A majority of businesses in Saudi Arabia expected overall business and revenue growth in the second half of 2009 according to last month’s SABB report on second quarter business confidence in the Kingdom. This month’s bulletin from Jadwa Investments in Riyadh points to a set back in the Kingdom’s economic recovery due to problems at the Saad and Ahmed Hassan al-Gosaibi groups which resulted in increased caution among lenders. The strangled credit situation has caused Jadwa to amend its forecast for Saudi economic growth for 2009 from -0.5 percent to -1.0 percent despite what it had seen as a revival in the oil market.

This SUSRIS IOI provides the July Jadwa report for your consideration and includes an examination of the Saad/Gosaibi story as well as analyses of other important economic developments. Among the indicators showing the weakness of the economy is the downturn in trade marked by an 18 percent decline in imports for the first five months of the year compared to 2008 figures, as well as an overall slip in non-oil exports of 1 percent. Petrochemical exports showed growth offsetting the 30 percent decline in all other goods.

The “Oil Market Watch” segment provides insight into conditions expected through 2010 with Jadwa’s oil forecast of $70 per barrel and an uptick in their 2009 forecast to $58 per barrel. The report also discussed demand forecasts for 2010 and the disparities between estimates from the IEA and Opec. Nevertheless Jadwa’s forecast calls for increased demand and a resulting boost in production of Saudi oil from 8.1 million b/d in 2009 to 8.4 million b/d in 2010.

The report concludes with a breakdown of stock market performance which was disappointing in the second quarter, with uncertainty following the Saad/Gosaibi episode – and lack of transparency therein – earning much of the blame. Jadwa concluded that it will update its market forecast in a forthcoming report but that it was with their forecast that the TASI would end the year down at a mark of of 6,200.

SUSRIS wishes to thank Mr. Brad Bourland, Chief Economist at Jadwa Investment, for sharing these timely and important reports with our readers.

Jadwa Investment Monthly Bulletin - July 2009

Economy hit by family business problems

The recovery of the Kingdom's economy has been set back by problems at one prominent local family business and an associated businessman. In addition to these two groups it seems that several other family groups are stressed financially. The causes of these problems appear to be short-term borrowing for long-term assets, investment losses and the accumulation of large inventories of raw materials whose prices subsequently collapsed. Owing to concerns about the health of family business and their own exposures, banks have become more cautious in extending credit to the whole of the private sector. As a result we are lowering our economic growth forecast for 2009 from -0.5 percent to -1 percent.

Problems at the Saad and Ahmed Hassan al-Gosaibi groups have received widespread publicity. These emerged when a Bahrain-based bank owned by the Gosaibi group defaulted on its debt repayments in May amid indications the group was restructuring its debts. The Saad group announced shortly afterwards that it was also restructuring debt, owing to liquidity problems. There are links between the two families through marriage, but the extent of the business links is unclear with each side issuing conflicting statements.

Any relations that did exist have now completely broken down. In mid-July the Gosaibi group presented a lawsuit in New York alleging that Maan Al-Sanea, chairman of the Saad group, fraudulently obtained $10 billion through the manipulation of the Gosaibi group‟s foreign exchange dealings. This is in response to a case filed against it by Mashreqbank of the UAE that the Gosaibi group failed to honor its contracted payments in a foreign exchange transaction.

The immediate causes of the recent problems are not unique to family groups. Companies worldwide that are heavily reliant on short-term borrowing have suffered from a drying up of credit from the banking sector. In Saudi Arabia only 22 percent of total credit has a maturity of more than three years. Similarly, losses on investments have been widespread as the value of assets has plunged (the Saad group has notable holdings in the property and financial services sectors, which have been particularly hit). Furthermore, many local listed companies have lost heavily through a decline in the value of their holdings of raw materials. Shortages in the first half of last year and expectations of a continuation of the economic boom encouraged some companies to stock pile while prices were rising only for the value of these stocks to collapse as commodity prices plunged as the global financial crisis intensified.

Nonetheless, it seems probable that the dynamics within the two groups aggravated the problems. Both groups started based on a single business line; for Saad this was contracting and for Gosaibi it was trading. Over the years their interests mushroomed and they became large conglomerates with diversified interests. Many family businesses have followed a similar path in the Kingdom, but it appears that the Saad and Gosaibi groups did not have sufficient internal controls to operate a diversified group of companies.

Due to the Gosabi and Saad group defaults, banks have become increasingly wary about lending to all family businesses (family business account for a large part of the private sector). Other companies within the private sector are also finding it tougher to raise finance as a result. Availability of credit was already constrained for the private sector. Total commercial bank lending to the private sector has declined in five of the seven months to end-June and the total outstanding is over SR14 billion below its November peak. Credit to the private sector rose by 0.5 percent in June, though the breakdown indicates that this was targeted to a few specific sectors.

None of the local banks have publicly admitted to exposure to the Saad or Gosaibi groups, but it seems that this runs into the billions of dollars. The Gosaibi group has acknowledged that it owes $9.2 billion to 120 banks across the world. Local banks have very large exposures to family businesses and second quarter results show that National Commercial Bank, Al Rajhi Bank, SABB, Samba, Banque Saudi Fransi and Saudi Hollandi Bank have increased their provisions for bad debts. It is highly likely that other banks will do likewise in the third quarter and that provisions made during the second quarter will be raised. Concern about the health of the banks has caused them to under perform the TASI by 12 percentage points since the news of the troubles broke in the middle of May.

Nonetheless, we do not think problems at family businesses will pose a systemic threat to the banking sector owing to its strong fundamentals; non-performing loans were just 1.3 percent of total loans at the end of 2008 and provisions were sufficient to cover over 153 percent of these loans.

However, there is likely to be a reform of lending practices at commercial banks. In cases where there are long-term relationships between banks and large customers, lending standards have sometimes been less stringent than would otherwise be the case as a result of the level of trust between the parties. “Name lending”, where a bank will lend with a personal guarantee from the borrower as the only collateral, has been widespread. From now on we expect that banks will undertake greater due diligence before lending and require more tangible collateral and greater transparency from the borrower.

The problems at family businesses and their impact on bank lending have stalled the economic recovery that seemed to be taking hold in response to the revival in oil and share prices in the second quarter. With activity generally slow over the summer and Ramadan, we do not expect a more palpable recovery within the private sector until the final quarter of the year. As a result we now forecast that the economy will shrink by 1 percent in real terms this year, compared to our earlier forecast of a 0.5 percent contraction.

In brief: Economy

New data from the Kingdom's ports emphasizes the weak economic performance so far this year. Over the first five months of 2009, imports through the ports were 18 percent lower than in the same period of last year. Imports of construction materials fell the most, by 29 percent, despite the government's ongoing infrastructure development program. With government spending on construction projects likely to have risen so far this year, we think that the decline can in part be attributed to stocks at local suppliers being drawn down. A 12 percent fall in imports of consumer goods points to heightened caution among consumers, though the very small decline in vehicle imports is more encouraging and may reflect lower retail prices. In month-on-month terms imports through the ports rose by 0.7 percent.

The data on exports through the ports is also not encouraging. Non-oil and gas exports were down by 1 percent over the first five months of the year, with only petrochemicals showing growth. This reflects the start of production at some facilities since May of last year. Exports of all other goods were down by over 30 percent. The month-on-month data also shows a continued fall, with total exports through the Kingdom's ports down by 0.9 percent compared with April, and non-oil and gas exports down by 1.8 percent. Note that the port data is in volume terms and therefore not distorted by changes in prices.

Point of sale transaction data, the closest proxy to retail sales, was poor in June. The annual value of point of sales transactions fell by 11.7 percent, the first annual decline since late-2006. In absolute terms, June was the second consecutive month during which sales had fallen. June and July are generally the best months of the year for point of sales transactions and strong performance in these two months last year means that a decline in year-on-year terms is likely in July as well.

Data on letters of credit opened by the private sector through commercial banks for imports improved significantly in June and stood at their highest level since September. The breakdown is consistent with preparations for the ramping up of the implementation of government projects over the month. Letters of credit for machinery imports were the second highest on record and double their April level, while those for building materials were at a 10-month high. Nonetheless, on a year-on-year basis new letters of credit opened by the private sector were down by 21 percent.

Oil market watch - Oil market conditions to improve in 2010

The oil producers and consumers organizations both released their projections for the oil market in 2010 earlier this month. While their numbers differ, they are both consistent with our view that growth in demand will outpace that of non-Opec supply, giving Opec scope to modestly raise production and secure higher prices. We maintain our oil price forecast of $70 per barrel for 2010 (WTI; equivalent to $64.8 per barrel for Saudi oil), but have lifted our price forecast for this year to $58 per barrel (WTI; $54.5 per barrel for Saudi oil), reflecting the stronger than expected prices over the first seven months.

The largest variation between the forecasts of the International Energy Agency (the main group of oil consumers) and Opec (the main group of oil producers) is in the projections for demand. The IEA expects global demand to rise by 1.4 million barrels per day (b/d) next year (a rise of 1.7 percent), whereas Opec anticipates that demand will grow by 400,000 b/d next year (up 0.4 percent). In part this reflects the standpoint of the two organizations; the IEA wants producers to be geared up to increase production and keep prices under control, while Opec producers will be more cautious about raising production if little improvement in demand is expected. The more significant reason for the divergence is the great uncertainty over the economic outlook for 2010.

The IMF recently raised its global growth forecast for 2010 to 2.5 percent from 1.9 percent but acknowledged that important risks remained and that these were primarily on the downside. The perceived momentum of the economic recovery in the US (the world‟s largest oil consumer) has been set back in the last few weeks (largely due to poor employment numbers) though a return to growth is still likely in the second half of this year. Both oil forecasters are cautious about the impact this will have on US oil demand given the likely anemic pace of recovery and the impact of earlier record high oil prices and government policy on consumer behavior. Instead, it is expected that the main growth in demand will come from the two regions that have seen the fastest consumption growth in recent years, Asia and the Middle East.

Prospects for non-Opec supply remain subdued. The IEA sees growth of 400,000 b/d in 2010, the Opec projection is 200,000 b/d. Actual non-Opec output has generally been less than forecast and uncertainty over prices and the investment environment may again stymie growth. It is therefore likely that higher production from Opec will be required to meet the gap between demand and non-Opec supply. Providing this additional output will not be a problem for Opec. Total non-Opec production is over 4 million barrels per day below its peak in June of last year and much of this production can quickly be brought back on stream.

Our forecast is in line with the IEA and Opec in that 2010 will see a recovery in demand and Opec will raise supply in response. We project Saudi production to average 8.4 million b/d next year, up from 8.1 million b/d in 2009, and maintain our forecast that WTI will average $70 per barrel. We have revised up our oil price projection for this year to $58 per barrel for WTI, reflecting a stronger first half of the year than we had anticipated (WTI has averaged $53 per barrel in the year to July 27).

In brief: Oil market

Oil prices have broadly moved in line with gyrations in sentiment on the health of the global economy over the past month. They slipped to below $60 per barrel in mid-July for the first time since mid-May in a week-long sell off prompted by poor unemployment data from the US, but have since recovered to the high $60 per barrel as other data has been more supportive for the global economy and therefore demand for oil. A price of over $60 per barrel should be sufficient for Saudi Arabia to run a budget surplus.

Oil prices look strong given the underlying fundamentals for demand, supply and stocks. The IEA continues to predict that global oil demand will average 2.5 million b/d lower this year than in 2008, but this month it revised up its projection for non-Opec supply marginally. Indications are that Opec supply also increased during June as compliance with its production quotas reportedly slipped. The IEA puts commercial stocks in the OECD at the equivalent of 62.5 of days of consumption in May, up 13 percent from one-year earlier. Weekly data show that oil stocks in US have come down by 8 percent from a 19-year high in early May, but they remain well above average during what is the peak of the driving season. In contrast to their usual season trend, US gasoline stocks have risen over the past month.

Plans are under discussion in the US to reduce the ability of financial investors to influence the oil and other energy and commodity markets by beefing up market regulator, the Commodity Futures Trading Commission. Ideas proposed include enhancing regulatory power, placing limits on the amount of contracts that traders can buy and providing more transparency on market activity. New regulations are expected to be put in place during the final quarter of this year. We think that financial investors have played a role in exaggerating price moves (both upwards and downwards) though they base their investment decisions on the fundamental factors that determine physical demand and supply of oil.

July should see the first full month of oil production from the Khurais oilfield, where output formally began in mid-June. Khurais is the largest single increment to oil production capacity in the Kingdom‟s history. Total production capacity is 1.2 million b/d (the same level as current output from Algeria), though initially production is below this level. The field produces Arab Light, a blend that is highly in demand due to the ease it can be refined into transportation fuels. Its completion formally raises the Kingdom's production capacity to 12 million b/d, giving current spare capacity of 4 million b/d, though actual spare capacity is below this level. Some of the oil being pumped from Khurais will compensate for lower output from the Ghawar oilfield (the largest in world) which is undergoing maintenance.

Stock market watch - Uncertainty and weak results hit TASI

There has been a notable divergence in the performance of the TASI and leading global and emerging markets recently. We think that this is primarily the result of uncertainty generated by the problems at the Saad and Gosaibi groups highlighted elsewhere in this report. In addition, financial results for the second quarter have generally been disappointing.

Since the rapid intensification of the financial crisis last September, the movements of the Saudi stock market have been fairly closely aligned with global markets and particularly with emerging markets. However, over the past two months these relationships have broken down. Since May 16, when news of the family business troubles first broke, the TASI has underperformed the MSCI emerging markets index by 13 percent and the US S&P500 by 7 percent.

Investors are clearly concerned about the lack of transparency surrounding the problems at Saad and Gosaibi and their potential impact on listed companies (notably the banks) as well as the financial health of other family businesses within the Kingdom. This uncertainty has been reflected in a clear dip in volumes. The daily average volume for both of the first two weeks of July was lower than for any week since September. Volumes have improved over the last two weeks as companies issued their second quarter results.

We think the second quarter results have in general been fairly disappointing. Earnings per share were down by 26 percent in year-on-year terms, compared to an annual fall of 22.8 percent in the first quarter. Compared with the first quarter, earnings per share were up by 7.1 percent. This is despite strong recoveries in oil prices (and to a lesser extent petrochemical prices) and the stock market and a generally better economic environment than the first quarter.

For petrochemicals, the largest sector on the TASI, earnings per share were up by over 90 percent on a quarterly basis, reflecting higher prices and a goodwill impairment on the books of Sabic in the first quarter. In year-on-year terms, however, petrochemical earnings were down by 68 percent. Earnings per share for the banking sector fell in both annual and quarterly terms as a result of increased provisions for bad debts by a number of banks. Six other sectors also recorded quarterly declines in earnings per share; building and construction, industrial investment, retail, agriculture, energy and utilities and media. The only sector where earnings per share was higher in both annual and quarterly terms was hotels and tourism, the result of a one-time land sale by one company.

We said in our May 2009 Monthly Bulletin that a period of consolidation was likely and there is nothing in the new numbers to suggest otherwise. In the absence of clear direction we think the market will continue to trade around current levels as volumes decline during the summer months. We will reexamine our market forecast in a forthcoming report, but for the moment are comfortable with our existing projection of end-year fair value for the TASI at 6,200.

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