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
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.
“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 ensure “All 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.”
US retail sales have failed to see the rise that most economists, and the US Federal Reserve, confidently forecast at the beginning of the year. The theory was that lower oil prices would stimulate discretionary spending, and ensure that the long-promised economic recovery finally arrived.
But September sales were up just 0.1% versus August, and even this small amount was only due to a 1.8% increase in auto sales. Excluding autos and gasoline, sales were flat versus January:
Consumers are now increasingly focused on price and convenience
They are “time rich and cash poor”, the opposite of the boom years when they were “cash rich and time poor”
Thus Wal-Mart, the US’s largest retailer, has just forecast a 12% fall in profits next year
Wal-mart’s news is confirmation, if confirmation were needed, that the formerly profitable middle ground of value-added products is fast disappearing. Affordability is the key driver for future success.
So what has gone wrong?
“TIME RICH” BECAUSE PARTICIPATION RATES HAVE FALLEN
The key issue is policymakers’ refusal to confront the issue of the ageing society, as they worry they will lose votes. They prefer to pretend that low interest rates can somehow restore full employment, and to ignore the structural change in the US population:
People no longer mostly die before retirement
Instead today, a 65-year old man can expect to live to 84.3 years on average, and a woman to 86.6.
As a result the participation rate in the US jobs market (the percentage of people actually in a job) is in long-term decline. It peaked at 68.1% in 1997, compared to just 62.3% today:
It has been in long-term decline since World War II for men, due to increasing life expectancy –
Life expectancy was just 60.8 for men in 1940, meaning that most people could expect to die before retirement.
The rate for women has also fallen back to 56.3% today from its 60% peak in 1999
This has reversed the decades-long increase due to Equal Opportunity movements, which allowed women to stay in the workforce after marriage
One likely reason for this is the lack of support for working parents, which has helped to push US participation rate for women below that for Japan. As the Financial Times notes, “A quarter of all women return to work less than 2 weeks after having a child“
“CASH POOR” BECAUSE MEDIAN EARNINGS HAVE FALLEN
The second chart (showing median US earnings in constant dollars of 1982-4), highlights another reason for households now being increasingly “time rich and cash poor”:
Average earnings today are actually lower at $337/week than in 2009, when they were $345/week
Average earnings for men have fallen from $402/week in 1979 to $373/week today, and are back at 2003 levels
Average earnings for women have continued to increase relative to men, but are still at only $305/week today
Clearly therefore, the situation today is quite different from 1985, when oil prices last halved (from around $65/bbl in $2015). Then, more and more BabyBoomers were entering the workforce and more and more women were working – and earning higher wages. This created a SuperCycle of demand for the economy, which saw personal consumption expenditure soar 45% in real terms by 1998, according to Census Bureau data.
But now we are set to see the reverse of this process, as the Bureau of Labor Statistics has noted:
“Slower GDP growth (will) become the “new normal.” In addition to the recession’s impact on potential growth, the economy faces a number of hurdles. As the nation’s demographic shift continues, with the baby-boom generation moving into retirement, the labor force participation rate will continue to decline, moderating growth.”
US retail sales tell a sorry story about the state of underlying demand. US sales at Wal-Mart, the world’s largest store chain, have failed to grow for 6 consecutive quarters, with shopper traffic falling 1.1% in Q2. The company’s explanation for the problems is worth pondering by anyone in business:
It is facing intense competition from discount ‘dollar stores’, as many working families have little spare cash
Major cuts to the food stamps programme are impacting the 20% of sales from this area
Consumer preferences have shifted away from big-box stores to small local convenience stores
Equally depressing is the recent boom in M&A. As the Financial Times notes, this does little to “materially improve the overall prospects for the economy and increase overall prosperity“. Instead, the end-result is merely to enrich the dealmakers, and investors in those companies being acquired.
The chart above from the New York Times highlights the core issue – the decline in incomes:
June’s median household income was $54k ($2014), down 3.1% from 5 years ago – the recession’s official end
The steepest decline has been in families with 3 or more children, normally a core group for retail sales
And the trend is long-lasting – median incomes today are lower than in 2000, when current data begins
The reason is, of course, demographics. The US boomer generation was 52% larger than the previous generation, and 2001 saw the oldest Boomer move into the New Old 55+ age group. As every consumer marketer knows, this is when retail spending starts to slow, for two obvious reasons:
The New Old 55+ already own most of what they need
Their incomes are declining are they move into retirement
US policymakers have tried to disguise this impact by creating ‘wealth effects’ – first in housing via subprime loans, and then in the stock market via the quantitative easing programmes. But buying a house that you can’t afford doesn’t create permanent wealth, as we learnt in 2008. And fewer Americans own stocks (52%) than own houses (65%).
Confirmation of this conclusion comes from the Russell Sage Foundation. Their new report shows the mean wealth of American households fell to $308k in 2013 versus its peak of $424k in 2007. This means household wealth is lower today than in 2003, when it was $337k.
SOCIAL SECURITY BEGINS TO RUN OUT IN 2016
Will things now get better? After all, the chart shows incomes have been seeing modest gains since 2011.
The key issue is the one that nobody wants to discuss, retirement incomes. America’s ageing population means there are more and more retirees. 46m Americans currently claim an average of $1294/month in Social Security benefit. And their numbers will rise to 77m by 2033.
As the Senate Finance Committee highlighted in March:
“Most Americans have saved only a fraction of what they need for retirement. Workers approaching retirement age have an average retirement savings of less than $27k. One third of Americans aged 45 – 64 have nothing saved for retirement at all”.
Even worse, as investment magazine Barron’s points out, the latest report from the Trustees of the US Social Security and Medicare systems shows that both are already living on borrowed time:
“You will find one thing, if you read deeply into even the most optimistic trustees’ report: We’re doomed.
“If benefits for the baby boomers — the wealthiest generation in U.S. history — are not tamed, they will consume the retirement system, then the health-care system, then the rest of the federal government, and finally the wealth of every younger American.”
It adds that within 5 years, the US Treasury “will have to sell bonds in the open market” in order to pay benefits. The reason is simple – Social Security is a pay-as-you-go system. So as more people retire, then costs go up. The blog’s detailed analysis of US demographics in December highlighted the critical data:
Increasing life expectancy means people live longer, so people claim Social Security for longer. Life expectancy has risen by 9 years since 1955
Decreasing fertility rates means fewer people paying into the system. US women today have half as many children as in 1955
Or as the Social Security website confirms, the average 65-year old American can now hope to live for 20 years in retirement. But by 2033 there will only be 2.1 workers for every beneficiary, compared to 2.8 workers today
Already the disability trust fund component of Social Security is expected to run out of cash around the end of 2016. The writing is also on the wall for the larger retirement trust fund, which will run out by 2033.
At that point, either taxes will have to rise to pay benefits, or benefits will cease. And the same is true of Medicare, which will run out by 2030.
Social Security is not a ‘nice-to-have’ benefit. Half of all married couples, and three-quarters of all unmarried people, rely on it for at least half of their income. Overall, it currently provides 38% of all retiree income.
Any company considering a new investment on the basis that ‘things will soon return to normal’ should therefore ask themselves ‘What do we mean by normal?’.
After all, the New Old are already responsible for more than a third of all US consumer spending. And consumption is more than two-thirds of the US economy.
We are in fact transitioning to a Boomer-led New Normal, which will be very different from the Boomer-led SuperCycle. As the retailers are already learning, this will feature lower incomes, reduced household wealth – and probably, lower retirement benefits.
WEEKLY MARKET ROUND-UP
The blog’s weekly round-up of Benchmark price movements since January 2014 is below, with ICIS pricing comments:
Brent crude oil, down 7% Naphtha Europe, down 5%.“Poor downstream demand continues to impact on the market, and cargo prices hit a new low for the year as a result” US$: yen, down 1% PTA China, up 1%. ”Downstream polyester demand remained weak during the week, with end users largely purchasing only on a need-to basis” Benzene Europe, up 1%. “With the spread of benzene over naphtha maintaining at $500/tonne or more, many downstream players feel that this is unsustainable and not a healthy reflection of global market fundamentals” S&P 500 stock market index, up 9% HDPE US export, up 12%. “Some traders and brokers still have older material on hand and are willing to offer it at a cheaper price, particularly as prices from Asia are moving lower.”
The past few years have seen an increasing number of countries and major companies moving to ban or reduce the use of plastic bags. Now Austin, state capital of Texas, and the 14th largest US city has voted to introduce criminal penalties for any retailer breaking its new law.
ICIS’ Joe Kamalick notes that “the Austin bag ban law also requires that retailers post signs informing customers that they must bring their own multi-use bags, any failure to post such signs could be subject to the misdemeanour criminal penalty”.
The maximum penalty is $2000, although the ban “includes exemptions for plastic bags used by laundries and dry cleaners, newspaper delivery bags and some other single-use plastic bags provided by specific vendors such as pharmacies and for restaurant carry-out foods”.
The blog remains fully supportive of such bans, although it regrets any criminalisation measures. The video above, first posted last May, highlights the enormous environmental damage caused by these single-use bags. They are simply too light, and cannot be properly contained during or after use.
The situation seems to parallel other occasions where products have been withdrawn after it was found they produced unintended, and unwelcome, side effects. Nobody today, for example, would advocate adding lead to gasoline to boost octane, now we know about its health hazards.
The polymer industry would boost its public image, and lose very little in terms of total sales volume, if single-use bag manufacturers were to voluntarily stop production.
The world’s leading retailers have been extremely reliable leading indicators for the chemical industry, since the Great Recession began.
They were the first, back in July 2007, to highlight the major changes underway in consumer markets. Tesco, the world’s 3rd largest retailer, warned then that they were changing their focus away from more affluent shoppers and green issues:
“Coming down the road is a tougher time, and that is why we are doing this now.”
Now Tesco’s UK CEO Richard Brasher, who gave that warning, has gone one step further. Launching a £500m ($775m) discount campaign, he explained:
“Today is the New Normal. Customers are challenged. They have got to make ends meet”.
Tesco is seeing the same issues as Wal-Mart and Carrefour (world No1 and 2), as well as thousands of smaller companies. The Boomer-led SuperCycle of demand is disappearing, as the chart above shows:
• From the 1980s onwards, consumer companies developed the concept of ‘mass customisation’, which aimed to provide higher perceived value
• They could afford to do this by outsourcing manufacturing to lower-cost factories in Eastern Europe and Asia
Consumers loved this benefit. But now, the market is polarising again.
Luxury brands are still doing well, and so are the bargain ‘Dollar Stores’ which keep prices low. But the middle ground is disappearing.
Tesco and the other major retailers are having to make a choice about how they position themselves in the New Normal. Clearly, they have to go down-market, and compete on price, in order to survive as volume players.
In turn, of course, they will force the same choice on their suppliers.
Companies will therefore find it increasingly difficult to ignore the New Normal, if they wish to maintain their volumes and pricing power.
The blog is a great believer in the predictive power of the retail sector.
Wal-Mart and Tesco were the first to spot the downturn in the summer of 2007, a year before it became obvious to everyone else.
Now Wal-Mart’s problems are providing some important messages about how companies need to adjust their strategies to survive as we transition to the New Normal:
• Financially-driven strategies are a dead end
• Focusing on Gross Margin loses sales
As the chart from the Wall Street Journal shows, Wal-Mart has increased Gross Margin consistently since the Great Recession began. But it has also suffered 9 quarters of declining US same-store sales. This is the key metric for any retailer.
As Wal-Mart’s COO, Bill Simon has told analysts, “I think the gross margin could be an impediment to sales growth.” The financial focus meant less attention was paid to customers’ changing needs:
• Wall Street loved Wal-Mart’s removal of low-priced, low-margin items
• But customers simply went elsewhere for their bargains
Many consumers are now living from pay-check to pay-check. They simply can’t afford to buy large sizes, even though these offer better value. As a result, they prefer the ‘Dollar Stores’, where they can cover their basic needs for the week ahead.
Wal-Mart is still the world’s largest retailer. But it will now have to move quickly, to catch up. Chemical company boards need to review their own strategies, to ensure they are not making the same mistake.