Room to grow

The Middle East diversifies its economies away from energy, but it is sound fundamentals, including a surge in demand for oil, which bolsters this growth and attracts investors to the region, writes Frances Hughes.

Daniel Day-Lewis's character in the film "There Will Be Blood" strives to make a fortune from oil. Eventually, this quest leads to his downfall.

While it is doubtful the director's intention was to warn cinema audiences about a reliance on oil, what happens to Lewis's character, Daniel Plainview, could be related to the situation in the Middle East.

Like Plainview, the Middle East's fortunes are linked to oil, and if it is unable to reduce its dependence on it, the future might not be so pretty.

The Middle East has most of the world's oil wealth. According to the BP Statistical Review of World Energy, 2008, it has more than 61% proven reserves. It also accounts for more than 30% of the world's oil production.

According to the review, last year it produced 1,201.9m tonnes of oil. This compares with 643.4m tonnes produced in America and 332.7m tonnes in South and Central America.

Since 2003, the price of oil has increased five-fold, while this year alone oil prices have surged more than 40%. At the end of June it reached almost $144 per barrel. At the beginning of 2007 it was about $60 a barrel.

Over the past three years, aided by the huge upswing in the oil price, the Middle East has enjoyed an average GDP growth of 5.8%, according to the International Monetary Fund (IMF).

It estimates GDP per head in the Gulf Cooperation Council (GCC) states (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and United Arab Emirates) at $21,781 compared with $8,434 in Eastern Europe and $6,710 in Latin America, for example. Qatar's GDP per head ranks the fourth highest in the world, according to the Institute of International Finance (IIF), and is estimated at more than $70,000.

Since 2002, the cumulative current account surplus of the GCC states is estimated to have reached almost $1 trillion in 2008, with much of this held in sovereign wealth funds.

While the Gulf states have built up their own assets many British investors are investing in the Middle East. Last month alone five such funds were launched.

Several groups launched funds in the past 12 months, including the Charlemagne Magna Mena, Franklin Templeton Mena, Investec Middle East and Africa, Pictet Middle East and North Africa, Schroders ISF Middle East, SGAM Fund Equities Mena and T Rowe Price Africa and Middle East funds.

Other funds, such as the Fidelity Emerging Europe, Middle East and Africa fund, GAM Star Frontier Opportunities and HSBC New Frontiers, which were launched in January, June and February respectively, invest a large proportion of their assets in the Middle East region. Earlier Middle East fund launches include the JPM Middle East Equities fund, which opened to investors in 1998.

Last month Schroders appointed Rami Sidani to the newly created role of head of Middle East and North Africa portfolio management. It also confirmed plans to extend its range of Middle East funds. Allan Conway, the head of emerging market equities at Schroders, says: "There are strong economic fundamentals in the Middle East. We have hired Rami as the first step in building our resources."

The Middle East region is enjoying a huge current account surplus; while the West is suffering from one of the worst liquidity crises it has ever seen. Again in contrast to the West, the Middle East is experiencing a property boom and is embarking on more initial public offerings (IPOs) at a time when Western companies are more likely to offer rights issues. The Middle East is launching companies while the West is shoring up faltering ones.

Indeed, funds from the Middle East have helped support some of the West's financial groups. Last month it was announced the Gulf state of Qatar is injecting more than £2 billion into Barclays, for example.The Qatar Investment Authority (QIA), the country's sovereign wealth fund, is the biggest new investor in Barclays, followed by Challenger, the company representing the chairman of Qatar Holding. The two have agreed to invest up to £1.764 billion and £533m respectively.

In addition to building up the wealth of GCC countries, a high oil price has enabled their governments to pay down debt.

The Middle East's ability to invest in companies is huge. The Organisation for Economic Co-operation and Development (OECD) estimates Abu Dhabi alone has about $800 billion, while it estimates Kuwait has $200 billion. The increasing importance of the Middle East as an investor in companies around the world is one reason so many fund groups have set up offices in the region.

But investing in companies around the world is one thing; another is the way in which the Middle East is investing in itself. Developing broader-based domestic economies is of crucial importance to the future of a region largely dependent on the price of oil.

High oil prices cannot be guaranteed indefinitely, nor for that matter the oil reserves themselves. Indeed, the ability to reduce their dependence on oil and diversify their economies away from energy is a concern for all GCC states. According to the Standard & Poor's report, How Sovereign Wealth Funds Are Underpinning Gulf States' Credit Quality, these products are central to the region's development and diversification away from energy.

According to Ben Faulks, a credit analyst at Standard & Poor's, the GCC governments' aim is to establish a broader base for economic growth away from oil, and it is this that provides a difference to oil booms of the past. The use of sovereign wealth funds is key to this. He says they are central to the region's longer-term economic stability and prosperity.

Indeed, the long-term investment argument for the region relies on its ability to diversify the range of areas that contribute to its GDP growth.

Oliver Bell, manager of the new Pictet Mena fund, says the interest earned from the Middle East's huge sovereign wealth funds represents a significant diversification of its income already. If the price of oil fell to $50 a barrel tomorrow, from its high of almost $144, he says Abu Dhabi for example, would generate more income through the interest it earns from its' wealth than it would from oil production.

Like Faulks and Bell, many acknowledge the Middle East is spending its money more prudently than during the 1970s boom (see box, above). Conway of Schroders is one of them.

"Everybody thinks of oil when they think of the Middle East," he says. "It has been the cornerstone of thewealth in the region. But these countries have started using these windfalls in a more productive way."

One aspect of this is the huge amount of money being spent on infrastructure projects across the region. According to Pictet Asset Management, $2 trillion of infrastructure spending has been announced in the GCC alone and half of this will be spent in the next five years. In addition, it says 75% of planned infrastructure spending will be outside the oil industry as regional governments seek to diversify their economies.

Other areas of investment include tourism. Dubai is the prime example of a Gulf state promoting itself as a tourist destination abroad. Furthermore, the private sector is heavily involved in its tourism drive. Projects aimed at attracting money though tourism include Palm Islands, which created a further 60km of artificial coastline and the World project, a collection of 250 man-made islands in the shape of the world's map.

According to a report published in February by the Kuwait research programme on development, governance and globalistaion in the Gulf States, 'Diversification and Reform, an introduction', the private sector has provided the main impetus to growth in the GCC region in recent years, unlike in previous oil booms.

Other sectors that are growing across the region include media, technology and manufacturing. In 2006 for example, Dubai's Media City was opened and has become a hub for international media organisations.

This followed the launch in October 2000, of Dubai's Internet City, created to support the business development of information and communications technology (ICT) companies.

Meanwhile, the Qatar government has budgeted for a $63 billion investment in non-energy sectors over the next five years, according to Zawya, a Middle East business information company working in partnership with Dow Jones. It says $17 billion has been allocated for tourism, $15 billion for airlines, $13 billion for infrastructure, $3 billion for utilities, and $15 billion for others.

Industrial development in the GCC also includes medium and small-scale industries, such as the production of cement, building materials and equipment, heavy and light metal products, electrical products and textiles.

Nick Price, manager of the Fidelity Emerging Europe, Middle East and Africa fund, says although infrastructure is still one of the big investment themes, it is not limited to tourism and hotels. He points to the emergence of areas such as aluminium smelting and the production of fertilisers.

Nigel Sillitoe, executive officer of Thames River Capital, Middle East, says Dubai leads the way in diversifying from a petrodollar economy.

"Abu Dhabi and Qatar are not far behind in also seeking a more diversified approach," he says, "and what is particularly encouraging is the expenditure on education, the lifeblood of future success."

Emad Mostaque, co-fund manager of the new Pictet Mena fund, says once the infrastructure is in place the Middle East will become less dependent on the oil price.

"A good example is Dubai," he says. "[It] has almost no oil. All of the oil is with its sister Emirate, Abu Dhabi. But [Dubai] has managed to grow its GDP based on tourism, real estate and the service sector."

Fredrik Nerbrand, head of global strategy at HSBC, is also positive on the Middle East's ability to diversify.

"Eight months ago we were saying that Middle East equities are one of our favourite places to invest, [despite] going negative on equity markets overall." he says. "[But] It's not just because of oil. There are different drivers supporting the [the Middle East] region. There is a growing middle class and the propensity of local investors to invest in their local economies has increased over the last few years. They are seeing more opportunities."

Indeed, the need to find opportunities outside the energy sector is a necessity for investors and fund managers looking to gain access to the Middle East. Not only because it underpins the economic stability of the region but also because most regional energy producers and transporters are still nationalised.

Energy only represents 2.47% of the MSCI Arabia ex-Saudi index. The largest components are financials, at 44.38%, telecoms at 18.48%, industrials at 15.18% and real estate at 8.87%.

Furthermore, there are restrictions on foreign investment in some areas of the Middle East. For example, Saudi Arabia remains closed to foreigners, as does half of the Qatar market. Nonetheless, there has beenconsistent liberalisation of GCC markets. Pro-privatisation policies and a reduction in protectionist measures have opened up the GCC economies to foreign investment. And although the public sector is still dominant across the region, the role played by the private sector has grown.

According to the IIF, private investment in tourism, infrastructure, manufacturing, financials and tele-communications is "buoyant" and has been helped by the inflows of foreign credit and foreign direct investment.

Middle East governments are taking greater steps towards lifting restrictions on foreign investors and improving corporate governance and transparency. Every market in the region, apart from Saudi Arabia, allows portfolio investment by non-GCC investors.

Further encouragement came last month when MSCI Barra announced it is considering the inclusion of some Middle East countries in its Global Emerging Markets index.The GCC countries are not represented. If they are included a much higher proportion of foreign inflows can be expected.

Plans to introduce products such as exchange-traded funds will also help to modernise the region's stock exchange. Last month it was announced that Qatar and the NYSE Euronext are to build a cash and derivatives exchange, for example. Completion of the transaction is expected to take place during the fourth quarter of this year.

But what if the oil price falls? Will the region be able to keep its promise of huge infrastructure spending? And will investors be as keen to put their money into Middle East companies?

A falling oil price will reduce the inflows into government current account surpluses and sovereign wealth funds. However, the budgets set by Middle East governments for public spending are based on an oil price of less than $50 a barrel, or $40 in some cases, according to Pictet.

As pointed out by Oliver Bell and Emad Mostaque, fund managers of the new Pictet Mena fund, at $60 a barrel Abu Dhabi, which has 7% of world oil reserves, will earn more in overnight interest on its sovereign wealth fund, than from its oil flows.

According to Middle East Economic Digest and UBS estimates, quoted by Pictet, the budget break-even oil price for most major producers in the Middle East, is below $50 a barrel. If this is correct, the budgeted infrastructure spending is sustainable even if the oil price falls by more than 65%.

Apart from Algeria and Iran, whose break-even oil price is $41 and $55 respectively, the price of oil would have to fall below $29 per barrel for infrastructure spending to be threatened.

Tom Nelson of Guinness Asset Management and analyst on the Guinness Global Energy fund, says he expects a pullback in the oil price closer to $100 a barrel in the short term. However, longer term he expects the oil price to settle between $150-200 a barrel.

He says demand from non-OECD countries is the important part of the puzzle with regard to the price of oil.

"It's possible that the overall demand will be reduced from OECD and non-OECD [countries] combined," he says. "But OECD demand disruption is a behavioural change. It's a reaction to price. The demand we're seeing from the non-OECD, developing world, is not behavioural. These countries are industrialising and developing and that's a far stronger force and not one that will be dampened by higher prices."

"When people talk about burgeoning oil demand from non-OECD countries it has been China and India that receive most of the focus," he says. "But a quarter of that demand growth will be coming from the Middle East."

According to the International Energy Agency (IEA) Oil Market Report published on June 10, 2008, the growth in demand for oil in the Middle East is not much different from China. The report estimates 2008 oil demand growth from China at 5.5%, while demand from the Middle East is estimated at 5.1% this year.

One aspect of this demand is a rapidly growing middle class in Saudi Arabia among whom car ownership is increasing dramatically, says Nelson.

Secondly, while subsidy programmes have changed in India and China, they are in place in the Middle East. "They can afford to maintain these fuel subsidies," says Nelson.

According to the IEA report, total demand from non-OECD countries in 2007 was 36.89 billion barrels a day, of which the Middle East's demand constituted 6.51 million barrels a day and China's, 7.85 million barrels a day. In 2008 it estimates these figures at 38.14, 6.84, and 7.95 respectively.

For many in the investment industry the fundamentals behind Middle Eastern growth are sound. The increased demand for oil from China and India in addition to the Middle East itself supports this outlook.

In addition it is generally accepted that if the oil price were to halve tomorrow the planned investment in infrastructure and other non-energy related projects would still go ahead.

Middle Eastern markets opening up to foreign investment is another driver. The growing number of IPOs on its stock exchanges demonstrates the beginning of its economic diversification.

In addition it is likely to encourage more investment from both foreign and domestic investors as they are given more choice. Similarly, the inclusion of the Middle East in wider emerging market indices would encourage more investment from abroad.

Although the wealth in the Middle East has come from oil, it does not necessarily follow that the bulk of its earnings must be related to it. Oil wealth has given the Middle East the chance to move away from the hand that has fed it and plant new seeds for growth, unrelated to energy.

Comparisons with the 1970s

Many commentators see parallels between the experience of the Middle East in the 1970s and what it is going on today. At that time the region boomed as the oil price surged. The catch is that as the oil price slumped in the 1980s so did the region's economic performance.

Investors in the Middle East will be hoping that the painful experience of the 1980s will not be repeated. Fortunately, the 1970s oil price surge had peculiar features that are unlikely to recur. Even if the oil price does fall it is unlikely to take the same form as the previous bust.

The 1970s was a turbulent time for the price of oil. A series of events resulted in supply shocks, with the production and exportation of oil linked to politics. By 1974 the oil price had quadrupled, having gone from $9.65 in 1970 (in 2007 dollar terms) to $48.92. But it was between 1973 and 1974 that the oil price really shot up, more than tripling within 12 months.

The rise began when members of the Organisation of Arab Petroleum Exporting Countries (Oapec, the Arab members of Opec in addition to Egypt and Syria) announced an embargo against Western states in October 1973.

The embargo was intended as a punishment for the West's support of Israel, in the October 1973 Arab-Israeli war. Shortly afterwards Arab producers also announced a 25% cut in output.

Following the embargo imposed on the West, American imports of Arab oil fell dramatically, with America suffering its first fuel shortage since the Second World War. European countries were also hit by the high price of oil.

In retrospect, 1973 marked a turning point in the world economy. It grew much faster before that date than after it. At the time the problems were often attributed to oil. But stagflation, a painful combination of stagnation plus high inflation, was a worldwide problem. In retrospect it can be argued that oil was not the cause of the problems although many blamed it at the time.

In 1979 there was a second oil crisis, brought on by the Iranian revolution. Until that time Iran was a key American ally in the region. So the overthrow of the pro-American shah was an enormous blow to America's power and prestige in the region.

Oil production in Iran reduced dramatically during this time, from 5.3m barrels a day in 1978, to 3.2m in 1979 and just 1.5m in 1980, according to the BP Statistical Review of World Energy, 2008.

Over the same period the price of oil increased from $44.77 in 1978 (in 2007 dollar terms) to £90.68 in 1979. In 1980, the price of oil climbed even further, reaching $93.08.

Furthermore, when Iraq invaded Iran in 1980, it affected not only Iran's oil production, but also its own. From 1979 to 1981 oil production in Iraq fell from 3.5m barrels a day to 0.9m barrels a day.

After 1980 however, there was increased oil production from other oil exporting countries. Mexico in particular boosted its oil production, going from 1.6m barrels a day in 1979 to 3m barrels a day in 1982. Between 1980 and 1984 oil exports from Mexico doubled. Meanwhile, the demand for oil was declining, with oil imports to America, Europe and Japan falling each year from 1980 until 1984. From 1980 the price of oil began a six-year decline.

What constitutes the region?

In theory the Middle East could stretch from Morocco and Mauritania in the west, to Kyrgyzstan and Pakistan in the east. Fund managers and fund groups often have different definitions. There is also a debate about whether Israel and Turkey should be included.

Pictet Asset Management defines the Middle East as "those countries that share a common Arab or Persian heritage and will benefit from the oil boom."

HSBC defines the Middle East as the Gulf Co-operation (GCC) countries of Saudi Arabia, Bahrain, Kuwait, Oman, Qatar and the United Arab Emirates (UAE).

Meanwhile, the Schroders ISF Middle East fund invests in a customised greater Middle East benchmark, a market capitalisation weighted index of Bahrain, Egypt, Jordan, Kuwait, Morocco, Oman, Qatar, Saudi Arabia, Turkey the UAE and other non-GCC countries.

With regard to Israel, Nick Price, manager of the Fidelity Emerging Europe, Middle East and Africa fund, says he does not include it in the Middle East, because he regards it as a more developed market. At the end of last year, FTSE also excluded the country, by removing it from its emerging market indices. As for Turkey, Price says the country fits better into an emerging Europe category, rather than Middle East.