FAST FINANCE

Thank you to everyone who joined us in Bahrain last week for the World Islamic Banking Conference. We were very pleased with the level of discourse that the event generated and have taken note of the feedback we received at the event itself as well as through our Twitter. One of the important things that came out of several sessions on FinTech is widespread agreement that it represents an opportunity for Islamic banking as long as the banks break out of their complacency. Another area of complacency that needs to be shed is in human capital, one of 8 reports launched at WIBC which is the subject of our headline article.

A key need: Islamic finance must embrace human capital Talent Development Goals

The Islamic finance industry is set to create tens of thousands of jobs over the coming 5-10 years; the Malaysia Islamic Finance Centre estimated that more than 1 million jobs will be created in Islamic finance globally by 2020. However, these demand estimates are often at odds with the actual experiences of Islamic finance graduates who struggle to launch their careers within Islamic finance.   The Simply Sharia Human Capital report was one of several launched at the World Islamic Banking Conference, held from 1-3 December 2015 in Bahrain, and as part of the report, a set of Talent Development Goals (TDGs) were identified to coordinate action by the industry and academia to support the industry’s needs and the needs of new graduates.

While some of these lofty estimates reflect the disconnect between the limited demand for skilled professionals in entry-level positions and trends in automation which have reduced the Shariah knowledge required to perform many jobs within Islamic banks. This is particularly true in customer-facing and back office positions in retail Islamic banks where the Shariah compliance processes are baked into the institutions’ procedures. However, once these jobs are taken out of the estimates, the most important needs become clearer.

The Talent Development Goals, which were based in part on a survey of industry practitioners, students and representatives of the educational industry and part on input from thought leadership contributions from a diverse set of industry leaders address the following 8 areas:

• Benchmarking Global Islamic Finance Education
• Talent & Leadership Programmes
• Shariah Scholar Development
• Islamic Finance Data Building
• Marketing, PR & Consumer Education
• Female Participation in Islamic Finance
• Human Resource Blueprint
• Supporting Entrepreneurship

Each of the TDGs has sub-items that need to be studied in more detail by multiple stakeholders within the industry—education leaders, financial sector leaders/institutions and young professionals—to take a deeper look within each goal. The strength of the TDGs is that they are not rigidly prescriptive but it could also become a weakness if the industry’s key stakeholders fail to adopt them and translate each part into specific action plans.

For example, one of the sub-goals of the Talent & Leadership Programmes is to make talent development and HR strategy that is aligned with the workforce skills gap, training, mentoring and succession plans. Taking one area—succession planning—as an example, there is likely to be a multiplicity of views about what, for example, the best form of succession planning is within an institution.

Some may prefer developing a flat management structure where more individuals are given more responsibility so that if quick succession plans need to be acted upon, there will be no formal successor identified but a large pool within the organization from which to choose who can quickly step into more senior positions. Other institutions may have a smaller number of internal candidates who have been identified along with external candidates.

Each system is workable and the one that is preferable will depend on the institutional culture of the organization but each calls for different priorities in terms of internal talent development to ensure that the next generation of leaders are being groomed. To develop the action plans needed to help the industry meet the TDGs, there must be a concerted effort to establish working groups representing the multiplicity of institutional types within Islamic finance paired with educational institutions offering professional development courses to ensure that whichever choice of succession planning that an institution chooses it has the resources to develop enough future leaders.

This particular example is similar to the challenge in other areas because it highlights the critical need to build collective action towards solutions. The problems of ensuring a supply of future leaders suffers from the coordination problems usually associated with public goods. Each institution has an incentive to piggyback off other institutions’ efforts and underinvest in talent development and instead poach the talent it needs rather than invest their full share in talent development. For the industry as a whole, this leads to underinvestment in talent development which is where cooperative action towards the TDGs is needed.

How oil could return to triple digits – Q&A with Emad Mostaque

Emad Mostaque is a Strategist at Ecstrat.

How do you look at the future for oil prices?

We are at an intriguing time as oil has moved from overpricing to underpricing geopolitical and supply risk. The adjustment back is likely to be volatile and the chances of an upside shock to oil prices are growing.

Spot, or immediate, prices are hard to model as demand is not linearly elastic, but dependent on hundreds of variables. Historical correlations also become irrelevant when sharp moves occur.

Oil due for delivery in three to five years is easier to gauge. This should approximate the marginal cost of production for a given level of future global consumption.

While spot prices are well off their lows, future oil is at levels last seen in the depths of the financial crisis when we were braced for a depression. The back end of the oil curve has effectively moved to partial-cycle costs, no longer incorporating full exploration costs. This mispricing has also dried up liquidity for future delivery, with major consumers unable to hedge at $60 even if they wanted to.

How has the shale revolution changed the way that oil markets work?

The shift is how shale producers claim to be profitable at $50 oil when they could barely generate positive cash-flow at $100 as exploration spending has been slashed and service providers squeezed. Oil is produced on a net present value basis; at each stage sales need to cover production costs excluding sunk costs, so the required price falls as wells age.

As prices have fallen, both demand and supply have risen sharply.On the supply slide production has increased at the expense of future ultimate recoverable resources.

In the US, shale companies have focused on their most productive areas, increasing rig density and extraction pressure to pull forward future production. In OPEC, Iraq has surged production and Gulf nations have tapped into their spare capacity. Essential maintenance has been deferred, as can be seen in rising North Sea production.

With the shale producers being responsible for most of the increased production, how does the oil glut get absorbed?

Fears of oversupply may be overstated. US inventories are nearly two thirds full, but part of this has been due to increased oil infrastructure. There are also similarities to the so-called “missing barrels” conundrum of 1999, where a large number of excess barrels were revised away.

Supply is approaching a “Wile E. Coyote” moment, particularly in the US, where production could fall by 1 mbpd versus expectations into the next year as lower drilling and spending catches up with the market.

Shale is not the “marginal” barrel. Contrary to declarations of leaps in “rig productivity”, spud to production time for shale wells can be up to four months. Wells, not rigs, produce oil. Once started shale wells will continue to produce as long as they cover their cash costs. As a comparison measures of OPEC spare capacity assume a maximum 45-day ramp up period.

Shale has also benefited from the easy monetary environment in the US to financing drilling. Confidence to finance new drilling is likely to lag any oil price recovery. Cuts to spending will also hit other nations, particularly those that have had issues attracting foreign investment in the boom years such as Algeria, Nigeria and Venezuela.

Gulf producers who have been diversifying downstream are likely to see seasonal declines as they maintain exports but internal demand subsides. This will be most apparent in Saudi Arabia, where production could fall 1 mbpd from its peak.

New supply from Iran is unlikely to exceed 0.5 mbpd and the oil sector needs over $30bn a year in new investment. The poor political situation in Libya is worsening, as in Iraq where a lack of cash is widening political divisions.

We had Dr. Hani Findakly speaking at the World Islamic Banking Conference last week and he highlighted the highly competitive nature of the shale producing market (6,000 companies of which he though up to 80% would eventually fail as a result of low prices). This competition, he argued, had forced innovation that drove marginal prices down from $120/bbl a few years ago to closer to $40-50/bbl today with some producers being in the high $20s per barrel. If frackers are not marginal producers today, would it be possible for them to drill and cap wells in the most promising regions around the world and become the ‘marginal producers’ that they are not today?

While I respect the opinion of Dr. Hani Findakly I would think of this part of the puzzle in a slightly different way.

If we accept that full-cycle shale cost, ie exploration and production in the US has dropped from $120 per barrel do $40-50/bbl with some in the high $20s per barrel, there are some intriguing outcomes we will soon see.

First is that the unconventional oil sector in the US should, given the prices over the last year, start to generate free cash flow in this scenario in the coming quarters. As noted above, the sector was unable to do this at higher prices over the last few years, although part of this in the 2011-2014 period was due to a move from shale gas to shale oil production. As production shifts from the plentiful Bakken and Eagle Ford to more untested reserves such as the Permian it will also be interesting to see what the blended cost of full cycle production is, as well as the well productivity figures (as a reminder rigs don’t produce oil, wells do).

Second, if this is the case then shale is certainly no longer the marginal barrel. To calculate the marginal barrel one looks at the demand cost curve, so the Gulf for example will be at the bottom of this curve and more expensive oil up to the 95mbpd of demand today will be near the top. Deep sea oil is clearly more expensive than US shale oil, which makes up 5% of global oil production and so would be the marginal barrel. It should also be noted that global decline rates are just over 5%, so the world needs to find another US shale of production each year to just stay still on production, some of which is from cheaper areas like Iraq or Iran, but a good portion of which is from very expensive fields. There have been cost drops on this oil as service companies have been squeezed, but this is another facet of exploration and maintenance spending being slashed in favour of production maximization, something that has short-term gains but will lead to long-term pain.

Finally, there is plenty of oil in the world but the US is unique due to a combination of factors in its suitability for shale production, from easy access to water and credit to property rights and local expertise. Huge reserves such as the Bazhenov shale in Siberia or Vaca Muerta in Argentina do provide future production potential, but only after significant investment which is not currently available and at a full cycle cost well above US shale wells. Thus any recovery in prices would likely lead to rigs being redeployed in the US well before spreading to other parts of the world.

There are huge amounts of oil in the world, the question is at what cost we can explore and produce it profitability. If one holds demand constant around current levels the marginal barrel looks to be even more expensive than before for the full production cycle.

How do the oil majors factor into the supply picture?

Supply from existing fields continues to fall, with decline rates above 5 per cent, or nearly 6 mbpd of oil that needs to be replaced annually. Major oil companies have historically spent at most 12 per cent of sales to try to stem output declines. As sales fall and profits essential for dividends are pressured by falling margins, we can expect further spending cuts even if oil prices rise. To visualize this at $20 capex per barrel, $100bn in cuts means 1.5 mbpd of oil not coming to the market in the next decade. While this will ramp up if oil prices rise as I expect, there is a considerable lag in these spending decisions being made once more and production coming online, even in shale reserves.

As commodities have weakened with the strong dollar and China slowdown, is there sufficient demand to drive prices markedly higher even if supply falls?

Demand is healthy, driven by China and the US in particular. High crack spreads have kept gasoline above $2.50 per gallon in the US, but as refineries come off heavy maintenance this could fall below $2.00 even if oil prices are flat, increasing demand. Chinese demand is likely to plateau but remain solid even as the economy rebalances and slows, with our expectation actually that it approaches 3%. The dollar is a key question, but it is likely that the dollar will start to peak in the coming year as competing currencies look overextended.

Where do you look to convert the picture of today’s low prices with the likely future position?

Oil for delivery in the future can give an indication of where oil prices may end up not as it is a predictor of future oil prices, but because it gives you information as to the marginal cost of production as an imbalance there means that consumers or producers can hedge out risk. As supply falls and demand remains solid, the back end of the oil futures curve should move towards $100 full-cycle marginal cost of off-shore deep sea oil, or even higher given increased demand versus 18 months ago and dramatic spending cuts. The current price for delivery 3-5 years out is reflecting these half cycle costs excluding exploration and other expenses as everyone is in full production maximization mode, but large consumers are unable to hedge their consumption due to a lack of liquidity from producers willing to sell at that level and lock in a multi-year loss.

The shape of the oil curve should also move from contango, where the spot price is below future prices, to mild backwardation, where spot prices are above future prices. We saw this for three years after the Arab Spring and it reflects a market that is either undersupplied, which it wasn’t, or one that fears supply disruption.

The Brent pricing mechanism is particularly susceptible to backwardation due to financial market participants and this may surprise the market in the coming years. The exit of large financial institutions from expensive commodity indices has also pressured Brent, but allowed oil to return from a super cycle to shorter, sharper commodity cycles.

What are the risks (e.g. geopolitical) which could result in higher prices than even your forecast which is significantly higher than consensus forecasts?

Spare capacity is at multi-year lows but geopolitical risk is the highest it has been in a decade. Multiple Middle East and African nations are reconstituting their entire social order as the Arab Spring becomes an Arab Winter. Russia is becoming increasingly assertive and ideological extremism is spreading worldwide as economies stagnate. Daesh continues its rampage, declaring the Paris, Baghdad, Beirut and Sinai attacks as the first of a coming storm, looking to remain in the Middle East but expand aggressively in North Africa and the Sahel where resistance is lower.

Speculators, who remain negative, could easily be caught short by market or geopolitical surprises. For example, an OPEC cut into next year, despite being largely meaningless as Gulf production will subside seasonally, would cause a significant squeeze.

The irrationality of the market at the moment can be seen by the fact that all OPEC would need to do would be to cut production 5%-10% (1.5-3mbpd) across the board and the oil price would almost certainly increase by far more than that, making up what is lost in volume by price.

After years of being too high, oil forecasts now appear too low. As supply rolls over we could see prices back at $100, with decade-high geopolitical risks shocking it higher.