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‘Decoupling Point’

April 2015

Have the crude oil prices and the GCC stock markets really decoupled, or at least are showing any signs of decoupling? Does a drop in crude oil price threaten hard times for Gulf economies and the markets? Three experts debate how deeper is the correlation between the crude oil prices and GCC’s stock markets

Crude oil is continuing its bearish run. On March 16 this year, it touched its lowest level since 2009 as West Texas Intermediate crude dropped to $44.39 a barrel. Last year, Crude oil price dropped by almost 55%, sending shock waves across the global stock markets including the UAE and GCC region. In the UAE, the Dubai Financial Market (DFM) which was the best performing market in the world in 2014 slipped to being one of the worst in just over a month last year.

On Feb 10 this year, ratings agency S&P revised its outlook on Saudi Arabia to negative from stable following sharp decline in oil prices, while it lowered its sovereign credit ratings on Bahrain and Oman. Economic diversification has been one of the key elements in the GCC. However, some believe diversification efforts have met limited success and oil price continues to be the key element for the Gulf economies and the regional stock markets.

There’s another side to this argument that the crude oil price volatility is more a psychological than a fundamental determinant for the region. The Gulf economies’ huge fiscal reserves along with growth in non-oil sectors such as tourism, trade and the real estate, will continue to fuel the economies and remain the major driver of growth than alone the crude oil.

Wealth Monitor invited experts to discuss the implications of low crude oil prices on the performance of GCC stock markets. We asked a few questions from these experts, such as how do you see the regional economies’ outlook if oil price continues to decline this year; do they agree diversification efforts have met limited success and oil price continues to be the key element for the GCC economies and stock markets; do they believe the magnitude of oil price shock on the GCC and the UAE’s stock markets is gradually waning; do they believe oil price volatility is more a psychological than a fundamental determinant for regional economies, as the Gulf economies’ huge fiscal reserves will continue to fuel their economies and remain the major driver of growth than the oil price; are they bearish or bullish for the regional markets in the near term and do they expect UAE’s and GCC’s markets to consolidate in the short term amid mixed global cues?

And here’s what they had to say…

MR Raghu, Senior Vice President-Research, Kuwait Financial Centre

Reserves As Cushion

The Brent crude oil price has rebounded in Feb, and has reached above $60 per barrel. Some of the GCC countries have already released their budgets for this year, and there doesn’t seem to be any drop in government expenditure. In fact, Oman, which doesn’t enjoy the cushion of oil surplus reserves unlike Saudi, UAE and Kuwait, has increased government expenditure, and is preparing to face a deficit situation. Saudi and Kuwait too have released budgets with larger deficits, with budgeted price assumptions pegged at $55-63 for the former, and $45 for the latter. Countries like Saudi Arabia and Kuwait have built up substantial reserves during the oil boom which cushions them from any sudden impact on spending. If oil prices go below $40 again, and remains there and thereabouts for a sustained period of time, then the regional economies may be adversely affected.

UAE More Successful

While the governments have shown the intent to diversify their respective economies, the execution of the plans has varied across the region. UAE has been relatively more successful, while countries like Kuwait have not. But despite the efforts taken, oil revenues still contribute majorly to the economies, and more efforts are needed to improve non-hydrocarbon economy in the region. For Saudi Arabia and Kuwait the contribution of oil revenues is still at 90% and 80% of total revenues respectively which shows that the diversification programs have not had the desired effect.

Changing Correlation

In the last few years, the correlation between the oil price and GCC markets has moved towards a new dimension. GCC stock markets react negatively to a fall in oil prices but do not have a similar trend with an upward move in oil prices. Prior to 2008, the index values approximately followed the movement in oil prices, while after 2008, the relationship changed slightly. The gradual increase in oil price seen from early 2009 till Apr 2011, had little or nil effect on the index values of oil exporting countries. This may be due to the regional governments’ efforts to diversify away from oil. Recent fall in oil price affected the GCC indices after a lag, as the markets were wary of medium to long term effect of lower oil prices in government spending, and also because of OPEC’s decision to not cut the daily output target. So we believe the magnitude of oil price shock on the GCC markets is gradually decreasing.

A Fundamental Determinant

The fiscal reserves accumulated so far are by no means inexhaustible, and investors are aware of the fact that oil price determines the longevity of the accumulated reserves. If in case low oil prices are sustained over a period of time, they will have an adverse impact on the regional economies, and will also eat up the reserves at the same time. So oil price volatility remains a fundamental determinant of the regional economies, until the efforts of diversification bear fruit. According to the IMF, the fiscal break-even price for Kuwait is the lowest in the region at $54 while for countries like UAE and Saudi Arabia, it is higher at $80 and $98 respectively.

UAE’ Outlook Positive

While oil prices have plunged and uncertainty prevails regarding its outlook, we believe GCC governments have accumulated significant reserves, offshore assets and command robust surpluses that could support continued infrastructure and social spending. With GCC reserves totalling over USD 2.8 Trillion, the key economies command an expenditure coverage ratio of over 3x, based on 2014 estimated expenditure figures. This should provide sufficient comfort and cushion to future government expenditure programs, and allay investor fears about regional prospects, which are predominantly fuelled by government expenditure programs. Our 2015 outlook for UAE remains positive on the back of robust reserves, buoyant economy, healthy earnings growth and surging market liquidity while we are neutral on other economies.

Rajiv Kumar, Dy CEO, Phillip Futures DMCC, Dubai

Budgets Highly Reliant On Oil

Despite progress on economic diversification in the GCC over the last decade, regional budgets remain highly reliant on oil revenues and are thus vulnerable to sustained changes in oil prices. Lower revenues may force governments to curtail their efforts to tackle energy subsidy reforms as a result impacting petrochemicals. Saudi Arabia derives substantial revenues from the hydrocarbons sector. Saudi Arabia’s economy is undiversified and vulnerable to a steep and sustained decline in the oil price. However, Kingdom’s decision to give bonuses to public sector workers recently is a clear indication that the kingdom will maintain currently budgeted public sector spending. With a forex reserve of almost $780 billion and government debt being 3 % of the GDP, indications are clear that in the near term falling crude prices may not have a drastic effect.

However, Qatar and UAE will be least affected by sharp fall in oil prices due to large scale diversification in non-oil sectors. In fact, the current situation may also turn out to be a trigger point for the GCC economies to reduce their dependency on Oil and diversify into other areas.

Limited Exceptions

The latest IMF regional economic outlook points out that despite progress on economic diversification in the GCC over the last decade, regional budgets remain highly reliant on oil revenues and are thus vulnerable to sustained changes in oil prices. Limited exception to these are UAE and Qatar where diversification has brought down the breakeven price of oil to large extent. In fact, Dubai is an exception in that it relies more heavily on trade, tourism, real estate and construction, and transportation and is enjoying favourable economic conditions. Qatar also is moving slowly in this direction by way of huge infrastructure investments.

Prolonged Drop Will Hurt

Correlation between crude oil prices and performance of local GCC markets will largely be dependent on the ability of the local GCC countries to diversify their economies revenue that is so far largely dependent on crude oil revenues. The non-oil sector particularly construction and retail trade will continue to drive economic activity especially in UAE and Qatar.

The impact on overall spending plans by respective economies are not going to be significant unless the oil prices remains low for a prolonged period as high oil prices over the past four years have allowed the GCC to build up massive financial reserves. According to IMF report, the GCC states held some $881 billion in official foreign reserves in 2013. In fact, with the emerging market status accorded to UAE and Qatar, low prices in the DFM and ADX can actually trigger a lot of funds inflow from Global Institutions and Funds as the valuation at this level may look attractive to them to enter these markets.

Fiscal Spending A Key Driver

No doubt, poor sentiment related to oil prices could slow growth next year however, big Gulf economies on account of their large accumulated fiscal and external reserves, can ride out an era of lower oil prices without facing debt crises or steep reductions in their economic growth. Fiscal spending, a key driver of economic growth in the region, will probably remain unchanged. Secondly, dependency of some of the GCC economies like the UAE and Qatar on oil revenue has come down on account of diversification.

Gulf economies are also facing intense competition from non OPEC producers to maintain their market share in the key emerging markets, where they export. As a consequence, they are offering deep discounts to these key importers which will prevent the oil price to rebound in the near future.

Markets Will Remain Under Pressure

Down 13.3 percent this year, Kuwait’s index is the worst performer in the Gulf whereas Qatar so far has been the best performer. UAE and Qatar markets may attract decent foreign funds into the markets because of the emerging market status accorded to them. As a diversification step, Saudi Arabia is also opening up its stock market to international investors in the first half of 2015, giving foreigners greater access to the Arab world’s biggest bourse.

Overall, markets will remain under pressure however, some consolidation may be seen in near term. Further it will recover faster if oil price start rising.

Muhammad Shabbir, Head of Equity Funds and Portfolios, Rasmala Investment Bank, Dubai

Limited Success in Diversification

Despite GCC governments efforts regarding diversification of their economies most of the economies are still too much reliant on oil. The dependence is visible as share of non-oil receipts to total receipts for the GCC as a whole have only worsened between 2003 and 2013, from just over 23% to less than 20%. Therefore we agree with the notion that diversification have had limited success. However, for a fuller picture one needs to look at the trend in this ratio over the last 10-15 years.

Spending Also Matters

The correlation between oil and the regional stock markets spiked to 0.9 in December 2014 compared to around 0.5 during the period between Jan 2012 to June 2014. Since then it has come down a bit but is still at elevated level. We believe going forward the correlation will remain significant but the magnitude of the shock will depend on the actions of governments regarding spending rather than just on the oil price.

Fundamentals To Rule In Long Term

We partially agree with the statement (that oil price volatility is more a psychological than a fundamental determinant for regional economies, as the Gulf economies’ huge fiscal reserves will continue to fuel their economies and remain the major driver of growth than the oil price). As was mentioned in the previous point the real determinant will be how those reserves will be spent during the period when oil prices are either low or volatility is high. While influence of the psychological factor will be high in the short term, the fundamental factors will rule over the longer term.

Consolidation in Near Term

We expect some consolidation in the near term as earnings will be pressured for names which are more linked to oil prices and investors wait for more cues regarding spending by both corporates and governments.

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