Global: The Case of the Missing Petro-Dollars
morganstanley.com
Stephen Roach (New York)
As disruptive as they have been, the oil shocks of the past have all had a silver lining: A significant portion of the revenue windfall accruing to oil producers -- especially those in the Middle East -- has been recycled back into dollar-denominated assets. In earlier oil shocks, the flows associated with these “petro-dollars” have been sizable enough to have contained the damage to US interest rates and to the interest-rate-sensitive components of the US economy. The energy shock of 2005 is different. While sharply higher oil prices may have generated close to a $300 billion revenue windfall for Middle East oil producers, the reflow back into dollars through the petro-dollar effect is largely missing in action.
That conclusion came through loud and clear in my recent trip to the Middle East. While I only spent a few days in Abu Dhabi and Dubai, I had the opportunity to gather views from a large group of decision makers who attended our second annual Middle East institutional investor conference. That conference, in conjunction with a number of private meetings, exposed me to a broad cross-section of investors, businessmen, and government officials from all of the region’s major oil-producing states. They were emphatic and virtually unanimous in stressing several reasons why the financial recycling of this oil shock is very different from shocks of the past:
· First, a significant portion of the oil revenue windfall has been plowed back into surging domestic equity markets. Coincident with the sharp run-up in oil prices, year-to-date gains in stock markets of major Middle East oil producers have been nothing short of spectacular; that’s especially true in Dubai (+166%), Saudi Arabia (+99%), Kuwait (+82%), Abu Dhabi (+80%), and Qatar (+69%). These markets have expanded so much in recent years, they now have the capacity to absorb large oil-related inflows; for example, the capitalization of the Dubai and Abu Dhabi equity markets, combined, is now around US$200 billion -- up dramatically from less than $15 billion in 2000. While there are understandable concerns that valuations in these markets have reached bubble-like proportions, there seems to be no rush to the exits. Awash in newfound revenues, Middle East oil producers now feel strongly about supporting their home markets.
· Second, booming domestic real estate projects have also absorbed a meaningful portion of the windfall. Dubai reminds me of Shanghai’s Pudong a dozen years ago. The scope and scale of this city’s construction boom may not be quite as massive, but there is one key difference: Unlike the Pudong “see-throughs,” which stood vacant for many years, the Dubai units coming on stream in the next two years -- reportedly some 89 condominium towers with over 300,000 units -- have been largely sold or rented. And plans for offshore development in Dubai are staggering. Add in a comparable effort in Doha and you have an entirely new option for petro windfalls that did not exist in earlier oil shocks. As one Middle East asset allocator stressed, “All of us in the GCC (Gulf Cooperation Council, which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates) are now developing and funding our own investment projects.”
· Third, post-9/11 security concerns are seriously hampering Middle Eastern capital flows into dollars. Many cited great frustration over the new regulatory requirements of the US Patriot Act, which require extensive documentation of Middle East portfolio flows into US financial institutions. At the same time, given the ongoing political turmoil in the region, many Middle East investors simply do not want to risk being exposed as pro-American in their asset allocation decisions. “It’s simply not worth the effort,” sighed one major institutional investor when commenting over his newfound reluctance to buy dollar-denominated assets.
· Fourth, Saudi Arabia, the region’s and the world’s largest oil producer, has a public sector debt problem that could absorb a significant portion of the nation’s windfall from higher oil prices. Official statistics put Saudi public sector debt at 92% of GDP in 2004 (source: Economist Intelligence Unit) -- far below the outsize overhang in Japan (164%) but well in excess of that in the United States (65%). This debt, which is an outgrowth of the country’s chronic budget deficits of the 1980s and 1990s, is held largely by Saudi national pension and social security funds. While that means the Saudi Arabian government effectively owes most of its debt to itself, there is good reason to believe that the Saudis will follow the pattern of earlier oil shocks and attempt to use a significant portion of the current revenue windfall to put their fiscal house back in order.
· Fifth, there is deepening concern over the dollar outlook in the Middle East. Despite this year’s rally following nearly three years of decline, most of the asset allocators I spoke with felt there was more to come on the downside. Like me, their concerns are mainly an outgrowth of America’s massive and ever-widening external imbalance. The Middle East “house view” on the dollar is yet another consideration that probably inhibits petro-dollar recycling of the recent windfall of oil revenues.
It is worth stressing again that the above five reasons represent a synthesis of the attitudes I picked up from my discussions with principals in the region. Nor should this attitude be taken to imply that Middle Eastern investors have no incremental demand for dollar-denominated assets. The point is that while there is always demand for dollars, the petro-dollar play this time around appears to be a good deal smaller than in oil shocks of the past. Moreover, it should also be underscored that this conclusion is very much an outgrowth of the sentiment that prevailed during the recent sharp increase in oil prices. Now that oil prices have receded somewhat from earlier peaks, there is less of a revenue windfall to recycle -- underscoring the inherent cyclicality of any petro-based reinvestment impacts.
Interestingly enough, the lack of petro-dollars also shows up in the US capital inflow data. Based on monthly US Treasury data from the Treasury International Capital System (TICS), OPEC holdings of US Treasuries have fallen from a peak reading of $67.6 billion in February 2005 to $54.6 billion in September 2005. To be sure, these flows are for the broader OPEC grouping, which, in addition to Middle East producers, also includes Venezuela, Nigeria, Libya, Algeria, and Indonesia. Moreover, the flows are just for Treasuries and exclude demand for Agencies and other dollar-denominated assets. But they provide a relatively clean read on the demand for the risk-free portion of capital inflows by oil producers into dollars -- a reasonably good indication of trends in petro-dollar flows. And in the midst of a huge run-up in oil prices and oil revenues, these flows went down -- not up, as the petro-dollar play of yesteryear would have suggested. Nor do I think this is a coincidence. The US capital inflow data very much corroborate the intelligence I picked up from the Middle East. These findings also reinforce an observation from our recent Lyford Cay roundtable, where one of the participants typically most connected to Middle Easter investors noted that they were showing little interest in the US equity market.
There could well be broader macro implications of this development. Many have cited the petro-dollar effect as a key reason behind the dollar’s surprising strength in 2005. The above arguments strongly suggest this line of reasoning is not well founded. Others believe that repatriation of some $500 billion of eligible overseas profits back into the US under the Homeland Investment Act may have been an important factor. Stephen Li Jen, head of our currency team, believes that, at most, only about $100 billion of the repatriated profits is “currency relevant” -- that is, either unhedged or not held in dollars. This is a relatively puny amount for global foreign exchange markets with daily turnover now in excess of $2 trillion. By process of elimination, that leaves the US capital inflow story -- and perhaps the fate of the US dollar -- more in the hands of “natural” dollar buyers such as private portfolio investors and foreign central banks. And, of course, in those quarters, the macro debate still rages.
I was pleasantly surprised by what I found in the Middle East. In the short span of some 32 years since the first oil shock, there has been an impressive transformation of the region’s financial and economic base. In the two oil shocks of the 1970s, OPEC was largely unprepared for the staggering revenue windfall. With little in the way of domestic infrastructure and internal development plans, Middle East oil producers focused on maximizing portfolio returns, and dollar-denominated assets became the major beneficiary of petro-income recycling. Today, the region is far more advanced -- it has a much greater menu of internal investment options to choose from. Each country has its own development projects, rapidly expanding internal capital markets, and increasingly sophisticated fund managers who look at a wide range of global portfolio choices, from traditional stocks and bonds to an increasingly broad array of alternative investments in hedge funds and private equity. All too often, these days, I hear a knee-jerk reaction in describing non-US preferences for the dollar: “Where else are they going to put their money?” Go to the Middle East and see for yourself. Dollar-based assets are now only one item on the region’s investment menu.
There’s always the possibility that the asset bubble(s) in the Middle East could burst -- sparking a flight to safety back into dollars. But the pin that pops that bubble would most likely be a sharp drop in oil prices -- a jolt that would also imply less oil revenues to recycle back into any asset class, including dollars. Notwithstanding the potential risks of such a post-bubble shakeout, the basic macro conclusion is inescapable: Dollar and Treasury bulls need to think twice before presuming that an energy shock begets an automatic surge of petro-dollars. The Middle East has come a long way from the plain vanilla petro-dollar play of the 1970s. |
