Four Reasons Why Iraq’s Impact on Oil Prices is Overstated

Written by: Fadi Khalife, Frontier Strategy Group Intern, EMEA

The recent events in Iraq naturally heighten concerns surrounding higher oil prices given the country’s position as OPEC’s second largest crude producer. However, despite a spike in oil prices over the last week due to the expansion of a broad based coalition of Sunni insurgents, led by ISIS, in northern Iraq, this volatility is likely to be short-lived. For MNCs, this means that it may be too early to adjust plans to account for a sustained spike in global energy prices.

Here are the reasons why:

1) Most of Iraq’s oil production and exportation is in the south

The seizure of oil fields appears to be a strategy of ISIS in general, as it has performed similar operations in eastern Syria to generate revenue by selling oil. However, it is important to remember that most of Iraq’s large producing fields and refineries are in the south, an area that has been largely unaffected by militant activity. Iraq’s northern oil exports used to amount to 300,000 bpd prior to March this year, but have since been shut off due to attacks on the pipeline to Turkey.  However, this figure still remains low in comparison to the 2.58 million b/d (as of May this year) that are exported from the country’s southern terminals.

iraq mapMap showing oil fields and pipelines: the most important are most are located in the south away from the fighting (Source: WSJ)

2) The expansion of territory gained by Sunni insurgents is unlikely to continue at its current pace due to the potential of foreign involvement

In particular, both the US and Iran have shown willingness to assist the Iraqi army fight the insurgency. Although Baghdad would be a natural next target for the groups, the capital is heavily fortified and any advancement on the city could trigger foreign military intervention, such as US aerial attacks.  Furthermore, Iraqi Shi’ite volunteers are being recruited in large numbers to counter the ISIS advancement and any attack on Shi’ite pilgrimage sites would almost certainly lead to Iranian military support

3) While fighting at the Baiji refinery is domestically disruptive, the facility does not export any oil

The refinery accounts for one third of the nation’s refining capacity (up to 310,000 b/d at full capacity) but it mainly supplies northern Iraq and Baghdad and does not export any oil products. Three quarters of Iraq’s oil production is in the southern part of the country so the danger to oil exports from fighting at the facility is low

4) The short-term volatility of global oil prices is likely to be mitigated by the thawing of relations between Iran and West

This is because both have an interest in curbing the expansion of Sunni insurgents, and better relations could eventually lead to a boost in Iranian crude exports to global markets which would offset the potential fall in Iraqi production. Just this week, UK Foreign Secretary William Hague announced that the British embassy in Iran will reopen and both the US and Iran have expressed a willingness to collaborate to curb the ISIS advancement

For more analysis of the recent violence on energy prices, FSG clients may access the report here.​

Mexico’s Prolonged Slowdown Continues to Rattle MNCs’ Sentiment toward the Fast-Reforming Market

The Mexican economy has continued to underperform in 2014, with expectations for 3%+ growth becoming increasingly unachievable. Q1 GDP growth came in at a weak 1.8% YOY, far below initial expectations. FSG’s forecasted 2014 GDP growth for Mexico has fallen to 2.5% YOY as domestic demand contracts and an expected recovery in exports is delayed due to US economic weakness. That said, FSG continues to expect that an acceleration of government spending and higher export demand through the remainder of the year will accelerate economic growth, however a recovery in consumer spending is likely to lag well into the second half of the year, as consumers adapt to higher taxes introduced back in January.

Mexico GDP

Meanwhile, progress on passage of key structural reforms has been slower than initially forecasted, although both telecommunications and energy reform are expected to be discussed and passed through extraordinary legislative sessions in June. Multinational sentiment remains bullish over Mexico’s long-term promise, largely as a result of these reforms, but the recent weakness of the economy and slow progress toward passage and implementation of these reforms has somewhat tempered exuberance toward Mexico.

In our latest quarterly market review on Mexico FSG explored three key trends that will have an impact on the business environment and corporate sentiment over the medium term:

  • Market liberalization will create upheaval and churn across key industries in Mexico: As the Mexican government looks to increase competition in concentrated industries, this will create new challenges for incumbent players and open up new opportunities for multinationals thinking of entering the market
  • The government’s centralization drive is transforming B2G dynamics: The government’s reform efforts, while largely supportive of greater market liberalization and private investment also seek to consolidate and strengthen the federal Mexican state against domestic interest groups, state and municipal governments, which will transform B2G sales efforts and government engagement strategies for multinationals
  • Energy costs remain the biggest threat to Mexico’s manufacturing competitiveness: Even as more companies are considering increasing their manufacturing presence in Mexico, rising energy costs remain an important threat to the cost competitiveness of manufacturing in Mexico

For more information, FSG clients can access the full report here.

Back to the Future for Emerging Markets?

“Back to the future”

Despite recent volatility, emerging markets remain in traditional positions within the global economy.  As in the past many emerging markets can be characterized as low-cost production and export hubs, with favorable exchange rates, cheap company valuations, and attractive demographics that can support domestic consumption growth.  While these emerging markets drivers are largely familiar in aggregate, not all emerging markets are created equal.

H2 2014 GPD Blog Post Image #1

The recent period of emerging markets volatility changed corporate perceptions of emerging markets.  Emerging markets went from star “outperformers” to high-risk markets, with companies refocusing resources on recovering developed markets.

H2 2014 GPD Blog Post Image #2

However, the revival of developed market growth will benefit emerging markets as many retain the traditional producer-consumer relationship with develop markets.  That said, the rising tide may not lift all ships. Emerging markets where costs of doing business have increased find that companies are reallocating investment toward lower-cost production centers and/or markets with a more vibrant domestic consumer base.  For example, Samsung recently announced plans to invest $4.5 billion into building two production plants in lower-cost Vietnam in an effort to preserve margins. FSG clients can read more about our emerging markets framework and country-specific management actions by downloading the latest Global Performance Drivers report.

Kenya: Worsening Insecurity Impacts Business and the Economy

As another major terrorist attack has hit Kenya, companies should expect this not to be the last one in the near future. Terrorism is creating a growing sense of fear that is harming consumer-oriented businesses and tourism, a major driver of the Kenyan economy. However, despite causing disruptions and uncertainty in the short-term, rising insecurity will not derail Kenya from its path of economic expansion in the medium-term and companies should ensure that they maintain a balanced view of the impact insecurity will have on their operations, customers, and long-term plans for the market.

Kenya WSJAt least 48 people were killed when militants attacked Kenyan coastal Mpeketoni on June 16th (Picture: Associated Press) 

To put Kenya’s terrorist threat into perspective, it is important to understand the underlying dynamics that form the root cause for mounting volatility:

  • Origins of the terrorist threat: Insecurity arises from political instability in neighboring South Sudan and Somalia. Since the Kenyan army’s military incursion into Somalia in 2011, there has been an upsurge in terrorist attacks on public places. The main threat comes from radical Islamist group Al Shabaab and homegrown Islamist militants.
  • The tarnished tourism industry fuels volatility: Tourist numbers tumble every time a new attack hits the country, triggering a drop in prices for hotel rooms. This leads to a rise in unemployment and economic grievances in coastal areas, which creates a fertile recruitment ground for radical causes.

The Toll on the Tourism Sector
New travel warnings to Kenya’s major tourist areas issued by the US, Britain, France, and Australia could cause large job losses and shave off a 1.0% point of GDP growth. The sector accounts for more than 10% of GDP. The number of tourist arrivals already declined by 7.0% from July 2012 to July 2013.

  •  Weak governance exacerbates insecurity: In its fight against terrorism, the government is mistreating Muslims and has arrested thousands of mainly ethnic Somalis. Its behavior is fueling discontent.

However, despite rising insecurity, Kenya’s positive economic drivers will outshine the challenges: Terrorist attacks will cause sporadic disruptions but the vibrant private sector, rising consumer spending and Kenya’s important role as a hub for East Africa are strong economic drivers which are unlikely to be derailed by insecurity. FSG clients should review our recent report, Market Spotlight: Kenya, which covers Kenya’s medium-term macroeconomic outlook and provides strategies companies can implement to be prepared for a rise in insecurity.

Actions companies can take:

  • Guarantee the security of your employees: Refrain from putting employees in international hotels or from holding marketing events in major hotels or malls, as these could become a target.
  • Adapt to changing consumption patterns: Package goods for consumption activity at home, as consumers are more likely to consume at home because of security concerns.
  • Maintain a balanced view: Carefully assess the risks stemming from terrorist activity to your business operations and demand for your products, as these may ultimately not be significant and should not warrant a decrease in investment in the market.


Emerging Market View: What Our Analysts Are Reading

EM View

FSG’s analysts are constantly speaking with senior executives in emerging markets and staying on top of the latest headlines from around the world. In this week’s Emerging Market View, our analysts have flagged several articles worth noting for the emerging market executive:

As market volatility plummets to multiyear lows, emerging markets are poised to ride the rising tide of global growth. According to Sam Osborn, Practice Leader on the Global Analytics team at FSG, “past volatility in emerging markets has caused some MNCs to shift focus from emerging to developed economies. However, a developed-market recovery is a positive for most emerging markets.” Despite current volatility in markets such as Venezuela and Iraq,  other emerging markets are rising in the ranks of prioritization according to a new MNC sentiment index created exclusively for The Wall Street Journal by FSG.

In fact, seven of the 10 frontier markets identified by the index are in Sub-Saharan Africa.  FSG’s Analyst for Sub-Saharan Africa, Alexa Lion, recently blogged about the East African Community, which includes Nigeria, the #1 identified market according to the frontier market sentiment index.  “Business success in Africa relies on local insights, unique customer segmentation, and long-term relationship building. Although adopting familiar approaches might come naturally to emerging markets executives, they must think outside the box and truly understand each African country’s individual context to succeed,” notes Alexa after reading The Right Way to do Business in Africa.

Meanwhile, Africa’s northern neighbors, Spain and Italy, are in need of a reality check.  FSG’s Lauren Goodwin explains that the “article highlights the view in FSG’s new Western Europe regional outlook that optimistic Q1 economic data for WEUR markets should not prompt companies to set more optimistic targets in their 1-3 year strategic plans. Good weather prompted strong production and relatively unstable emerging markets prompted more FDI, but these one-off trends will not continue, putting Europe’s economy at risk.”  FSG clients should review our Western Europe Regional Outlook report for more information.

MNC Insight: Five things I learned during my 10-day visit to Dubai

I met with more than a dozen Dubai-based senior executives from multinational companies across several sectors. Five important issues emerged during our conversations:

1. Improving performance in Africa is the focus of MEA strategic planning 

During my visit to Dubai, 70% of the companies that I met were focused on improving their performance in Africa. Interestingly, most of the companies use Dubai as a hub for Sub-Saharan Africa. The UAE is already an established regional hub for the Middle East, because of the advanced commercial infrastructure, air travel links to rest of the world (Gulf flights can reach 2/3 of world’s population in 8 hours), access to skilled, albeit expensive expatriate labor, and relative ease of anticipating local costs.

2. MNCs are frustrated increasingly by the procurement process in Saudi Arabia 

Many executives cited an extended and unclear procurement process as an obstacle to business growth. There are new procedures and staff in many ministries, in part to ensure compliance, and this has led to more delays in the approval process. SAGIA, Saudi Arabia’s investment agency, recently announced a new fast-track option for processing foreign investor applications and I will investigate how it is being implemented during my upcoming visit to the market.

3. Executives are still mystified by MENA’s frontier markets, particularly Algeria and Iraq

In Algeria, companies often work through a local partner, but have underperformed due to a difficult operating environment. Many are watching whether President Abdelaziz Bouteflika’s fourth term will usher in an era of growth or support stagnation. In Iraq, most companies do not have enough info to navigate the market appropriately and find it difficult to make the case for resources given dramatic headlines that appear in Western news outlets every day.

4. Investment in Iran is still a taboo topic for many despite the market’s huge potential

Iran has the 2nd largest population in MENA and among the largest oil and gas reserves in the world. Yet the market opportunity still seems too far off for many MNCs, especially those with US headquarters. Interestingly, I met with a consumer-oriented Danish company that is trying to get expansion plans approved by their board. The executives are worried about rising competition from American companies if a nuclear deal is reached in July.

5. Companies are not worried enough about MENA’s vulnerability to a Chinese slowdown

China’s growth trajectory was not a concern for many executives until I connected the dots to the overall health of MENA economies. The Middle East supplies nearly 50% of China’s oil. Strong Chinese demand drove an oil price surge that increased GDP in GCC countries by $1 trillion between 2003 and 2013. In addition, 15% of MENA exports go to China and Chinese-based companies are major foreign investors in the region. As a result, executives need to factor into their strategic plans how a slowdown in China (below 7% annual growth) would hurt economic activity in MENA.

Brazilians on the Edge of Their Seats during the World Cup? You Bet – but not for the Reason you Might Think.

During my most recent trip to Brazil, a week before the start of the World Cup, I was eager to understand the mood of the country, and to see whether Brazil, infamous for miraculously pulling things together at the last minute, would live up to that reputation.

My initial impressions were positive. Upon landing in São Paulo, I was pleasantly surprised when our plane taxied right past Guarulhos’ notoriously decrepit facilities to a gleaming new terminal. Riding on the Marginal Pinheiros into the city, I saw crews busily laying fresh sod along the highway, picking up litter, and painting lanes on the road.

However, the more time I spent in São Paulo, speaking to people from taxi drivers to multinational executives, the more it became clear that enthusiasm for the Cup is as shallow as the roots of the freshly laid sod I’d seen along the highway. Of all the executives I spoke with over the week, only one individual was planning on attending a World Cup match.

This may seem odd in a country where football is akin to religion, but I think it reflects the overwhelming sense of anxiety surrounding the impending spectacle. Brazil’s economy has slowed dramatically in recent years, and only 34% of Brazilians believe that the World Cup will boost economic growth. Meanwhile, the slowdown, which is unlikely to reverse course without major economic reforms, has been long and deep enough to affect Brazil’s notoriously Pollyannaish consumers, whose confidence fell in May to the lowest level since 2009.

Despite the country’s economic malaise, FSG clients have generally been more concerned about hitting profitability targets in Brazil than maintaining their top-line growth rates. However, this perspective has recently begun to shift as companies realize that the World Cup is likely to lead to lower sales and falling productivity as consumers stay home and infrastructure is overwhelmed. Indeed, among the executives that I surveyed during our São Paulo Supper Club, 40% stated that they had low confidence that they would hit their 2014 top-line targets in Brazil, the highest level of pessimism we have ever seen among our clients in Brazil.

In addition to the country’s economic malaise, a lot of the anxiety also seems rooted in uncertainty over whether the event will bring escalating protests and violence, and how Brazil is likely to be portrayed in the global press. Brazilians are right to be anxious, given that the atmosphere is ripe for increased protests, with 72% of Brazilians reporting dissatisfaction with how things are going in their county, and roughly six-in-ten thinking that hosting the Cup is bad for Brazil.

However, a poor showing in the World Cup may be precisely what the doctor ordered for the Brazilian economy. Anything but resounding success could very well prove to be disastrous for the incumbent, Dilma Rousseff, in October’s presidential elections. This is crucial because political change in October is a prerequisite for Brazil to implement meaningful economic reforms. Indeed, a recent survey of investors shows that much more than the World Cup itself is at stake during the 32-day-long football tournament, with those polled forecasting that the BRL is likely to slide to 2.5 BRL/USD if Dilma is reelected.

Given what’s at stake for the future of Brazil during the World Cup, I suspect that many Brazilians will be sitting on the edge of their seats over the next few weeks; however, their attention is quite likely to be more focused on what’s happening off the field than on the field.

Volatility in Venezuela: Using Scenario-Based Forecasts in Strategic Plans

As economic conditions worsen and social unrest continues, multinationals are facing significant challenges in planning ahead for their Venezuelan operations. With both the short-term and long-term outlook for Venezuela unclear, and with government policies lacking coherence and credibility in the face of growing problems, multinationals are increasingly using scenario-based forecasting as they develop their strategic plans for Venezuela.

FSG has recently released for its clients a set of comprehensive scenarios for Venezuela, focusing on the economic and political dimensions that will determine how economic indicators and the business environment will evolve as Venezuela continues to deal with its enormous challenges. The scenarios that we have developed include the following:

Venezuela Economic Scenario Planning Table

Along with these scenarios, we look at the potential for deteriorating economic conditions to lead to greater political instability, which would increase the prospects for regime change, for good or ill.

For FSG clients interested in learning more, the full report is available here.

Tracking Corporate Sentiment about Frontier Markets: New Index by FSG and The Wall Street Journal

Seven of the 10 frontier markets most frequently tracked by multinationals are in Sub-Saharan Africa. Meanwhile, 13% percent fewer multinationals are tracking Ukraine following its ongoing bout with political and economic volatility.

These figures come from FSG’s Frontier Markets Sentiment Index recently published in The Wall Street Journal’s Frontier Markets section. FSG began its partnership with The Wall Street Journal six months ago with the goal of developing a proprietary index that describes corporate sentiment about frontier markets (as defined by the WSJ).

The index relies on anonymous metadata from our clients’ online market prioritization tools to create two proprietary metrics. The first metric is a market inclusion rate which shows the percentage of multinationals tracking a specific market. Argentina has the second-highest market inclusion rate (25%) as companies track it closely while the economy struggles. The second metric is market sentiment which measures period-on-period change in the market inclusion rate. Changes in market sentiment reflect corporate perceptions about frontier markets in response to the changing business and macroeconomic environments.

WSJ FSG Sentiment Index

Matt Lasov, FSG’s Global Head of Advisory and Analytics, alongside with Sam Osborn, Practice Leader on the Global Analytics team, constructed the index in partnership with The Wall Street Journal.  Describing the renewed corporate interest in frontier markets, Sam Osborn says that “we see a paradigm shift of attention from the BRICS, a cluster of countries once admired for high-level growth, to frontier markets.  Frontier markets, though often undeveloped and full of business challenges, provide a great opportunity for many of our clients in the medium-to-long-run as their demographic and economic advantages are bolstered by additional investment flows.”

FSG and The Wall Street Journal will update the Frontier Market Sentiment Index on a quarterly basis.

For more information about the index contact:

ECB’s negative deposit rates will leave eurozone to muddle along

Central banks act when expectations miss to the downside; today was the rule and not the exception. The European Central Bank (ECB) cut interest rates, notably lowering the interest rate on the deposit facility into the negative territory of -0.10%. The ECB’s response to very low price growth is too little too late, but it sends an important message to markets that Europe’s head economists understand the eurozone’s downside risks and are willing to act against them, at least marginally. Europe’s growth will not be improved as a result of today’s action, but the ECB has helped the economy dodge the vicious market correction that inaction would have prompted.

Considering the practical effects of negative interest rates, banks effectively will be charged for any reserve cash they hold over reserve requirements. A reduction of interest rates for banks doesn’t necessarily translate into a reduction of rates for Europe’s business and household savers ─ that’s a decision that banks make on an individual basis and concerns their own margins  ─ but sustained low profits make it likely that banks will carry the cut over to their business and consumer customers.

Lower rates, and even negative rates, will not spur banks to lend, which would provide the much-needed boost for European business which relies heavily on bank lending for their corporate financing. Near-zero rates for years have not improved lending activity, and European bank stress tests will discourage banks from shedding any capital from their balance sheets. Perhaps more importantly, demand for loans will not improve as a result of these measures, nor will banks suddenly decide to trust businesses and households.

Lending is contracting at the fastest rate since the crisis as of Q4 2013
(Loans to non-financial businesses and households, %YOY)
ECB Rate Cut

The ECB assuredly recognizes this shortcoming, and thus announced its intent to intensify the preparatory work related to outright purchases of asset-backed securities (ABS). In other words, quantitative easing (QE) is still on the table for the next meeting on July 3. Although it is not yet clear what assets the ECB can buy within its mandate, quantitative easing would be a large step toward boosting the European economy, reducing the value of an overpriced euro and encouraging export growth in most European markets, creating jobs and reducing inflationary risk.

In the meantime, the ECB’s rate cut will serve only as a market signal. The central bank cannot yet engage the highly politicized QE, but knows that markets would lash back at inaction in light of prolonged low inflation. FSG’s base case for growth in Europe thus remains intact: the region will see very low growth in the long term, which will separate outperforming companies from their peers similar to the Japanese experience of the “lost decade”. FSG clients may use the new Western Europe Regional Outlook, to be released June 9, to outline specific opportunities for growth in a low inflation environment.