Oil has Oman over a barrel

Published in Euromoney, 27 September 2017

Oman is a country that finds itself surrounded by turmoil. To the southwest there is war in Yemen, to the north a fractious Gulf Cooperation Council (GCC) and to the east the question marks that hang over Iran’s relationship with the rest of the world. Domestically, the local economy is also being undermined by low oil prices.

There are opportunities as well as threats, however. The Qatar crisis in particular offers an opportunity for Oman to increase trade with Qatar, which is now forced to bypass its old trading partners in Saudi Arabia and the UAE. The nuclear deal with Iran also opens up the potential for more trade across the Gulf of Oman. In the longer run, once the Yemen conflict ends, there may be opportunities in the reconstruction of that devastated country.

Indeed, there are already indications that links with Qatar are providing a windfall of sorts. Qatar Airways has been increasing services to Omani airports, and at Sohar port – the closest Omani transport hub to the other Gulf countries – plans are afoot to grow.

“It’s time to start thinking about expanding the port. We’re thinking about reclaiming more land from the sea. We’re evaluating what use we can make of the land,” says Mark Geilenkirchen, chief executive of Sohar Port and Free Zone. “Qatar is putting a lot of cargo volumes through. We see more opportunities to work long term on things.”

Despite this silver lining to the regional diplomatic clouds, making the most of the potential at a time of crisis will be challenging for Oman. It calls for nimble policymaking and wide-ranging reforms that no government would find easy, let alone the one in Muscat, which has long had a reputation for cautious deliberation rather than rapid policy shifts.

Deft footwork

Oman has long been one of the quieter corners of the Middle East, and in the heat of the summer the streets of Muscat are calm. The white-washed walls of the low-rise buildings that characterize the city are in marked contrast to the skyscrapers of other Gulf capitals. Even the traffic feels less frenetic and there is none of the hustle for riches you get in Dubai. But with Oman and its economy being assailed from all sides, maintaining a reputation for stability will require some deft footwork.

The fundamental problem is that Oman is as dependent on oil revenues as ever, but prices are struggling to rise much above $50 a barrel, while the government’s breakeven price is closer to $80. The authorities essentially have three options, none of them easy: they can cut spending, increase borrowing or try to boost non-oil revenues. They are attempting all three at once, but can they do so quickly enough?

Take the mooted oil privatization programme, for instance. In April 2017, Bloomberg reported the state-owned Oman Oil Company was seeking advice from banks to list some units on the local bourse. That fits into a wider regional trend, with plans to list parts of Saudi Aramco and Abu Dhabi National Oil Company (Adnoc).

However, since the story first emerged, little has happened and, according to one government official who did not want to be identified, an IPO is still some way off: “We are trying to structure the financing of the oil sector. The idea is we want to really commercialize our oil and we want to ensure that whatever debts are raised are raised on their own merits. We’re not saying IPOs are not happening, but we’ve got a long way to go and there are a lot of other things we can do.”

Even so, there are some signs of innovation. On August 3, the ministry of finance announced it had arranged a $3.55 billion, five-year senior unsecured loan from a group of unnamed Chinese financial institutions. That followed a $5 billion bond and a $2 billion sukuk issued earlier in the year. The most recent loan means Muscat has met its borrowing requirement for the year, which takes some of the pressure off the government.

The Chinese deal marked a new approach for the sultanate, which had previously bridged its budget deficits by issuing debt to local and Western investors. This loan was marketed exclusively to Chinese institutions and opens up a new pool of investors.

It was not a huge surprise that China was willing to step in. For several years, Chinese firms have been investing huge sums in the port and industrial zone around Duqm, in the south of the country, as part of Beijing’s Belt and Road Initiative. But while the Chinese loan is certainly useful, it only goes part of the way to helping Oman deal with its macroeconomic challenges. Far more will be required to put the economy and government finances on a sustainable footing.

Plan to merge

One thing that might help, at least on the margins, is a plan to merge the country’s two sovereign wealth funds. The State General Reserve Fund (SGRF) and the Oman Investment Fund (OIF) hold assets of $18 billion and $6 billion respectively, according to the Sovereign Wealth Fund Institute. That is part of a fairly healthy cushion of savings Oman built up during the good years.

Recently, the government has been using these funds to cover some of its financing needs, drawing down OR1.5 billion ($3.9 billion) from the SGRF in 2016, according to ratings agency Capital Intelligence.

Although no timetable has been announced for the fund merger, it is apparently just a matter of waiting for the royal decree to be published.

“The two funds ended up duplicating each other to some extent – not entirely but there is an overlap. That’s fundamentally the rationale for the merger,” says the government official, who works closely with both funds. “There are economies of scale from a merger because each fund has its own business support function, its own investment resources. That means expensive staff, IT, subscriptions and so on.”

The sovereign funds can also play a potentially useful role in what is the biggest economic challenge facing the country: the need to diversify away from oil.

Fabio Scacciavillani, chief strategist of the OIF, points to a number of investments his fund has been making to boost local capabilities, including in tourism developments, aquaculture and manufacturing. Its holdings now include Techno Plastic Industries and Sigit Oman Automotive Group, which together are part of a move to develop auto component manufacturing in Oman, taking advantage of the country’s petrochemicals industry. The strategy is, in essence, to pick industrial sectors where there is the potential for high value-add and substantial job creation.

“Why don’t middle-income countries manage to develop? Because they don’t adopt the strategy that puts them into the global value chain,” says Scacciavillani. “Automotive has it all. It is at the forefront of engineering, computing and IT, rubber, plastics, batteries. It’s on the cusp of a great transformation to electric, driverless cars. Yet it is labour intensive. If you put $2 billion into a car manufacturing plant, you generate say 10,000 jobs. If you put the same amount into solar panel manufacturing, you employ 120 people.”

He recognizes the difficulties inherent in such a strategy, but says Oman does not have much choice. “You cannot try to move into low value-added sectors, because people here are not poor. They have an income that is comparable to western countries,” he says. “You cannot hope to provide them with jobs in a sweatshop. You have to have jobs in high value-added sectors. It’s not a choice, it’s a fact. You have to try and go into fairly complex manufacturing, or IT, or knowledge-based industries.”

Initiatives

There are many other initiatives underway to diversify the economy, boost the position of the non-oil private sector and provide jobs for locals, including the activities of inward investment agency Ithraa and the National Program for Enhancing Economic Diversification (Tanfeedh).

Another is Sharakah, a body which promotes entrepreneurialism by helping Omanis set up their own businesses. Since 2007 it has helped 151 local small and medium-sized enterprises with financing and operational support, ranging from Five Oceans, a seafood processing firm, to Galfar Gases, which provides gases to industrial and medical customers.

The collective impact of all these efforts is, so far at least, rather muted. The vast majority of public-sector workers are still Omanis and most private-sector staff are still expats, but Abdullah Al Jufaili, general manager of Sharakah, says things are starting to change.

“I have been working with SMEs, entrepreneurs and start-ups for almost 12 years now and over that time I have noticed the number of individuals who have the willingness and interest to start a business has increased tremendously,” he says. “I have witnessed a paradigm shift. People are leaving school and saying: ‘I don’t want to work for someone else, I want to work for myself’. This is happening more now. And I am meeting more people who are taking early retirement in their late 40s or early 50s to start their own business.”

That is at least helping to keep economic activity ticking over, even as the oil industry weathers a slump. The IMF estimates that in 2016 the economy grew by 3.1%, with non-oil at 3.4% and oil at 2.7%. For 2017, the organization’s projections are for overall growth of just 0.4%, with non-oil GDP expanding by 2.5%, but oil contracting by 2%.

The government may be making all the right noises about getting its fiscal house in order, but so far at least it has found it impossible to implement its cost-cutting and diversification agenda in full. The budget deficit grew from 14.8% of GDP in 2015 to 20.1% in 2016 and is expected to stay in double figures this year, at around 12%.

“All of the Gulf states have made a big play for diversification, and Oman has been similar in that,” says Khalid Howladar, founder of Dubai-based consultancy Acreditus and a former Moody’s Investors Service analyst. “They haven’t quite delivered on their diversification efforts, and that really is the challenge. They’re spending the money in terms of infrastructure and diversification, but they haven’t yet reaped the gains.”

For as long as diversification efforts do not fully deliver, the government will be under pressure to carry on spending to maintain economic activity and provide employment for locals – which is in turn only going to weaken its fiscal position more.

“The government’s investment programme and the drive to create jobs has been the key driver in the economy since the Arab Spring [of 2011],” says Rami Sidani, head of frontier investments at Schroders. “Since the drop in oil prices in 2014, the government has been having a hard time trying to roll back spending. This has resulted in an enormous budget deficit. The government has failed to match the spending cuts outlined in the previous budgets. It has run a deficit of around 12% so far in 2017. That’s lower than in 2016 but it’s higher than budgeted. Oman’s reserves are relatively substantial, but it is burning through them. The uptick in debt issuance will be unsustainable in the long run.”

Stubbornly wedded

As a result of all this, the health of the economy remains stubbornly wedded to movements in the price of oil.

Although Oman has relatively limited oil and gas reserves compared with other nearby countries – with proven reserves of 5.3 billion barrels of oil and 700 billion cubic metres of natural gas, according to BP – the industry remains the dominant feature of the economy. Hydrocarbons account for 52% of GDP, 61% of exports and more than 85% of budget revenue, according to Capital Intelligence.

The cost of extraction for Oman is relatively high, at around $23 a barrel. That is well below the current market price of oil of around $50 so far this year, but alongside the cost of government spending commitments, it means the price of oil needed to balance the budget – the breakeven price – will be $79.20 a barrel this year, according to the IMF, one of the highest in the region.

That situation makes the credit ratings agencies wary of the government’s fiscal position and has been pushing down the sovereign’s rating. In May 2016, Moody’s downgraded its sovereign rating for Oman from A3 to Baa1, pushing it closer to non-investment grade, and changed the outlook to negative from stable. In explaining the move, the agency cited slower than expected progress in addressing the country’s structural vulnerabilities, the large fiscal and external deficits and the expected continued reliance on hydrocarbons for government revenues.

In May this year, S&P cut its rating on Oman from BBB- to BB+, which put the country into junk status. For now, Fitch is siding with Moody’s by maintaining Oman at investment grade, but all three agencies are basing their views on the same underlying data and the fact they are divided about the creditworthiness of the sovereign hints at how finely balanced the outlook is. If Moody’s or Fitch were to also categorise Oman as junk, it would hit investor confidence severely.

“This is very negative,” says Sidani of the ratings agencies’ actions. “It highlights the path Oman is travelling. The current situation is not sustainable. If there isn’t an increase in revenue due to a rebound in oil prices or an aggressive cut in spending from the government, the currency peg [to the dollar] will be put at risk.”

Also undermining the ratings outlook is the fact that the government’s bond, sukuk and loan issuance programme has led to a sharp rise in debt levels. S&P estimates gross general government debt will increase to 36% of GDP in 2017 and rise towards 50% by 2020. That is manageable, but contrasts with debt levels of just 2% in 2014 and highlights the fact that the current path the country is on looks unsustainable over the medium term.

“For more than two decades, Oman hasn’t really borrowed; so as a proportion of GDP, debt remains a fairly low number, but obviously it has to be kept under control,” says Paul Callaghan, partner at KPMG Oman and a long-term resident of Muscat.

Some fiscal reforms are being introduced. A value-added tax (VAT) is due to be introduced sometime in 2018 across the GCC. Other local Omani taxes are also being increased or expanded in scope; although there are question marks about how ready local businesses are for some of these changes. The authorities know that such moves must be done carefully, lest they provoke the kind of social unrest seen in 2011.

“VAT has to happen and I am confident, given the need for it to take place, that it will happen,” says Al Jufaili. “I am concerned how much the average person on the street knows about this. The average person and a lot of SMEs are not aware of what is happening. If it is not communicated properly, it may cause some concern or dissatisfaction.”

In addition, the corporate tax rate has been increased from 12% to 15%, more companies and sectors are being brought within the tax net and fees have been increased for some government services. Fuel subsidies are also being cut, which is having a noticeable impact on the price at the pump. One local says the price of filling up his car has increased from OR7 to OR11, a 57% rise. Callaghan says the expansion of the tax base, including things like a withholding tax on foreign interest payments and dividends paid to foreigners, “may act as a disincentive to invest”.

Bank impact

The economic environment is, unsurprisingly, having an impact on the country’s 16 banks, with credit growth slowing and margins narrowing. Overall, however, the country’s lenders remain in pretty decent shape. According to the Central Bank of Oman, the capital adequacy ratio of banks averaged 16.8% in December 2016, while non-performing loans were just 2.1% of the total.

Abdul Razak Ali Issa, chief executive at Bank Muscat, the country’s largest, says the sector is characterized by “adequate asset quality with relatively low impaired assets and sound capitalization.”

Even so, Dina Ennab, sovereign analyst at Capital Intelligence, points out that: “Omani banks still face liquidity pressures as they mainly rely on the local market for funding.”

This year’s slightly improved oil price has made life a little easier for the banks, but no one is getting too excited just yet.

“The recent minor volatility in the oil price with the small price rebound has had no major impact on the banking sector,” says Andrew Long, CEO of HSBC Oman. “The recent rise is only expected to have a material impact if there is a sustained, larger change over a longer period of time. Overall, due to the volatility, we believe the banking sector in Oman will need to continue to adapt and operate in a more challenging oil price environment for the time being.”

The tough conditions are certainly making it harder to do business. Banks, both local and international, say customers are increasingly cautious.

“Due to the rise in interest rates and tightening liquidity conditions, the demand for overall credit has relatively slowed down,” says Abdul Hakeem Omar Al Ojaili, chief executive of Bank Dhofar.

Long adds: “It is prudent for corporate customers to be selective around new investments or new projects as they manage their trading and working capital requirements carefully. The slowdown in bank lending is a reflection of this trend.”

What may be needed to strengthen the sector is a round of consolidation. In 2012, HSBC Oman bought Oman International Bank. Since then there have been some other merger attempts, including one between Bank Dhofar and Sohar Bank, but they have ultimately come to nothing. Although bankers say it would make sense to have fewer but larger banks, it is not clear there is strong enough appetite to push such deals through, even if the authorities would like to see them.

“Consolidation in the banking sector is required, given the size of the market and number of players,” says Issa. “The government and the central bank have always encouraged such moves. But, mergers are largely driven by shareholders and management.”

There are other areas where improvements could be made that would help both the banks and their customers. Oman is currently ranked 66 out of 190 countries in the World Bank’s Ease of Doing Business list, 40 places behind regional leader the UAE at 26. Companies in Oman complain about difficulties in getting visas for expat employees and of securing all the various permits and approvals needed to conduct business.

“It’s still a work in progress in terms of making it an easy place to do business,” says Callaghan. “It is on the right people’s agendas, but it’s not really there yet. Oman has always been a fairly cautious country, for good reasons. I don’t think it wants to be the fastest place to do business, but it does need to improve its speed. The challenges around getting enough visas and being able to bring in the people you need to do the work and train the young Omanis is a challenge that everybody faces.

“What Oman needs now is to develop the private sector. No longer can the government really create the jobs or drive the economic growth with the oil price where it is. So anything to encourage inward investment is to be encouraged.”

For all the difficulties, there are clearly some opportunities too. Where the fastest growth will come from in the future is an open question, but a few sectors look more promising than others. Among them are tourism, logistics, mining and some areas of manufacturing.

“Although the situation is challenging, we think Oman still has a lot of cards to play,” says Sidani.

The Qatar crisis provides another potential area of growth. Bankers say they have yet to see any sustained impact on their business as a result of the regional diplomatic rift, whether positive or negative, but there has been anecdotal evidence that Qatari investors are increasing their exposure to Oman. The ports at Sohar and Duqm are certainly being used to ferry more goods to and from Doha now that the ports in Dubai are no longer open to Qatar-bound ships.

With a mixture of fatalism and optimism, the government official sums up the situation: “In crises there are opportunities to be smart. Necessity is the mother of invention.”