By Ahmed Tabaqchali, CIO of Asia Frontier Capital (AFC) Iraq Fund.

Any opinions expressed are those of the author, and do not necessarily reflect the views of Iraq Business News.

The herd instinct among forecasters
makes sheep look like independent
thinkers
” — Edgar Fielder

The crash in oil prices, brought on by the oil price war between Russia and Saudi Arabia, and the collapse in consumption due to COVID-19, seems like the perfect storm to hit Iraq given its vulnerabilities to such external shocks.

Though, this is not the first perfect storm to hit it. The last one which was arguably more perfect than the current one took place in the summer of 2014 when ISIS took over a third of the country, threatening its imminent break-up, and for good measure oil prices crashed.

As in 2014, the fall in oil prices poses serious threats to Iraq’s oil-dependent economy, but the current storm hits a very different Iraq from that of 2014 – especially changed this time is its equity market. Then, the equity market was at the end of a multi-year bull market that, as measured by the Rabee Securities RSISX USD Index (RSISUSD), had almost doubled by early 2014 from the levels of 2010.

Comparatively, now the equity market is at the end of a multi-year bear market that saw it decline 71% from the 2014 peak. Fuelling the 2014 bull market were foreign investor inflows and the government’s multi-year investment spending program which boosted the economy and domestic liquidity. The opposite is true in the current bear market with most foreigners having withdrawn from the market and the government’s investment spending having been practically non-existent for a number of years.

RSISUSD Index: Bull market 2010-2014 – Bear Market 2014-2020

(Source: Bloomberg)

The significant drop in oil revenues will force the government to sharply curtail expenditures in the same way that it did in 2014-2016, with negative consequences for the economy, yet unlike then the cuts will not be magnified by the need to shift resources to the sharply increasing cost of the ISIS conflict. The combination of the different profiles of investment spending and expenditures have vastly different implications for both the economy and equity market.

In 2014-2016 the dramatic cuts to investment spending and diversion of resources towards the war effort led to year-over-year contractions in non-oil gdp of 3.9% and 14.4% in 2014 and 2015 respectively. The severity of the drop was such that the small bounce of 1.3% in 2016 was followed by a 0.6% drop in 2017. The multiplier effect of these contractions negatively impacted corporate earnings and ultimately led to the equity market’s multi-year decline.

Today’s different circumstances mean that the non-oil economy will not face the same severe double whammy as then, and as such the contractions will be of a different magnitude. It will nevertheless be negatively impacted by the effects from the COVID-19 lockdown far more than any cuts to the government’s investment spending. While every sector of the economy will feel the effects of the lockdown, the informal sector which is dominated by retail and hospitality and which accounts for the bulk of private sector economic activity will be particularly hard hit. Whereas, these effects on the equity market will be through a few sectors that dominate the market, consisting of banking, telecoms and consumers staples.

The banking sector was hurt the most between 2014-2016 as the cuts to the government’s investment spending were disastrous for private sector businesses at the receiving end of the cuts, whose finances deteriorated. This in turn affected the quality of bank loans as these businesses accounted for the bulk of bank lending. Consequently, the banks’ earnings suffered from the increasing non-performing loans (NPL’s) coupled with negative loan growth, as well as losing funding sources due to negative deposit growth. The scale of the effects on private sector businesses from any future cuts by the government ought be smaller this time around and should not lead to the same negative effects for the banking sector. However, it would be reasonable to assume that the sector’s tentative recovery will be on hold, while any reversal would be limited given the nascent recovery prior to the COVID-19 shock and the sector’s limited exposure to the informal economy. With the sector contributing the most to the market’s 71% decline from the 2014 peak, it’s difficult to see how bank stock prices can decline much further in response to these developments.

Other reasonable assumptions that can be made are that telecom stocks could benefit from the increased need for broadband induced by the lockdown, while any moderation in consumption for soft drinks – whose local bottler accounts for the bulk of the consumer staples sector market capitalization in the equity market – should be limited. These are very early thoughts and much more data, on the economy and company specific, are needed before any meaningful analysis can be made. However, such data and analysis in the short term will play second fiddle to shifting expectations on the future direction of oil prices.

Forecasting the direction of oil prices, especially at critical junctures, is fraught with uncertainty, as subsequent prices have made a mockery of all predictions throughout recent history: from those calling for ever higher prices when “peak oil” was the consensus thinking, to those calling for ever lower prices when “lower for longer” became the consensus. However, analysing the supply-demand for oil, while equally fraught with uncertainty, it is possible to analyse a few broad trends to help frame expectations for the general direction of prices.

The effects of the lockdowns related to COVID-19 have been profound on the global demand for oil given that about 60% of consumption comes from transportation. The first contraction in demand was seen when China went into lockdown in January and expanded as the rest of the world followed suit in March. Current expectations call for a decline in April of up to 20 million barrels per day (mbbl/d) from initial world oil demand estimates of 101mbbl/d.

The known nature of the virus precludes a return to full normalcy when global lockdowns are expected to ease from mid-summer onwards. Combined with the unknown nature of the new normal as the world learns to deal with and ultimately contain the virus, the return to a pre-virus oil demand picture is unlikely within the next 12 months. But, in six to nine months demand for oil should recover from the extreme lows of April and trend upwards to a small drop from base-line demand by year end, as suggested by the chart below.

Global Oil Demand Impact from COVID-19

(Source: CNBC 26/03/2020 citing Goldman Sachs Investment Research, International Energy Agency, Bloomberg, Reuters, New York Times)

The supply-side of the equation is much harder to predict given the multitude of possibilities of producer reactions to low, yet extremely volatile oil prices in which a great deal of oil production becomes uneconomical. The International Energy Agency (IEA) estimates that about 3.8-5.0mbbl/d of global production is uneconomical at $25-30/bbl prices for Brent crude. The industry has responded to the severe price drop by cutting expenses and in particular capital spending plans with the IEA reporting a range of 20-30% in cuts to initial plans for 2020. It would be reasonable to conclude that these and other actions would lead to the removal of about 2-5mbbl/d from an initial supply estimate of 102mbbl/d for 2020. But these will take a few months to alter the supply-demand imbalance and as such all the excess supply will end up in storage.

Global crude storage capacity will likely be maxed out in the next few weeks, currently estimated at 63% capacity with an effective full capacity at 80%, which will force additional significant production cuts above and beyond the above mentioned 2-5mbbl/d – this time by economically viable crude producers. This will likely accelerate, or pre-empt, the currently discussed plans for a new round of coordinated production cuts by OPEC+, or OPEC++ if other countries such as the U.S. join.

All of the above will likely mean that oil prices will remain under pressure for the next 9 to12 months, probably in a price range of $30-40/bbl for Brent crude. However, with a return to some sort of post-lockdown normalcy in early 2021, low oil prices should stimulate demand, and coupled with the massive worldwide fiscal stimuli to the global economy should begin to recover. Following a time-lag, as demand absorbs the stored supply, the supply-demand picture should be tilted in supply’s favour, and oil prices will trend higher – likely to a price range of $45-55/bbl for Brent crude.

The outlook for Iraq, within this scenario, i.e. an average of $30-40/bbl for Brent crude over the next 12 months, is far from benign, but hardly bleak. As noted here in the past, the economic consequences from the continued political paralysis would be that no new budget will be passed, and thus the government will continue to implement the current spending parts of the 2019 budget. However, it will embark on dramatic cuts to investment spending plans and expenditures on goods and services, though it will maintain expenditures on salaries, pensions and social security. These measures could lead to annual expenditures of $69bn resulting in a cumulative 12-month budget deficit of $25bn-38bn. This can be comfortably funded by indirect monetary financing by the Central Bank of Iraq (CBI), with its foreign currency reserves of $67bn as of the end of 2019.

Beyond the next 12 months, Brent crude prices in a range of $45-55/bbl will remove much of the pressure on government finances, but the exact timing of the post-lockdown return to normal with the new level of oil prices means that Iraq cannot avoid embarking on an accelerated and significant set of economic reforms, previously agreed to with the IMF in the 2016 Stand-By Agreement (SBA) but abandoned when oil prices recovered in 2018. However, with an increasingly alienated population these reforms would not come about without meaningful political reforms.

As a measure to contain the outbreak of COVID-19, the government announced a one-week nationwide curfew, starting on March 16th that was extended twice to April 11th. Trading on the Iraq Stock Exchange (ISX) was suspended in response to these instructions and the market, as measured by Rabee Securities RSISX USD Index (RSISUSD), ended the month down 7.1%.

The concentrated selling in the few foreign favoured stocks that began in January continued into March. However, as in February, the list narrowed further, and turnover declined. Given the uncertain global economic outlook, this selling could continue when the market resumes trading. Nevertheless, as Iraq’s equity market was discounting neither an economic nor a corporate earnings recovery, it’s difficult to see why it should decline as other markets have elsewhere. Most global markets have had multi-year bull markets and would need to discount vastly different economic assumptions than those that led to their multi-year rises. This explains the better action by the ISX compared to other markets during the recent sell-off – the decline, at least until March 16th, was less than other markets as can be seen from the chart below and arguably makes the risk-reward profile more attractive for the ISX versus these markets as portfolio allocations are rebalanced in the light of the changed global environment.

Trailing 12-months normalized returns for the RSISUSD Index vs MSCI World Index, MSCI Emerging Markets Index and MSCI Frontier Markets Index.

(Source: Bloomberg)

Please click here to download Ahmed Tabaqchali’s full report in pdf format.

Mr Tabaqchali (@AMTabaqchali) is the CIO of the AFC Iraq Fund, and is an experienced capital markets professional with over 25 years’ experience in US and MENA markets. He is a non-resident Fellow at the Institute of Regional and International Studies (IRIS) at the American University of Iraq-Sulaimani (AUIS), and an Adjunct Assistant Professor at AUIS. He is a board member of the Credit Bank of Iraq.

His comments, opinions and analyses are personal views and are intended to be for informational purposes and general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any fund or security or to adopt any investment strategy. It does not constitute legal or tax or investment advice. The information provided in this material is compiled from sources that are believed to be reliable, but no guarantee is made of its correctness, is rendered as at publication date and may change without notice and it is not intended as a complete analysis of every material fact regarding Iraq, the region, market or investment.

By Ashley Goodall.

At this challenging time what kind of activities are businesses undertaking in Iraq and how are they doing things differently?

In canvassing Iraq Britain Business Council (IBBC) members, we found a consistent pattern of adaptation and response across the membership which can be summarized in three headings:

  • Firstly, taking care of staff and looking after their well-being and income. Members recognize that employees are the most valuable element in a business, and for those who wish to sustain their businesses longer term, employee care is top of the list, with regular online calls and management videos to support people working at distance. Ultimately this is good leadership and communications.
  • Secondly, Technical adaptation: in supporting employees and clients, businesses are undertaking various adaptations, mainly the move to work from home and using online technology to enable this. Often, home video conferences and use of Skype/Teams or Zoom are the first time these systems have been used and should well lead to longer term benefits and changes. In this way businesses are becoming more flexible and productive delivering work and client activities.
  • Finally, Communication: those who work with clients are spending more time supporting them online, especially where an intangible service such as Insurance, Banking or Consultancy are concerned. Communicating, regularly and constantly is key to retaining and supporting client business for the short and long term.

One of the most proactive is Sardar Group who tell us:

Due to the present lock down across all the cities we operate in Iraq, all our companies are working from home.

“Business, which was very busy until the 14th March 2020, has suddenly come to a halt and effected all our business big time by stopping all the operations and thereby stopped all turnover.

“To support our employees, we have Group-wide travel restrictions that are updated regularly based on changing conditions and on advice from governments and health ministries. As well as ensuring that we meet all local regulatory authority requirements, we have instituted additional measures such as reduced face-to-face meetings, working from home, split teams and locations, and cancelling or delaying community events.

“We are arranging salary payment to all the employees in regular intervals subject to the governments relaxing the lock downs. Many companies are unable to pay for salaries, but Sardar Group is planning to support our employees for a longer period of time.

John Goering of Constellis says:

“Our primary business in supporting the Oil & Gas industry in southern Iraq continues to function. With our staffing, we have adopted a one in one out system, so the majority of the staff in now are probably in for a bit of a long haul. We are operating at full capacity, but remain flexible to our clients’ needs and dispositions, it’s challenging times for sure!”

Sara Safa Kasim, MD of Al-Maseer Insurance, quotes:

“We are working from home and at a distance – and have put new systems in place to support that. Enjoyably, we are also connecting more with clients to support them at this time.”

Mike Douglas of SKA said:

“We stand firm in the face of adversity and get the job done. These combined challenges just make us more determined to succeed. Fuel supplies are vital to industry, transport and power generation and we will keep them flowing.

“Of note, the vital dredging we just completed during the curfew, guarantees that the biggest cargos on LR2 vessels, are not stalled; before we started, that size of ship had never been seen in the river. The company was built on the motto of “doing difficult jobs in difficult places” and now, more than ever, that is true.’

“We thank all our local and expatriate staff, and the Iraq Government, for their steadfast support and cooperation. We realize that it is not easy to be away from homes and families in these challenging times, but together we will continue to ensure that the Iraqi people get what they need to overcome these daily challenges. We hope and pray that SKA as a company and Iraq as a nation will emerge stronger at the end of all this.

Shehad Khudairi from the Khudairi Group reports:

We are looking into various options such as online ordering and delivery (via Miswag). At the moment, Iraq is essentially shut down, so we are trying to find ways to continue to do business.

“We are communicating internally a lot more and trying to keep morale high in a very uncertain time, via video messages. Additionally, we are trying to keep the employees as safe as possible with our HSE team. Each branch has to report daily on every single touch point of the offices.

“The HSE team is most useful to our business to ensure the safety of our employees. Additionally, being flexible on how we work and our personnel are key to ensuring we are able to ride this out.

Raed Hanna of Mutual Finance, tells of how technology and online communications via Skype and Hangouts are enabling new ways to communicate for them with video conferences and virtual meetings.

Finally, Phil Malem of Serco Middle East says:

Patients in hospitals rely on us now more than ever. We are preparing for peaks in demand and implementing infection screening and control measures across the healthcare facilities we work in.

“Citizens still need to get from A to B and our frontline staff are committed to keeping vital infrastructure operating. Our business continuity planning and workforce management ensures that sickness leaves of absence do not affect the operational efficiency or experience of those using a service.

“Residents should feel like everything possible is being done to protect them and where we operate in real estate or the higher education space, disinfection is a key priority. Escalating cleaning and sanitisation programmes is increasing confidence within the communities across the facilities we support.

“Across all sectors we operate in, it is our responsibility to ensure all staff are educated and trained on good hygiene practice and understand how they can do their bit to limit the spread of this disease. Increased sanitisation programmes across company provided accommodation and transportation have been introduced. Staff health is being monitored daily with various programmes, including temperature checking, which provides an early warning of the onset of any fever related conditions.

The upshot of all this is that challenging times bring out the best of best management practice:

Do the right things and look after and care for your people, as they are your most valuable asset. Find new ways to adapt and communicate with them, deploy new technology, and ensure your communications are working harder to support clients and staff alike.

While times are challenging, it could be a time to upskill, build in resilience and make your business even more productive for the long term. The future will be different.

(Source: Ashley Goodall, IBBC)