Post courtesy of Suha Najjar and Akkadia Partners.
After what was one of the most turbulent years in Iraq’s modern history, there are reasons to be cautiously optimistic about Iraq’s Economy. The events of June when the so-called ‘Islamic State of Iraq and Sham (ISIS) captured Mosul and reached the gates of Erbil were ensued by a military campaign and forming a new, more widely accepted government. In addition, a breakthrough agreement was reached between the Central Government and the Kurdistan Regional Government (KRG). The political situation seems to have settled but the military conflict continues. A victory against ISIS is more likely than not, but the timing, extent and repercussions remain unclear.
Iraq’s economy took a double hit in 2014 with the decline in oil prices and the advancement of ISIS into large parts of the country. According to our estimate, GDP is likely to have contracted by 2.3% in 2014 and is expected to witness a sharper decline of 3.7% in 2015 before it starts to accelerate in 2016. This is due to lower oil prices and to a lesser extent, the loss of economic output in the ceased territories. The 2014 budget is expected to record a deficit, which is likely to reach 9.5% of GDP in 2015. The shortfall is a function of lower oil prices and the escalating cost of the military operations.
Oil production reported a marginal growth in 2014. Average daily production stood at 3.1 mbpd compared to 3.0 mbpd in 2013, despite a temporary loss of production in some of the northern fields. The sector was intact as 87% of Iraq’s production comes from the southern fields, which continued to report growth in output. Assuming no further deterioration, production should report healthy growth in 2015. However, official expectations of 3.8 mbpd might prove ambitious.
The stock market suffered a blow as a result of the year’s events. Foreign selloff reached over 80% of turnover in some of the large market caps and pushed prices to record lows. On a year on year basis, the official Iraq Stock Exchange (ISX) index was down 18.8%.
Earnings of listed companies took a hit as a result of economic contraction and political deterioration. Baghdad Soft Drinks (IBSD), the largest industrial stock by market capitalisation saw its earnings drop by 8.5%. Given the se- verity of the year’s events, the loss to earnings appears to be limited. The banking sector was worse affected with earnings decline of over 20%. Our largest holding in the sector, Bank of Baghdad (BBOB), reported a 22% drop in profits in the first three quarters of the year.
GDP and GDP Growth:
Since 2009, real GDP growth in Iraq has been one of the highest amongst developing countries, driven by an accelerated in- crease in oil production. The IMF has forecasted real GDP growth to average or exceed 8% for the period 2013-2018.
Growth over the past two years has fallen short of expectations. During 2013 real GDP growth slowed to 3.7% due to a drop in oil exports. One of the bottlenecks in Iraq’s dynamic oil sector is poor refining and export infrastructure. The IMF stated towards the end of 2014 that real GDP growth will drop by nearly 0.5% in 2014. Our own estimate indicates that GDP is likely to have dropped by 2.3% in 2014. Our estimates are based on the following factors:
According to Iraq Ministry of Oil, average production in 2014 was 3.1m bpd. This was below the hoped for 3.5 mbpd as a result of the interruption to production in the northern fields,
According to the same source, prices achieved in 2014 were at an average of USD 92 per barrel, compared to USD 102 per barrel in 2013,
Oil generates close to 65% of GDP. The second largest contributor to GDP is social services at 14%. The non-oil sector is likely to have contracted in 2014 on the basic assumption of a halt in operations and loss of eco- nomic activities to ISIS in the ceased territories. In addition, investments and trade throughout the country are likely to have contracted.
Oil producing countries experienced negative shocks to their economies as a result of the sharp decline in oil prices during the last few months of 2014. Iraq is likely to be one of the worst affected, over and above the impact of lower prices due to the following:
-Loss of economic output from the territories captured by ISIS,
-Slowdown in economic activities and investments across the country due to political uncertainty,
-Interruption to production in the northern fields, High dependency on oil, which generates 65% of GDP and 98% of public revenues.
We anticipate that GDP will witness a sharper decline of 3.7% in 2015 based on the following assumptions:
Government estimate of production at 3.8m barrels per day. This estimate assumes that production from the northern fields will not be interrupted and will be consolidated with the rest of the economy. It also assumes some growth in the southern fields. While such fore- cast is not unrealistic, it might be a bit ambitious given the various challenges facing the sector namely poor infrastructure and a hostile security situation particularly in the northern parts of the country.
GDP composition is unlikely to change in the foreseeable future. The new government seems to have the intention to reform on both the political and economic fronts. It is possible for Iraq to witness a pickup in investment activities during 2015 as government efforts to attract foreign investment and rebuild the country bear fruits. This is likely to have a positive impact on the non-oil sector but it will not necessarily alter the composition of GDP in the short term given that growth in the hydrocarbon sector will continue to outpace that of other sectors,
Oil prices have dropped below USD 50 per barrel in the early weeks of 2015. The draft budget assumes a price of USD 56 per barrel. By far, lower oil prices are the most detrimental factor for the Iraqi economy in 2015. Although Iraq is expected to witness the highest growth in oil production amongst oil producing countries, in the short term, such growth will be insufficient to offset the sharp decline in oil prices.
The budget is a central point in Iraq, on various fronts and for various reasons. Aside from the many issues surrounding it, it is generally difficult to accurately assess the figures. According to the Central Bank of Iraq (CBI) statistics, the budget has exhibited a surplus until 2013. This does not come as a surprise given the rapid growth in oil revenues. A fiscal surplus is always a welcomed indicator especially for a war torn country in desperate need of reconstruction, however in Iraq it demonstrates a deficiency in spending policies. The lack of progress on the capital spending meant that public services and rebuilding efforts were minimal leaving the country with poor infrastructure and for the large part, a dysfunctional economy.
The Ministry of Finance publishes budget proposals that show the composition of spending between operational and investment at 70% and 30% respectively. Investment spending has consistently fell short of projections. This came to the detriment of a sustained economic growth leaving the economy extremely vulnerable to economic and political shocks as was demonstrated in 2014.
Another factor to take into consideration is the high level of corruption prevailing during previous administrations. It is not possible to accurately assess the magnitude of government revenues lost to corruption, but they are likely to be significant.
The budget is a victim of a hostile political environment. It can be viewed as a result but also a cause. The most obvious case is the dispute between the Central Government and the Kurdistan Regional Government. A disagreement centering on oil contribution from the region to the central bud- get and actual payment of the region’s 17% share of the budget has been a stumbling block economically and politically for years. It was also used as a tool for forming political alliances over the years. Less publicised issues were the dissatisfaction of a number of provinces, especially the oil rich ones, with their share of the budget relative to their contribution.
The budget issue came to the forefront in 2014. With high level of uncertainty prior to and during the elections followed by the rapid advancement of ISIS into the north, a budget was never passed. The figures have not yet been published but it is likely that the budget will exhibit a large deficit. On one hand, revenues are expected to decline reflecting lower production and prices. On the spending side, escalating costs of the conflict with ISIS have taken their toll on the budget. These are composed of two elements; funding the military conflict and to a lesser extent, subsidising an internally displaced population of nearly 2 million people.
With supressed oil prices and ongoing military operations against ISIS, the 2015 budget is also likely to see a wide deficit. A draft submitted earlier in the year proposed some austerity measures. A budget for 2015 of IQD 119 trillion (USD 102 billion) was ap- proved by parliament towards the end of January. The budget was based on oil production expectations of 3.3 million barrel per day at a price of USD 56 per barrel.
Revenues were set at IQD 94 trillion (USD 80 billion), including oil revenues of IQD 80 trillion while the balance of IQD 14 trillion were non-oil revenues consisting of taxes, public sector profits and others. The budget follows an agreement with Kurdistan Regional Government (KRG) whereby the latter will export 300,000 barrels per day of oil from Kirkuk and 250,000 bpd from their own fields in return for a 17% share of the budget. The proposed 2015 figures mark a contraction from previous years. The main challenges posed for the government finances in 2015 are the sharp decline in oil prices, an escalating cost of the conflict and compensating a displaced population.
Expenditure was budgeted at IQD 119 trillion (USD 102 billion) leaving a shortfall of IQD 25 trillion. Of which IQD 80 trillion (USD 68.6 billion) are operating expenses and the balance of IQD 39 trillion (USD 33.4 billion) or 32% of total expenditure consist of investment spending on existing projects. The expenditure figures indicate some tightening, where possible. The government will withhold 15% of high-level government salaries, to be paid back in the future. In addition, Kuwait has agreed to defer Iraq’s repatriations for the 1990 war for one year.
The deficit is proposed to be financed through local and foreign borrowings. In addition, Iraq plans on drawing funds from the International Monetary Fund (IMF) through its Special Drawing Rights (SDR). Import duties are likely to be introduced this year to compensate for the decline in oil revenues, however, this has not been included in the budget.
The Monetary Environment:
For a war economy, Iraq’s monetary environment is solid. This is demonstrated through relatively low and stable inflation and interest rates. This is a function of dollar denominated revenues, which have accumulated sufficient level of foreign currency reserves providing a comfortable cushion for the Iraqi dinar. The acceleration of oil production meant that foreign currency revenues were continuously exceeding foreign expenditure, which consisted of imports and to a lesser extent foreign obligations.
Inflation was therefore kept at bay with a currency that is effectively pegged to the dollar. Interest rates in Iraq are low for a post war country. However, an important consideration when assessing the monetary environment in Iraq is that interest rates are not necessary used as an indicator or a monetary tool in Iraq for a number of reasons. First, and typical of a frontier economy Iraq is predominantly cash based. According to the Central Bank, only 12% of money issued goes through the banking system. Banking penetration in Iraq is exceptionally low. Total banking credit to GDP is at 14% while loans to deposit ratio is 20%.
The banking sector, where interest rates are used as an effective tool, do not operate as a proper conduit for the economy in Iraq. The consolidated balance sheet of commercial banks is small compared to the size of the economy, let alone its potential size once economic capacity utilisation reach normal levels. This is partly self-inflicted but is also a function of the general security and economic conditions.
With sufficient foreign reserves, the Iraqi dinar was stable throughout the year, despite the decline in foreign revenues and a corresponding increase in foreign expenditure. This is partly attributed to a slowdown of non-military exports. A stable monetary environment was also reflected in the size of the Central Bank of Iraq (CBI) daily currency auction, which did not witness an increase. It is not unlikely that the Iraqi dinar sees some depreciation in 2015 with a prolonged military conflict and depressed oil prices. And these two factors remain key for the outlook on the currency and every other aspect of the Iraqi economy.
The government started the year 2014 hoping for a big rise in oil production and exports. Oil in Iraq is mainly produced from two regions (north and south). The bulk of Iraq’s oil is produced in the south and shipped abroad through the Gulf. Key southern fields are Rumaila, West Qurna-1 and Zubair. The giant West Qurna-2 field began commercial production in March 2014. Production in the southern fields has been rapidly expanding since 2010 following rounds of oil auctions whereby Baghdad signed a series of service contracts with major International Oil Companies (IOC’s).
The Kirkuk oilfield is the most strategic in Iraq’s northern production. Kirkuk is connected to world markets by a pipeline to Turkey’s port of Ceyhan. Exports of 300,000 bpd from Kirkuk ceased since early March 2014 for almost 200 days due to attacks on the pipeline, which carries about a fifth of Iraq’s total crude exports. Militant attacks also prevented repairs threatening to extend an outage that is the longest since the sanctions years of the 1990s. The pipeline resumed operations in October but at lower capacity.
The closure of the northern route has held back a hoped-for growth in exports that was also hampered by the dispute be- tween the Central Government and Kurdistan Regional Government. An average of around 300,000 bpd was pumped through the Kirkuk-Ceyhan line in 2013. It was projected that exports would reach 1 million bpd by the end of 2014 with the help of a new 200-km pipeline to Turkey.
Production range in 2014 was at 2.85–3.36 million barrels per day. Average production stood at 3.11 mbpd. As illustrated in the table below, exports from Iraq’s southern terminals reached 2.76 mbpd in December, the highest since at least 2003. Total exports ranged between 2.23 and 2.94 mbpd with the average around 2.52 mbpd equating to an average revenue of USD 7,010 million per month.
As most of the oil reserves are in the southern fields, thus beyond the reach of the so called militant group, ISIS, oil production was not impacted. Based on data published by the Ministry of Oil, production levels in 2014 stood at an average of 3.11 mbpd, up from 2.98 mbpd in 2013, with exports slightly increasing over 2013 levels at 2.5 mbpd. The average price of Iraqi oil was USD 92.3 per barrel compared to USD 102.2 per barrel in 2013.
June was one of the deadliest months in Iraq since calm was restored following the civil war in 2006-2008. On the 10th of June the so called “Islamic State of Iraq and Sham” otherwise known as ISIS took control of Mosul, the second largest city in Iraq and started progressing towards the capital. There were conflicting reports about the country’s largest refinery in Beiji being lost to ISIS. Iraqi forces were able to recapture the refinery in the weeks that followed. With the risk of further advances by ISIS, Kurdish forces took control of the oil hub of Kirkuk, a disputed territory between the Central Government and the KRG.
Confined to its southern terminals, Iraq’s oil exports and production, were not materially affected. Oil companies operating in the south were unanimous in their action and statement of no disruption to their operations.
In early in 2014, the former Iraqi government cut budget transfers to the Kurdistan Regional Government (KRG) over oil disputes. The conflict over oil reached a climax when KRG announced that it was prepared to pump oil through a new pipeline directly to Turkey, bypassing the Central Government. The KRG’s exploitation of its own oil resources has been at the centre of a long-running dispute with the Central Government. The government in Baghdad insisted that Kurdish exports through the pipeline are illegal under Iraqi law and took it as far as launching legal proceedings. In the meantime, Kurdistan was exporting some of its own oil output by truck and via a new pipeline to Turkey, despite pressure from Baghdad.
A breakthrough in the longstanding dispute took place following the appointment of the new government in October 2014. The Central Government and KRG reached an agreement that allows for the resumption of long-withheld budget transfers to the Kurdish region. The new deal stipulates that KRG will contribute 250,000 barrels per day of its own oil exports to the federal bud- get. In addition, another 300,000 barrels will be exported from Kirkuk, which is currently under the control of the KRG, through a pipe that extends through Kurdistan to Turkey. This is an initial agreement that will be rolled over until such time when a more comprehensive agreement is reached.
According to the Minister of Oil, production and exports should enjoy healthy growth in 2015. The official forecast by the Ministry is 3.8 million barrels per day, including KRG production (the budget is drafted at 3.3 mbpd). If materialised, this will be an increase of 15% over the 2014 levels. The outlook on prices remains shadowed but prices are unlikely to rebound to 2013 levels during this year. The long term outlook on oil production in Iraq remains positive especially now that the decline in prices lessened the com- petition from alternatives. The agreement with the KRG is a welcomed development assuming it is sustainable. A tight budget and poor state of the sector’s supporting infrastructure such as refining and transportation are pushing the new government to adapt a more welcoming policy towards foreign companies. As is the case with every aspect of the Iraqi economy, unity and security will determine the faith of the sector and the country as a whole.
Iraq Stock Market:
The ISX ended the first three months of the year lower than its 2013 close level. April saw the index reverse and regain some of its losses. The gains extended throughout May but at a slower pace. June was one of the worst months in terms of security since calm returned to the country after the civil war in 2006-2008. The ISX was down sharply in June when it lost 14% on a month on month basis. This was the biggest monthly decline for the index. The market also witnessed high levels of Non-Iraqi sell offs reaching 86% of the total volume in a number of large market capitalisation stocks. July also continued the negative trend but to a lesser extent. Positive sentiment returned to the market during August as the new government was taking shape and the international coalition to support Iraq in its fight against ISIS gathered momentum. The index recaptured some of the losses realised during the previous two months and gained 7%. The index remained flat during September, however, the Non-Iraqi sell off sentiment continued to constitute a high percentage of market volume.
Since October 2014, the ISX official website stopped calculating and is- suing the ISX index due to certain technical problems. We estimated the index level based on the monthly price change of individual stocks taking into consideration the weight of each stock based on its market capitalisation. According to our estimates, the index dropped by 9% during October on the back of poor performance of the banking sector and several other sectors. Banking stocks, which collectively constitute around 50% of the market capitalisation, fell on average by 6%. The telecommunication sector represented only by Asiacell (TASC) and accounting for almost 37% of total market cap, lost 14.5%. November saw the ISX index lose a further 2% of its value mainly on the back of a 4.5% decrease in the telecommunication sector, a 2.3% decrease in the industrial sector, and a 4.6% decrease in the tourism and hotel sector.
The ISX saw mixed performance for large cap stocks during December. On average, the largest companies saw a positive increase of 2.4% during the month. Asiacell (TASC) saw its shares climb by 2.77%. Banking stocks, witnessed mixed performance with Credit Bank of Iraq (BROI) leading the gains by 10.5%, followed by Gulf Commercial Bank (BGUC) at 7.1%. Bank of Baghdad (BBOB), one of the largest banks by market value, lost 3.1%. The overall banking sector performance was positive during December at approximately 2.6%. The industrial sector also saw varied performance amongst its constituents with Baghdad Soft Drinks (BDSI), which is the largest contributor to the sector, declining by 1.7% while Electronic Industries (IELI) appreciating the most within the sector by 11.9%.
The overall performance of the market during 2014 was negative, with the majority of large cap stocks finishing the year in the red. On a year on year basis the ISX lost 18.8% in 2014. The turbulent political and economic situation fuelled this decline particularly in the second half of the year.
The tourism and hotels sectors were the market top gainers rising 16.6% and 2.3% respectively. The performance of the other sectors was negative but to varying degrees. The telecommunication sector, which is dominated by Asiacell, was down 29.7% by the end of the year. The investment and banking sectors were also among the worst performing sectors declining by 23% and 21.7% respectively. The industrial sector, which ac- counts for almost 5% of the ISX index ended the year down by 13%.
Other Market Developments:
Change in trading systems. The ISX and NASDAQ announced in November the successful on-schedule go-live of the X-Stream Trading System, which replaced the existing Horizon platform. NASDAQ has delivered trading technology to the ISX since 2007.
New listings: The ISX did not report new listings on the official market during 2014.
Kirkuk for Producing (IKFP) was delisted from the market as of 2014 as per the ISX letter on 26/11/2013, bringing the total number of listed companies on the ISX to 83 companies.
With the exception of the banking sector, using earnings performance of companies listed on the Iraq Stock Exchange as an indicator of corporate performance has its limitations. The majority of companies listed on the exchange are residuals of the old Baghdad Stock Exchange. Most of these are either non-operational or non-profitable. Private sector companies that have been able to benefit from the economic transformation and upturn following 2003, continue to be privately held, i.e., not listed. Another important factor to consider is that a number of sectors in Iraq continue to suffer from the physical damage caused during years of conflict, mismanagement and neglect. The worse destruction was caused during and following the attacks in 2003 where premises and country wide infrastructure were destroyed on a wide scale.
One of the fund’s largest holdings is Baghdad Soft Drinks (IBSD). It is one of the market’s large capitalisation stocks and perhaps the only profitable in listed sector companies. In absolute terms, the revenue and profit base of the company are low when considering that it is one of the three Pepsi Cola franchised bottlers in a market of 35 million people. Nevertheless, the company has been able to grow its revenues and profits over the past few years, albeit modestly, benefitting from its modern facilities, a growing market and improving overall operating conditions. On a compounded average basis, revenues grew by 8.4% during 2009-2014. This is lower than the corresponding growth in GDP per capita, which stood at 10.4% in the same period. The slow growth in revenues is due to strong com- petition from cheaper imports and the start of other bottlers’ operations in other parts of the country. Net profits grew by an annual average of 23% in the same period. Margin expansion was a function of improving infrastructure, thus a reduction in costs. In addition, utilising its own distribution channels resulted in significant cost savings and contributed to the improved profitability.
The company was negatively impacted in 2014 where sales and profits dropped by 7.8% and 8.5% respectively. Given the gravity of the year’s events, the decline was relatively limited. This can be attributed to the same factors that prevented the company from rapidly growing its sales over the past few years. First, the Iraqi market is by large serviced by imports that have been worst impacted in 2014. This was particularly the case since the borders with Turkey and Syria, Iraq’s largest trading partners, have been controlled by the extremists groups. In addition, the company’s geographic focus areas, which are the central provinces, have been less affected by the advancement of ISIS.
For obvious reasons, future projections for companies operating in Iraq might lack credibility due to the high level of uncertainty on the different fronts. Assuming the security situation does not further deteriorate and the company’s areas remain relatively secure, large drops in revenues and profits are unlikely due to the above mentioned factors. In fact, it is possible that the company will be able to grow its revenues over and above the historic levels as it captures market share from imports. In addition, the newly formed government seems more serious in implementing import duties as a tool of raising desperately needed public revenues but also as a protection measure for the local industry.
Based on year-end prices and results, and from the outset, the company does appear to be reasonably priced based on multiples, when taking into consideration the risk factors. The stock is trading at a PER14 and P/NAV14 of 13.9x and 1.6x respectively. However, we continue to argue that the case for Iraqi equities is the expansion of earnings rather than multiple expansion. We carried an exercise using consumption per capita figures, captured population and taking out the impact of imports. Based on our top down analysis, in a normalised environment BDSI sales should be a 3x multiple of their current levels. Margins are also supressed in the case of BDSI due to the various operating challenges and bottlenecks. On a normalised basis and using headline indicators, the company’s earnings appear to be considerably supressed.
The majority of private banks are listed on the stock exchange. Their performance is more reflective of the sector. But while bank earnings reflect the real status of the sector, Iraqi banks do not reflect the status of the economy. This is due to a number of factors such as the cash nature of the economy, the security environment, regulatory and governance hurdles. The sector as a whole is controlled by government banks and their main activities centre on government trade business and payrolls. Private sector banks act as deposit centres and the bulk of their revenues are generated from commissions and foreign currency transactions. Given the high risk environment and poor governance practices, the credit market continues to be significantly small. Loans to GDP stood at 14% at the end 2013. Loans to deposits were at 20% reflecting highly liquid balance sheets.
There is no consistent trend amongst banks in Iraq. Private sector banks have a small share of total banking assets, for reasons mentioned earlier. Accordingly, the sector in general only marginally reflects the broader economy. In addition, there is a wide variation in the performance of the various banks depending on their operational focus, shareholders’ base, geographic focus, amongst other factors.
The banking sector constitutes 51.6% of our portfolio and 50.2% of the market. The fund’s largest holdings in the sector are Bank of Baghdad (BBOB) and Gulf Commercial Bank (BGUC). Both banks reported a drop in earnings in 2014. We used annualised three quarter results for Bank of Baghdad as the year-end results were not published by the time of issuing this report. Revenues were down 9% largely on the back of the decline in investment revenues. The bank’s investment portfolio primarily consists of overnight deposits and government papers. The decline in deposits, thus excess liquidity, was reflected in lower investment revenues. A 14% increase in costs, as a result of deteriorating security contributed to an overall drop of 22% in net profits.
The contraction in the balance sheet was limited with a 3% decline in total assets. As is the case with the sector as a whole, deposits are the primary determinant of balance sheet growth. The deposit base contracted across the sector as a result of funds outflow following the advancement of ISIS into the Northern parts of the country. In the first three quarters, deposits were down 8.2%. Funds deployment was unchanged with nearly 80% of total assets in government papers and cash deposits with the Central Bank.
The year end results for Gulf Commercial Bank were in line with profits down 23.6%, also on the back of a decline in investment revenues and commissions in addition to rising costs. However, BGUC was able to grow its assets following a capital increase and a 9% increase in deposits. The disparity in balance sheet performance between the two banks is a factor of their different client base. Bank of Baghdad has a wider retail base that measures the pulse of the economy more accurately. By contrast, BGUC has a concentrated corporate base and a smaller balance sheet.
Both banks have seen their share prices decline over the course of 2014. On a y-o-y basis, Bank of Baghdad was down 24.8% while BGUC lost 21.7% of its market value. Based on year-end prices, BBOB was trading at 13.04x earnings and 1.27x its book value. Gulf Commercial Bank multiples are 5.86x earnings and 0.69x book value. The premium on BBOB shares is due to the heavy foreign and strategic presence in the stock. The downside is limited in both given that book value constitutes of paid up capital and retained earnings. Asset quality is generally good and therefore the risk of write-downs is limited. Earnings multiples at the current price levels are discounting the risk and future growth.