Saudi Arabia: Excited by the Market not Transformation

“All change is not growth, as all movement is not forward.” – Ellen Glasgow

“The stock market is just too important to leave to the vagaries of an actual market now.” Babar Rafique, CFA of Setter Capital

“Successful offense brings victory. Successful defence can now only lessen defeat.”  – General Curtis Lemay

Gabriel:  Have you ever heard of Harry Houdini? Well he wasn’t like today’s magicians who are only interested in television ratings. He was an artist. He could make an elephant disappear in the middle of a theatre filled with people, and do you know how he did that? Misdirection.

Stanley: What the f*** are you talking about?

Gabriel: Misdirection. What the eyes see and the ears hear, the mind believes.

Swordfish (2001)


Failures and negative outcomes are often followed by a call to action. College football teams regularly fire successful coaches after a poor season, companies replace senior executives following a series of public relations mishaps, and rarely does an administration overseeing a recession survive the electorate.

The Great Recession gave us the Obama presidency. Coca-Cola losing market share to its rivals gave us the “New Coke” debacle. A spate of bad press and multiple revelations of past misconduct ultimately cost Travis Kalanick his job as chief executive of Uber. After failing to win a grand slam for three years in a row, Roger Federer parted ways with Stefan Edberg and started training with Ivan Ljubicic. The examples are countless. The results mixed.

One such recent call to action, with its own wrinkles, has been the national transformation plan announced by Saudi Arabia. The kingdom has come under severe economic pressure since the collapse in the price of oil. A monarchy has little appetite for political change. Any change therefore has to be either economic or social in nature with a view towards prolonging the political status quo. Prolonging the political status quo remains paramount.

Central to Saudi Arabia’s transformation plans are a more equitable participation by the private sector in the economy, enhancing downstream petrochemical capabilities and a reduced reliance on oil revenues. To reinforce the message of transformation, Mohammed Bin Salman (MBS), the driving force behind the plans and favoured son of King Salman, announced plans to publicly list Saudi Aramco, the state oil company.

The headlines have come thick and fast since MBS unveiled the kingdom’s Vision 2030 in April 2016: a USD 3.5 billion investment in Uber; a USD 17 billion international bond offering – the largest ever by an emerging market nation; a USD 20 billion commitment to a Blackstone infrastructure fund; an anchor investment into Softbank’s Vision Fund; King Salman’s dismissal of Mohammed bin Nayef – dubbed as the “the prince of counter-terrorism” in Washington – as Crown Prince and the ascension of MBS as successor to the throne; Saudi Arabia along with the UAE, Bahrain and Egypt placing economic sanctions on Qatar; and MSCI placing the Saudi equity market on its Emerging Markets Index inclusion watch list.

These are the headlines, the real change, however, is happening on the ground. Nowhere is change more visible than in the socioeconomic framework that has been the staple of the Al Saud dynasty. To understand these changes, let’s take a step back and understand Saudi Arabia’s economic model.

The Saudi Arabian economic model is straightforward and not too dissimilar to the economic model of other emerging markets generously endowed with natural resources. It is a model of government largesse in return for compliance and forsaking political freedom. It is a model where the lion’s share of profits in the economy is provided by the government.

Some of the ways the government provides profits include:

  • Transferring natural resources to the private sector at below market prices
  • Infrastructure spending
  • Being the largest employer in the country – even excluding the large government controlled private sector entities

The private sector is largely organised to exploit the profit making opportunities provided by the government. Refiners and converters acquire natural resources at subsidised rates and convert them to mid-stream and downstream products to capture the difference between subsidised prices and market prices plus a refining / converting margin. Energy intensive industries take advantage of subsidised energy prices. Contractors and construction companies bring in low cost labour from countries such as Egypt, Pakistan and the Philippines and bid for lucrative infrastructure contracts. Traders and retailers cater to the bulk of remaining local demand through imports.

The banking sector remains steeped in traditional lending practices with an almost non-existent shadow banking sector. There is limited participation by international creditors beyond lending to government and government related entities subsequent to the Al-Gosaibi / Saad Group scandal that rocked the Saudi financial sector in 2009. Topping it off, the Saudi Arabian Monetary Agency (SAMA) has adopted a tough and conservative regulatory framework requiring banks to remain well capitalised and adhere to prudent lending practices.

The Saudi Arabian economic model is unsustainable and true to Herbert Stein’s Law – “if something cannot go on forever, it will stop” – in 2016, it came to a stop. The government signalled that it was not willing, nor able to be the source of ever increasing private sector profits. It admonished the private sector for not doing its fair share in supporting the economy and addressing the challenges of youth unemployment.

Gasoline and diesel prices were increased. Feedstock subsidies for petrochemical producers restructured. Electricity and water tariffs revised. Municipal fees introduced for commercial activities. Airport taxes increased. Cigarette prices doubled with the introduction of “selective” taxation. Roll-out of a value added tax proposed.

These were some of the fiscal reforms. Austerity followed.

The government stopped awarding contracts for a large number of projects, vaguely classified as projects where the “scale of spending was not compatible with the economic and development returns hoped for them.” Contractors stopped receiving payments, which coupled with public sector borrowing crowding out private sector credit snowballed into an epic liquidity squeeze. With pressure mounting, the government, towards the end of 2016, pledged to settle its dues to the private sector.  Despite the pledge, around 70% of outstanding dues to contractors of public projects in Saudi Arabia remain unpaid, according to local broadsheet Okaz.

The Saudi Riyal Interbank Average Offered Rate – 3 Months Source: Bloomberg

Perks and financial benefits for public sector employees were also cut – based on our discussion with locals, we found that Saudis from all classes unanimously had the a priori belief that public sector pay was sacrosanct. By cutting public sector pay, the government crossed the proverbial line in the sand and we are not surprised that decision has since been reversed.

After fiscal reforms and austerity came protectionism.

According to McKinsey Global Institute, 4.4 million jobs were created in the kingdom from 2003 through 2013 – a decade of booming oil prices – about 1.7 million were taken by Saudis with the remaining being taken by foreign workers.

Much to its chagrin, the government remains the employer of choice for Saudis.

The public sector is bloated. Salaries and allowances accounted for 45% of government spending in 2015. Efforts to rein in spending will be in vain unless the private sector hires more Saudis. Half the population is under the age of 25. Attitudes of and towards the private sector must change. The government appears unwilling to take any chances and has, much to the private sector’s displeasure, opted not for the carrot but the stick.

Starting July 2017, the government implemented a “dependant fee” on all expatriate employees. This levy entails an expatriate employee paying SAR 100 (USD 27) per month for each of his or her dependants holding a residence permit. The fee will be increased annually till 2020. An expatriate employee with a wife and two children living in Saudi Arabia will be out of pocket SAR 14,400 (USD 3,840) annually from 2020 onward. Expatriates, holding work or residence permits, require exit and re-entry visas to travel in and out of Saudi Arabia. The cost of obtaining exit and re-entry visas was also increased starting July 2017. Predictably, we are receiving anecdotal evidence that expatriate employees are starting to relocate their dependants back to their home countries or leaving the kingdom all together.

During 2012, the government doubled the cost of expatriate employee work permits from SAR 100 (USD 27) per month to SAR 200 (USD 53) per month. It also introduced a fee to penalise companies that employed more expatriate staff than Saudi staff. Companies with 50% or more of the workforce comprised of Saudis did not incur any additional direct costs. Companies that failed to meet the 50% “Saudisation” threshold were required to pay a monthly fee of SAR 200 (USD 53) multiplied by the number of expatriate staff in excess of Saudi staff. For example, a company with 100 employees, 60 expatriates and 40 Saudis, would be required to make a monthly payment of SAR 4,000 (USD 1,067) to the government. These payments were to be utilised to support the training and development of the existing and prospective Saudi workforce. Starting January 2018, the monthly fee will be increased and will be applied to every expatriate employed and not just the number in excess of the total number of Saudi staff. The fees will be increased annually till 2020. In 2018, a company with 100 employees, 60 expatriates and 40 Saudis, will be required to make a monthly payment of SAR 14,000 (USD 3,733).

The introduction of the “expat levy” in 2012 created demand for Saudi staff. Predictably salaries for Saudis went up, an intended consequence of policy. However, given the challenging economic environment and based on a number of discussions we have had on the ground, this time companies are more likely to shed expatriate staff over hiring additional Saudi staff.

Cost of doing business is going up. Capital investments are shrinking. The consumer is retrenching and the expatriate population maybe declining. All factors contributing to declining private sector profitability.

New Letters of Credit Opened – Six Month Moving Average (SAR in million)Source: SAMA

Where will the growth in profits come from to drag the economy out of its doldrums? Government plans highlight seven industries that will receive concentrated government support; chief amongst them is the petrochemical sector.

The petrochemical sector is at the core of Saudi Arabia’s non-oil economy. In 2015, petrochemical products accounted for USD 30 billion in exports, representing almost two thirds of total non-oil exports. Olefins – ethane and LPG derivative products – account for three quarters of total petrochemical capacity. While aromatics – naphtha derivative products – contribute 13% of capacity.

Local production is skewed towards commoditised chemicals – unsurprising given the generous subsidy regime, which incentivised management teams to capture the spread relative to market prices as opposed to venturing further downstream. A lower price of oil and expectations of further subsidy reform places the onus on producers to increase value creation by focusing increasingly on specialty chemicals. This is not without risks. Producing specialty chemicals requires technical expertise that is in limited supply both locally and regionally. Developing technical expertise requires time and investment. There also needs to be a cultural shift towards innovation and research & development – no mean feat given the government’s majority ownership of and influence over a number of the major producers.

Shale, not for the first time, may scupper Saudi ambitions. As a major new source of natural gas, shale has revived the US petrochemical industry. With the Permian Basin’s level of natural gas production expected to increase by 5.5 million cubic feet per day between 2016 and 2020, the revival is only getting started. Majors such as Dow Chemical and ExxonMobil have already announced major investment plans to expand their production capacities in the US. Even Saudi petrochemical giant SABIC is looking at investment opportunities in the US.

Economic reform is one aspect of the transformation. Privatisation (read: selling state assets to shore up finances) is another. Everything is up for sale.

The success of the government’s privatisation efforts hinges not only on the quality and price of assets but also the robustness of the legal and regulatory framework governing those assets. With a judicial system steeped in bureaucracy and a reputation for arbitrary interpretations, the system is in real need for change. Yet, signs of legal and regulatory transformation remain largely absent. As a case in point, the kingdom still does not have a bankruptcy law. The absence of which has long discouraged failure and by extension curtailed innovation.

Saudi Arabia is only at the very beginning of a long and arduous journey towards sustainability.  Rational thinking dictates that Saudi Arabia must remain committed to transformation. Political will to stay the course, however, remains untested with signs already emerging that it is waning. Ultimately, all decisions in a monarchy come down to one person and their desire to do the right thing weighed against their need to be celebrated. In Saudi Arabia, that one person happens to be a thirty-something prince who has designs on becoming king. In a world where Donald Trump is President, we now know popularity tops all.


Investment Perspective

The Saudi Riyal is the primary determinant of the cyclical direction of the equity market. At first glance, that may appear to be a strange statement given the currency is pegged to the USD. The peg, however, is precisely why asset prices must adjust to reflect the value of the currency. As the currency moves from being undervalued – real effective exchange rate (REER) below 100 – towards fair value, equity market performance deteriorates, as witnessed late 2014 onwards. While cyclical upturns in the equity market are witnessed as the currency moves from being overvalued – REER above 100 – towards fair value, as witnessed near the start of the millennium.

Tadawul All Share Index vs. Saudi Riyal REER (Inverted)Sources: Bank for International Settlements, Bloomberg

The Saudi Riyal is the most overvalued it has been in over fifteen years. The question, therefore, for those weighing up the opportunity of investing in the Saudi market, is whether they believe the currency can become even more overvalued. The answer to which lies in whether you (i) are an oil bull or bear; (ii) believe the Saudi government can reduce its budget deficit; and (iii) are in the Saudi Riyal devaluation camp or not.

Whilst all three points require a discussion, in and of themselves, to summarise our views on the first two, we are of the opinions that (i) oil price risk lies to the upside; and (ii) the Saudi government has undertaken a number of initiatives that will enable it to reduce its budget deficit. For these reasons, we are of the opinion that the Saudi market may be at the beginning of a cyclical upturn.

With respect to the USD peg, we contend that the peg is inextricably linked to political stability and maintain that prolonging the political status quo remains paramount. In a country where local demand is almost entirely met through imports while exports are largely commoditised goods priced in USD, the political concerns relating to a de-peg or devaluation outweigh the potential for economic gains. We think, the powers that be will maintain the peg till the point of maximum absorbable pain. And the willingness of the government to sell its assets only confirms our thinking.

To some our scepticism over the transformation plans and concerns around shrinking private sector profitability may appear contradictory to our view of a potential cyclical upturn in the equity market. To that we would counter that markets are made at the margin. We are seeing evidence of economic activity picking up; improving money supply metrics; and we expect the government to move from a heavy- to even-handed approach to reform. That being said we do have a number of concerns that we highlight below.

Saudi Arabia Money Supply M2 YoYSource: Bloomberg

A quote from Babar Rafique of Setter Capital best captures our major concern around the Saudi equity market: “The stock market is just too important to leave to the vagaries of an actual market now.” In a country bereft of social activities, the equity market is embedded in the social fabric – making it ripe for policymaker intervention. Our discussions with brokers and asset managers lead us to believe that is indeed what has happened.

Take for instance, the performance of the equity market on 25 April 2016, the day MBS’s interview unveiling plans for the country’s transformation was aired. It is important to note that the interview was pre-recorded and most of the facts had already been drip fed to the public or revealed in a Bloomberg article published on 21 April 2016.

Tadawul All Share Index (19 to 26 April 2016)Source: Bloomberg

We leave it to you to guess at what time the interview started airing.

As a second case in point, we consider the best performing stock across the Saudi market since Salman bin Abdulaziz Al Saud became king. The stock happens to be Saudi Research and Marketing Group (SRMG). The performance of this stock is staggering. So much so that its return is more than 2.5 times the return of the second best performing stock over the period. When we consider that the company has failed to turn a profit since 2012, the performance is even more remarkable.

Why has this company caught our attention? We quote from the company’s profile on Wikipedia:

From 1989 to his death in 2002, Ahmed bin Salman was the chairman of the company. Then, his younger brother Faisal bin Salman became the chairman of the company. On 9 February 2013, Turki bin Salman succeeded Prince Faisal as chairman of the SRMG when the latter was appointed governor of the Madinah province. Prince Turki’s term as chairman ended in April 2014 when he resigned from the post.

From 1989 to April 2014, each appointed chairman happened to be a son of King Salman.

While we have found other instances of curious market action coinciding with government announcements, we do not want to belabour the point any further.

Another concern we have is valuation. The market is not cheap at around 18 times trailing twelve months’ earnings as compared to the MSCI Emerging Markets Index which trades around 16 times trailing twelve months’ earnings.

Lastly, any discussion related to Saudi Arabia is incomplete without considering geopolitics. We are not political analysts and therefore will limit the discussion to matters that we consider important to investing in Saudi Arabia. To that end, we find it important to highlight concerns around the Qatar Crisis. Saudi Arabia traditionally opted for a defensive stance and used backchannels and its wealth to achieve its geopolitical ambitions. The current leadership, however, has opted for offense. We believe the change in stance has been caused by insecurities that arose out of Obama’s Asian pivot and US disengagement in the Middle East region. As an added benefit, geopolitical tensions redirect the population’s attention away from economic hardship and foment nationalism. Irrespective of the motivations behind the move, we believe that Saudi Arabia’s and its partners’ move to isolate Qatar damages the investment case for the GCC region as a whole. Further, if Saudi Arabia continues to take the more aggressive approach it only increases the political risk premium that should be attached to investments in the region.

We are long the iShares Saudi Arabia Capped ETF $KSA.