Saudi oil policy risks creating perfect storm for Aramco flotation

Good business strategies generally create good investments over the longer term. And so Aramco needs to ensure it has the best possible strategies, if it wants to maximise the outcome from its planned $2tn flotation. Unfortunately, the current oil price strategy seems more likely to damage its valuation, by being based on 3 questionable assumptions:

  • Oil demand will always grow at levels seen in the past – if transport demand slows, plastics will take over
  • Saudi will always be able to control the oil market – Russian/US production growth is irrelevant
  • The rise of sustainability concerns, and alternative energy sources such as solar and wind, can be ignored

These are dangerous assumptions to make today, with the BabyBoomer-led SuperCycle fast receding into history.

After all, even in the SuperCycle, OPEC’s attempt in the early 1980s to hold the oil price at around today’s levels (in $2018) was a complete failure.  So the odds on the policy working today are not very high, as Crown Prince Mohammed bin Salman (MbS) himself acknowledged 2 years ago, when launching his ambitious ‘Vision 2030:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil.  We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

As I noted here at the time, MbS’s bold plan for restructuring the economy included a welcome dose of reality:

“The government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal:

“The process of listing will completely change the character of the company and demand a new openness from its senior management“.

MbS is still making good progress with his domestic policy reforms.  Women, for example, are finally due to be allowed to drive in June and modern entertainment facilities such as cinemas are now being allowed again after a 35 year ban.  But unfortunately, over the past 2 years, Saudi oil policy has gone backwards.

SUSTAINABILITY/RENEWABLES ARE ALREADY REDUCING OIL MARKET DEMAND

Restructuring the Saudi economy away from oil-dependence was always going to be a tough challenge.  And the pace of the required change is increasing, as the world’s consumers focus on sustainability and pollution.

It is, of course, easy to miss this trend if your advisers only listen to bonus-hungry investment bankers, or OPEC leaders.  But when brand-owners such as Coca-Cola talk, you can’t afford to ignore what they are saying – and doing.

Coke uses 120bn bottles a year and as its CEO noted when introducing their new policy:

“If left unchecked, plastic waste will slowly choke our oceans and waterways.  We’re using up our earth as if there’s another one on the shelf just waiting to be opened . . . companies have to do their part by making sure their packaging is actually recyclable.”

Similarly, MbS’s advisers seem to be completely ignoring the likely implications of China’s ‘War on Pollution’ for oil demand – and China is its largest customer for oil/plastics exports.

Already the European Union has set out plans to ensureAll plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.

And in China, the city of Shenzhen has converted all of its 16359 buses to run on electric power, and is now converting its 17000 taxis.

Whilst the city of Jinan is planning a network of “intelligent highways” as the video in this Bloomberg report shows, which will use solar panels to charge the batteries of autonomous vehicles as they drive along.

ALIENATING CONSUMERS IS THE WRONG POLICY TO PURSUE
As the chart at the top confirms, oil’s period of energy dominance was already coming to an end, even before the issues of sustainability and pollution really began to emerge as constraints on demand.

This is why MbS was right to aim to move the Saudi economy away from its dependence on oil within 20 years.

By going back on this strategy, Saudi is storing up major problems for the planned Aramco flotation:

  • Of course it is easy to force through price rises in the short-term via production cuts
  • But in the medium term, they upset consumers and so hasten the decline in oil demand and Saudi’s market share
  • It is much easier to fund the development of new technologies such as solar and wind when oil prices are high
  • It is also much easier for rival oil producers, such as US frackers, to fund the growth of new low-cost production

Aramco is making major strides towards becoming a more open company.  But when it comes to the flotation, investors are going to look carefully at the real outlook for oil demand in the critical transport sector.  And they are rightly going to be nervous over the medium/longer-term prospects.

They are also going to be very sceptical about the idea that plastics can replace lost demand in the transport sector.  Already 11 major brands, including Coke, Unilever, Wal-Mart  and Pepsi – responsible for 6 million tonnes of plastic packaging – are committed to using “100% reusable, recyclable or compostable packaging by 2025“.

We can be sure that these numbers will grow dramatically over the next few years.  Recycled plastic, not virgin product, is set to be the growth product of the future.

ITS NOT TOO LATE FOR A RETURN TO MBS’s ORIGINAL POLICY
Saudi already has a major challenge ahead in transforming its economy away from oil.  In the short-term:

  • Higher oil prices may allow the Kingdom to continue with generous handouts to the population
  • But they will reduce Aramco’s value to investors over the medium and longer-term
  • The planned $100bn windfall from the proposed $2tn valuation will become more difficult to achieve

3 years ago, Saudi’s then Oil Minister was very clear about the need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”

As philosopher George Santayana wisely noted, “Those who cannot remember the past are condemned to repeat it.”

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2018 will see Winners and Losers appear in plastics markets

Two major challenges face petrochemical and polymer producers and consumers in 2018:

  • The likely disruption created by the arrival of the ethylene/polyethylene expansions in the US
  • The growth of the circular economy and the need to dramatically increase recycling capacity

My new interview with Will Beacham, deputy editor of ICIS Chemical Business, focuses on both these key issues and suggests they will create Winners and Losers.

The new US product will likely change the global market. Its ethane feedstock is essentially a distressed product, which has to be removed to enable the shale gas to be sold.  It is also clear that this 40% expansion of USA polyethylene capacity, around 6 million tonnes, cannot be sold into the US domestic market, which is already very mature:

  • US net exports have actually been in decline in recent years, so it will also be a challenge to export the volumes
  • President Trump’s apparent wish to start a trade war with China will make that market difficult to access
  • It is likely, therefore, that a significant volume will end up arriving in Europe, causing a price war

We have seen price wars before, and the “Winners” are usually the integrated producers, who can roll through margins from the well-head or the refinery into ethylene and polyethylene sales.

The economics of this are relatively simple.  In the US, producers will have to absorb lower margins on the small percentage of shale gas that is used as ethane feed into the cracker.  Similarly in Europe, refinery-integrated producers will have to absorb lower margins on the small percentage of oil that is used as naphtha feed into the cracker.

As the chart shows, this development will be good news for ethylene consumers.  As Huntsman CEO, Peter Huntsman noted a year ago:

“There is a wave of ethylene that is going to be hitting the North American markets quite substantially over the next couple of years. I’d rather be a spot buyer than a contract buyer. I can’t imagine with all of the ethylene that is going to be coming to the market that it’s not going to be a buying opportunity.”

In turn, of course, this will pressure other plastics via inter-polymer competition

Non-integrated producers clearly face more difficult times.  And like the integrated producers, they share the challenge being posed by the rise of sustainability concerns, particularly over the 8 million tonnes of plastic that currently finds its way into the oceans every year.

This issue has been building for years, and clearly consumers are now starting to demand action from brand owners and governments.

In turn, this opens up major new opportunities for companies who are prepared to realign their business models with the New Plastics Economy concepts set out by the Ellen MacArthur Foundation and the World Economic Forum.

The New Plastics Economy is a collaborative initiative involving leading participants from across the global plastic packaging value chain, as the second chart illustrates.  It has already prompted action from the European Union, which has now set out its EU Strategy for Plastics in the Circular Economy.  This aims to:

“Transform the way plastics and plastics products are designed, produced, used and recycled. By 2030, all plastics packaging should be recyclable. The Strategy also highlights the need for specific measures, possibly a legislative instrument, to reduce the impact of single-use plastics, particularly in our seas and oceans.”

Clearly this represents a paradigm shift for the industry, both producers and consumers.

It may seem easier to do nothing, and to hope the whole problem will go ahead.  But the coincidence of the arrival of all the new US shale gas capacity makes this an unlikely outcome.  Companies who do nothing are likely instead to become Losers in this rapidly changing environment.

But as I discuss in the interview, companies who are prepared to rethink their business models, and to adapt to changing consumer needs, have a potentially very bright future ahead of them.  Please click here to view it.

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Indian auto sales decline as the middle class myth disappears

India autos May14India’s stock market has hit new records this week, as investors anticipate radical policy changes after election results are announced today.  And the chart above highlights a key area behind the need for change, namely the problems of the important auto market:

  • Indian auto sales dipped in April to just 183k (red square)
  • This is the lowest April figure since 2009 (blue line)
  • The boost from stimulus programmes since then has now completely disappeared
  • Even the pre-election tax cut appears to have had only a very temporary impact

As the detailed data from Team-BHP shows, only 5 models managed a month-on-month increase in sales.  Whereas there were 10 models with >40% volume drops.  And overall, the market is now down 5% in 2014, after an 11% decline last year (green line).

Stock markets often travel in hope, and then turn down when reality arrives.  Thus the new government will have to move fast to reverse current trends, before its honeymoon period ends.  Its key issue is that there is no ‘quick fix’ for the problems it faces.

Investors and company executives all wanted to believe that India had suddenly become ‘middle class’ with Western spending levels.  But in reality per capita income this year is expected to be just Rs 74920 ($1200).  Until the government resets expectations, they will find it hard to make much progress.

The key is to accept that the idea of India being middle class is a complete myth.  Investments made on this assumption either need to be closed, or sales redirected into export markets, as Ford is doing with its Ecosport model.

Instead, the business model should be that of Hindustan Unilever, India’s largest consumer products company.  Their mission statement sums up the world of the New Normal, as we discussed in Boom, Gloom and the New Normal:

We meet everyday needs for nutrition, hygiene and personal care with brands that help people feel good, look good and get more out of life.”

Unsurprisingly, they continue to do well, with Q1 profits up 9%.  Its a great pity that so much money and effort has instead been wasted by other companies in pursuing an illusion.

World Bank warns "real-side recovery is weak"

Spain trucks Jan13.pngThe risk of global recession continues to rise, with the World Bank last week warning that “the real-side recovery is weak and business sector confidence is low“. Spain, the world’s 12th largest economy, provides a good example of how the problems are spreading.

Financial markets have temporarily decided that it has ‘turned the corner’, due to support from the European Central Bank. But in the real economy, things are getting worse, not better. As the chart shows from Spain’s El Confidencial, freight transport is in a “profound crisis”. Truck movements are a key indicator of economic health:

• They have fallen 33% since the pre-crisis peak (in terms of millions of kilometres driven)
• Q3 saw a 7.7% fall, which has continued into November

Even worse is data from the relatively rich Catalonian region, where the Red Cross says 28% of children now suffer from child poverty. Yet budget cutbacks means only 9% of schoolchildren get free school meals. Many of the rest go hungry.

Consumer products giant Unilever tells the same story. Its European head, Jan Zijderveld, warned back in August that “poverty is returning to Europe” and highlighted how they were successfully introducing business models from “Indonesia (where) we sell single packs shampoo for 2 to 3 cents and still make good money”.

Benchmark price movements since the IeC Downturn Monitor’s 2011 launch, and latest ICIS pricing comments are below:
Naphtha Europe, down 16%. “The current surplus is being sold at heavy discounts, and is being replaced by new volumes originating from Russia, as well as product from local refineries.”
HDPE USA export, down 14%. “Tight supplies helped boost prices in some cases”
PTA China, down 11%. “China’s polyester sales shrank further during the week and the sales-to-output ratio of Chinese polyester yarn producers waned to 30-50%, compared with last week’s 50-80% and 80-120% seen in early January”
Brent crude oil, down 11%
Benzene NWE, up 10%. “Growing buying interest among suppliers ahead of a bullish February helped push current month values up as the week progressed”
S&P 500 stock market index, up 9%

If you build it, they may not come

Dreams.pngThe story of the 1989 US movie Field of Dreams summed up the happy days of the economic supercycle that was then getting underway. Starring A-list players such as Kevin Costner and Burt Lancaster, its theme that “if you build it, they will come” came to define the era.

In the world of manufacturing, companies stopped worrying about end-user demand. Instead, they became convinced that growth was a constant, and that demand for their product could be modelled on a spreadsheet as a ratio to GDP.

Similarly in financial markets, banks abandoned the use of personal judgement and experience. Instead, they hired maths and physics graduates to build black-box computer models. Risk became managed via spreadsheets and complex ‘value-at-risk’ models.

The blog rather likes spreadsheets itself. But ‘garbage in, garbage out’ is a good definition of their limitations. Equally, it worries that the models only use relatively recent data, often from just the past 5 or 10 years. This is not long enough to capture the trends of even a single generation.

Now, of course, the models are starting to misfire left, right and centre. Demand no longer follows GDP growth, as we demonstrate in Boom, Gloom and the New Normal. Whilst JP Morgan’s $2bn+ trading loss is only the latest in a long sequence including US subprime and Lehman.

Field of Dreams was a great film. But it is time to make a break with its message of wish fulfilment. The hard truth today is that ‘if you build it, they may not come’. Nor can banks continue to run their business via computer models.

This is why the blog believes Unilever CEO Paul Polman’s message about today’s increasingly VUCA environment is so important. Volatility, Uncertainty, Complexity and Ambiguity are likely to be the theme for at least the next few years.

Affordability a key trend for Western markets

Nescafe stick.pngThe Red Queen in the classic book, Alice in Wonderland, would have recognised today’s financial markets when she boasted “Why, sometimes I’ve believed as many as six impossible things before breakfast.”

Fellow blogger Doris de Guzman noted one great example last week, when questioning whether Facebook could really be worth the combined value of Dow, DuPont and ADM.

Another is the widespread myth that says China is now a ‘middle-class’ country, and can easily replace any loss of demand in the West. Unfortunately, 96% of its population has an income of less than $20/day, well below the poverty line in the West.

Readers can no doubt compile their own lists of myths very easily. And as we are seeing with Facebook, those who invest of the basis of them can easily lose a lot of money.

Belief in such myths can also blind us to what is happening in reality. Convergence is indeed taking place between Western and emerging markets, but in the opposite direction.

As the blog noted in March, automakers such as Renault, Ford and Datsun are all focusing on the low-cost market in the West. Renault are the most successful, with low-cost models such as the Dacia now seeing more sales in Europe than in their original Indian target market.

Equally, as Unilever’s European marketing head notes in the Wall Street Journal:

“With around one in five people now officially living beneath the poverty line in countries like Spain and Greece, it’s critical that we find new solutions to ensure that people across the region continue to enjoy our brands, while keeping in control of their household budget.”

Similarly, food giant Nestlé is seeing strong growth in sales of cheap, smaller package-sized products. One example is packs of 25 single-serve Nescafé instant coffee sticks, which sell for €2 in France – less than the price of an espresso in Starbucks.

These examples are further evidence for our argument in Boom, Gloom and the New Normal that affordability, not value-in-use, will be the key to future profitability.