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On the cover

Saudi Arabia prepares itself for lower oil prices

Global Economy, On the cover

Yesterday the government published the final deficit figures for Saudi Arabia , which exceeded $98 billion. With an economy where oil accounts for nearly 90% of the tax revenues and more than 40% of GDP , revenues have fallen while expenditure increased above estimates. This led to a deficit of almost 17% of GDP. However, in this figure there are positive and negative elements.

On the positive side, Saudi Arabia is one of the countries with a lower debt in the world, 19% of GDP . Government policy avoids getting in debt as a tool and therefore during the decade of high oil prices the country reduced its debt burden to a bare minimum. Additionally, it has dollar reserves exceeding $645 billion.

On the downside, actual dependency on oil prices seems higher than estimated in an economy where subsidies, political and military spending are virtually impossible to reduce.

But what matters is the future. The government estimates that in 2016 the deficit will be about 87 billion dollars, as revenues drop despite spending cuts (subsidies, which amounted to $25 billion annually, will go down with the oil price, as should be expected, while gasoline prices have increased and wages have been slightly reduced). The Saudi government expects another drop in revenues and this shows that the Kingdom does not consider any improvement in oil prices in the near term.

In 2016, Saudi Arabia can produce up to 11 million barrels a day in its strategy to improve market share. That, added to the more than likely increase Iranian production following the lifting of sanctions, can lead to OPEC at levels of 32 million barrels a day, if estimates from other countries are met. Remember that OPEC countries tend to produce above their quotas.

The war we mentioned in my book ‘The Energy World Is Flat’ (Wiley) is fought on several fronts. Efficiency , which makes  demand grow slower despite economic growth, technological transition, which leads to the fall of the monopoly of oil in transport, and diversification , with new sources of production in non OPEC countries.

The strategy of maintaining market share in Saudi Arabia, therefore, is logical. Cutting production makes no sense. Why would the lowest cost and most efficient producer have to be the one who balances the market? Additionally, it would show their customers that they are not the reliable supplier of cheap and flexible product. And thus it would accelerate the transition to renewable technologies. Cutting production is suicidal, moreover, when the US has already approved to export its production surplus.

The US has become in six years the second global oil producer. This is a threat not only to the oil price but also for market share

Until a few months ago, the US was just a problem for oil prices globally but not market share one, as it was forbidden to export. Lifting this ban makes the US , which has become in six years the second largest global oil producer, a threat not only for price but for market share. This can be up to half a million barrels a day more competing for Russia and OPEC’s traditional customers. Russia is also producing at record levels (more than 10 million barrels a day).

Many fracking companies are suffering in a low oil price environment. If Saudi Arabia was to cut output it would help the inefficient and do very little to balance the market.  More than 89% of the production of fracking in the US is in large companies with little debt (95% of production is in 127 companies with less than 1.8x net debt to EBITDA). Lower cost strategies will prevail and the most efficient operators will absorb the inefficient. It is the story of 150 years of oil industry. It has always been like this.

And producing countries? The ones who have saved and become stronger in the decade of high oil prices will continue to battle and compete in better conditions. The ones that thought that high oil prices would last forever are suffering. Because the mother of all battles has only just begun. Now comes the second phase, accelerated replacement . In a world of low growth, technology further reduces costs. The efficient operators will be winners.

Video: Spanish Elections. Conservatives Win, Left Wing Coalition Risk (CNBC)

Global Economy, Interviews, Media, On the cover, Sin categoría, , ,

Courtesy of CNBC

Fear of a Portuguese-style “left wing” losers’ coalition seems small as PSOE (Socialists) would need to agree with up to 11 different parties. Challenges for PP (Conservatives) to reach a government agreement despite the victory.

– Conservative party wins with small majority (123 seats) despite austerity backlash, but loses absolute majority, while Socialists get worst result in Spain´s democracy history.

– Vast majority of Spanish citizens voted for moderate, centre parties (PP, PSOE and Ciudadanos)

– Neither PP+Ciudadanos nor PSOE+Podemos+Communists reach clear majority for government.

– Key to stability and growth will be to find a coalition between Conservative PP and Ciudadanos and maybe PSOE.
– Biggest risk is a coalition of populist radicals Podemos with PSOE and other radical and nationalist parties looking for constitutional changes and anti-EU measures
– If a left-wing coalition unwinds all reforms made by the PP and starts a constitutional change it could mean 0.7%-1% impact on GDP and zero job creation.
– We can expect a few months of uncertainty, affecting investment, growth potential and investor confidence.

Read my article (here)

It was difficult to think that Spain would make a comeback in 2011 when the Conservative Party (PP) won the elections. The challenges were too large.

The previous administration, PSOE, Socialist, had left a deficit of 9% of GDP after promising a maximum 7%.

When the crisis started, the socialist government consciously decided to substitute the bursting real estate bubble with a massive civil works stimulus. It spent 3.2% of GDP, debt ballooned by 350 billion euro and destroyed more than 3 million jobs. On top of it, in the period from 2007 to 2009 the average annual trade deficit was around 6% of GDP and at one point in 2008 reached 9% of GDP.

Spain was a Keynesian dream becoming a nightmare.

When the socialist government left office, Spain had more than 40 billion euro in unpaid invoices from the public administrations to the private sector, the public savings banks presented a capital requirement of 100 billion euro and the regions and municipalities faced a bailout of 125 billion euro.

It was an unsurmountable situation.

However, after a large austerity plan that was split 50% in tax increases and 50% in spending cuts, and a very substantial set of reforms, including the financial sector, labor market, entrepreneurship programs and early payment schemes, Spain recovered.

Between 2014 and 2015 Spain started to grow well above the EU average. It led job creation in the Eurozone, with more than one million jobs, and brought unemployment rates back to September 2010 levels. It went from a massive trade deficit to a balance by 2015.

In summary, Spain undertook the largest adjustment seen in an OECD economy, 15 points of GDP, and managed to do so growing and creating jobs.

Despite critics´calls of a recovery fuelled by the ECB QE and low oil prices, these claims are easily refuted as Spain is growing more than countries with a similar sensitivity to interest rates and oil prices, like Italy or Portugal, and has recovered with no increase in total (public and private) debt.

However, all is not well and many challenges remain.

– A high unemployment rate, despite the reduction and the evidence that many jobs are hidden in the underground economy and counted as unemployed.

– A large fiscal deficit. Despite the massive adjustment, Spain´s deficit is well above the EU stability pact target.

– External debt remains at 100% of GDP and public debt at 97%.

The austerity plan helped bring Spain out of the living dead, but did not create social stability. Despite the conservatives´efforts to maintain social spending, the population perceived that the cuts were unacceptable. Public debt increased to 97% of GDP partially due to the bailout of the regions and savings banks as well as taking care of unpaid bills, but increasing pensions and keeping unemployment benefits didn´t please part of the public, as real wages fell. As in Greece, fringe parties started to appear fuelled by “magic solution” promises of default, massive increases in public spend and interventionist “miracles”.

In any combination, the new government will not have a strong majority, and most of the likely agreements may only come with parties who promise more spending.

The risk of Spain falling under the QE trap, putting all the bets on the European Central Bank, as it did in 2008, and go back to the same mistakes of deficit spending and public sector white elephants to “boost growth” is not small. Halting reforms and going back to past failed measures will likely give the same results. Less growth, less jobs, more debt.

Spanish political parties tend to mention the Nordic nations and Obama as examples, yet they support the rigidity and intervention of France and Greece, not the economic freedom and flexibility of the leading economies. And when you copy France and Greece you get the growth of France and the unemployment of Greece.

Let us hope the decision is not to bet on repeating 2008.

 

– Daniel Lacalle is an economist, CIO of Tressis Gestion and author of Life In The Financial Markets and The Energy World Is Flat (Wiley)

Spain: Politics and Catalonia risk cloud investment opportunities

Global Economy, On the cover, Sin categoría, Spain

My comment on CNBC on the 24th Sept.

I will not go into aggressive and emotional debate that many use with Catalonia. I just wonder … If the fiscal benefit (balanza fiscal) is so large and the solvency of independent Catalonia is so obvious, why is it not recognized by rating agencies and investors?

The Catalan bond has junk status , according to Standard & Poor’s. You may think it is “because Spain robs them”. But no rating agency, either Moody’s, S&P or Fitch, grants the slightest advantage to independence. None of them say something like “if Catalonia were to become independent they would be Investment Grade “. They say the opposite and clearly. Without the support of the central government the risk is higher.

The Catalan 10 year bond has the widest premium to Germany of the EU after Greece. No other region or country has a higher financing cost. In fact, since secession messages began prior to the elections, the Catalan 2020 bond´s risk premium has risen by 100bps.

I’ll try to explain two concepts in the bond market that many do not take into account. A “credit event” and “underlying risk.” These are the arguments of independentists debunked:

“… What rating agencies say does not matter because they are influenced by the Spanish Government and have no credibility”

Suppose it was that way. That Moody’s, Standard & Poor’s, Fitch, Merkel, investment banks, Cameron and Hollande are all “kidnapped” by the Spanish central government, even though it has never been able to influence these entities in the past when they had negative views of Spain. Assume that those people and entities have vested interests but the separatists are all altruistic, even if it is at least childish. Just remember that the rating agencies have historically failed for being optimistic, not pessimistic, hence their mistakes in the crisis. If you think that agencies have no credibility in saying that independence is an increased risk, at least have very clear that they are being diplomatic.

“… But the Catalan debt is guaranteed by the Spanish State, and if we don´t want we will not pay it”.

Welcome to a “credit event”. Suppose a country owes all its debt to a single nation. With default, everyone will be happy and the country will finance itself like royalty, right? It is not like this. The risk is not reduced, it multiplies. Because reliability as a debtor is destroyed. Not only will refinancing be more expensive. It is more difficult to access markets. See the case of Ecuador, which defaulted and it took years to access the debt markets. When it finally came to issue bonds, it was for a very small amount at 7.95% for ten years in dollars. Today it is financed at 10.5%. And it is an oil rich country.

“… But the new Catalan State will have a very low debt to GDP and investors would love to invest in it”.

A very low debt to GDP does not mean anything. Brazil has 56% and is junk status.Andorra has a 41% debt to GDP and issues very small amounts above the EU rate, and is two points from junk. The Baltic countries had no access to markets after independence despite their low debt. The debt to GDP is one of several elements to analyse risk. That is stock of debt. We must analyze the repayment capacity.

The repayment capacity is clouded by the uncertainty of the whole process. In the absence of certainty about the impact on economic activity, tax revenue, capital outflows, etc, no one takes an optimistic or neutral scenario from the beginning. We must assess the pessimist. All secessions in modern economic history have seen a very significant fall in GDP , and with luck, a recovery in the medium term in V shape. And overwhelmingly, it has happened  in countries rich in commodities and that brutally devalued the currency. Pensions and social spending in real terms suffer as the economy stabilizes.

“… Fiscal balances are enormous”.

Fiscal balances are not a cash concept. On day one of the Catalonia independence it does not count with 9 billion euro of added revenues, starting from the fact that the much-discussed figure is only an estimate. Not least because the tax revenue estimate includes those of Catalan companies paid to the central government as income tax and “owed investments”, all that before thinking of “Inversion Deals” (Catalan companies establishing headquarters elsewhere to avoid the impact of secession). In the best of cases, without counting the costs of the independence of 4.5 billion euros, Catalonia would have a deficit of 10% between revenues and income. The transition cost figure is calculated by the National Transition Council.

Even the National Transition Council acknowledges that the Catalan state must be financed through patriotic bonds and  “bonds tradeable for future taxes”.

Welcome to the underlying risk. A bond whose underlying is supported by unknown and future income when there is no clear and predictable regulatory and tax framework. And whose principal is not guaranteed if those revenues don´t appear!

“… But the Catalans banks are covered by the ECB”.

Suppose it,s true -and it is more than likely that they would have to move headquarters to access the ECB, which in any case would mean another loss of tax revenue to Catalonia-. The bonds issued by the “new State”, if placed, would not have the support of the ECB and would not be part of the repurchase program (QE). Therefore, in the banks’ balance sheet these bonds would be high risk and without warranty of the central state or the ECB, the risk premium would, at least, be very high. And the amounts raised would be very small to non-existent for years, as has been seen in all similar cases. In all.

No wonder the Catalan bond yields have soared 40% in a matter of weeks.

“… But they will have to accept it”.

Okay, Mr. Lacalle, all this may be true, but as Catalonia is a very important economy, the EU, rating agencies, investors and the world will have to bow to whatever we want, whenever we want. Oh dear, just what Tsipras and Varoufakis said about Greece, which resulted in the success we all know.

General election risks

Spain has showed an impressive recovery. Leading employment creation in the EU, 3.2% expected GDP growth, strong PMIs and growing consumption and confidence.

However, the risk of a coalition between the Socialist party and Podemos is not small, because it will be predicated on undoing the structural reforms that have made the country lift itself from recession, introduce more rigidity in the labour market and intervention in the economy, as well as increase spending when Spain is still far away from complying with the 3% deficit target.

The impact of unwinding the reforms has been measured at 1.5% of GDP, but it could be much larger if the foreign investments that the Spanish economy so badly needs, simply stop.

Coalitions spell trouble for the economy. As I said on CNBC “they won’t agree on anything, and that will stop reforms from being passed”.

At this point, all the parties are promising higher spending. Higher public spending runs the risk of a higher deficit, which analysts caution could trump a recovery.

“It’s a lethal combination, increasing public spending and increasing taxes. Because what happens historically [in Spain] is that they spend more than what they bring in from taxes … revenue from taxes don’t cover the increase in spending so the deficit widens,”

Raising taxes, increasing public sector spending, adding intervention and rigidity is what made the country spend more years in recession than most comparable economies. It destroyed 3.5 million jobs while doubling public debt to “invest in growth”.

Spain will not get the unemployment rates of the UK or the US copying the Greek or French interventionist model. When you copy the policies of stagnant economies, you get the growth of stagnant economies.

 

Analyzing the risks is not to scare. It is being prudent. Ignoring the risks and assuming a happy land of superpower funding is simply suicidal.