries in the GCC area to retain their higher investment grades and, as result, to be able to continue accessing funds at lower cost and better terms. 27. As not all Arab petroleum‐producing countries are rated, APICORP maintains its own “perceptual mapping” of the energy investment climate. The mapping is a two dimensional representation of a 3‐D space encompassing all 15 Arab petroleum‐producing countries (Figure 8). Countries are plotted on the basis of three scored attributes: country risk, enabling environment and potential investment. They appear in different quadrants at varying distances from an Ideal Point, which is the centre of gravity of the highest achievable scores. Figure 8: Perceptual Mapping of the Energy Investment Climate Strong enabling
environment
Ideal Point
Vast investment potential
KSA
Low
country risk
QAT
UAE
KUW
OMA
BAH
LIB
ALG
IRQ
SUD
High
country risk
EGY
MAU
YEM
Weak enabling
environment
APICORP Research
Updated Jan‐Feb 2011 TUN
SYR
Limited investment potential
CRA Sovereign Rating
Investment grade
Speculative grade
Not rated
28. The mapping, which has recently been updated to assess the impact of the financial crisis, is under review in an attempt to ponder the impact of the events unfolding. At the moment of writing the changes captured in this way range from Saudi Arabia settling near the “ideal point” benchmark, to a significant deterioration of the positions of Egypt and Tunisia. Egypt breaks out of the cluster formed of Libya and Algeria, and Tunisia out of that formed of Bahrain and Oman. The remaining countries are in three contrasting clusters: a) while maintaining their strong positions, Qatar, the UAE and Kuwait have moved apart from each other with Qatar widening its lead; b) Mauritania, Sudan and Yemen see their position slightly deteriorating; c) The still singly Iraq continues its positive streak; even though very far from the ideal point, its current location underscores rapid progress. Conclusions 29. Notwithstanding heightened uncertainty stemming from the ongoing turmoil in parts of the Arab world, we expect global economic and financial fundamentals to continue supporting the resumption of energy investment growth in the region. The impetus for recovery will be strongest in the GCC area despite project sponsors facing many of the same challenges, i.e. cost uncertainties, feedstock availability and funding accessibility. However, access to funding will be most testing in countries affected by the turmoil. While the predicament they face could turn for the better, the likelihood is that of a deteriorating investment climate that could deter both domestic and foreign capital for some time. Meanwhile, faced with more pressing social demands, governments will hardly be capable of funding the resulting shortfalls. 1
IMF, World Economic Outlook, October 2010. For the determination and justification of this band see: A Aissaoui
“GCC Oil Price Preferences: At the Confluence of Global Energy Security and Local Fiscal Sustainability”, in Energy Security in the Gulf: Challenges and Prospects, ECSSR, Abu Dhabi, 2010. 3
We usually covers MENA region, whose potential energy investment is projected to $615 billion for the 5‐year period 2011‐15 (source: APICORP’s Economic Commentary, Vol. 5 No. 10‐11). In the present commentary, we focus on the Arab world only, i.e. excluding Iran. 4
Abu Dhabi’s first such a plant is not expected before 2017. 5
For a thorough analysis of the pattern of natural gas supply in the region, see Ali Aissaoui, “MENA Natural Gas: A Paradox of Scarcity Amidst Plenty”, MEES, 27 December 2010. 2
© Arab Petroleum Investments Corporation Page 5/5 Comments or feedback to: aaissaoui@apicorp‐arabia.com