Latest Emerging Market Viewpoints
From the North of South Capital team
For the last few years, the world has been bracing itself for the IPO of what would surely become the largest listed corporation in the world. This was not going to be a high-growth technology stock and it wasn’t based in any of the world’s largest economies such as the US or China. It would be a distinctly old fashioned resource company, in the business of extracting oil.
Saudi Aramco was initially mooted to be worth US$2trn – approximately Apple and Google market capitalizations combined. This has been narrowed down to a more modest US$1.6-1.7trn. Even though only a tiny 1.5% of the company is being listed, it will be one of the largest IPOs in the world this year. Along with MSCI’s recent inclusion of the Saudi market in its flagship Emerging Market index, this may be seen as an endorsement of the country as an investment destination.
At North of South we have been active in the Kingdom in the past, most notably during 2012 and 2013. At the time oil prices had been enjoying a multi-year period of stability around US$100 per barrel with supply effectively managed by OPEC. This allowed the government to maintain a healthy budget surplus even while providing a generous welfare system to its young population. With the currency tied to the US$ and significant current account surpluses, the cost of capital was extremely low in an emerging market context. Domestic growth was supported by a demographic boom with a young population of consumers. Politics was stable and predictable.
At the same time valuations for Saudi stocks were far below those of comparable Emerging Markets such as Turkey or South Africa, as the Saudi market was not included in global indices. Liquidity was good however due to an active domestic investor base.
By 2014/2015 valuations had become stretched and our exposure much reduced. Then the oil price collapsed as Saudi Arabia found itself in a production contest against US shale. The government budget collapsed to a deficit equal to 15% of GDP. With a generational shift in the ruling family, policy became far less predictable. Over the following two years the Saudi market almost halved.
Today, the market remains around 30% below its 2014 peak but valuations reached historic highs in early 2019 on the back of global index flows. The high profile Aramco deal has been scaled down and is largely backed by domestic investors and political entities. We estimate that fair value is likely below US$1trn based on low valuations for global oil majors and even adjusting for its natural advantages. Nonetheless, after this deal Saudi Arabia is likely to account for a bigger weighting in MSCI EM than traditional markets like Mexico or Indonesia, comparable even to Russia.
We believe that oil prices remain a fundamental driver of the Saudi economy. We note that the country has suffers from the Dutch disease – the abundance of a natural resource has prevented the emergence of a globally competitive economy. This has been exposed as oil revenues have dropped by 30-40% in recent years. There are many good domestic consumer companies but as the government adjusts to lower oil prices their consumers are being squeezed. At the same time requirements to hire more Saudis increase their operating costs.
Our view on oil is cautious. We note that the world is now able to produce solar energy at the equivalent of US$28 oil prices. Around 40% of electricity additions worldwide are solar and wind. Gas must compete for capacity with solar.
Meanwhile shale exploitation has turned the US from a gas importer to the third largest LNG exporter in the world. Gas is therefore trading at equivalent prices to the cost of solar and eating at the margins of oil demand via diesel in generators, shipping fuel replacement for fuel oil and swapping out remaining oil-fired electricity generation. These add up to around 10% of global oil demand, before we even factor in electric vehicles. Shale oil production has also transformed the US from the world’s largest crude oil importer to an exporter which is an additional swing in supply/demand. We may therefore be seeing $50-$60 oil as the new equilibrium price which means Saudi Arabia still has a difficult road ahead of it as it tries to adapt to the new realities.
We contrast the Saudi experience with Russia which has also suffered from a form of the Dutch disease. However the government has adapated to new realities and runs its budget with assumptions of oil at US$40 and saves any surpluses. This has also impacted domestic consumption but had significant benefits in reducing the cost of capital in Russia. Meanwhile stocks remain inexpensive and we find this a more attractive way of investing in a commodity producing country.
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