Corporate Credit

Overview

While ESG has been a prominent investment theme for years, the environmental component has recently exhibited significant momentum. In particular, decarbonization has become a goal that has impacted practically every corner of the investment universe. Increasingly, as part of this movement, many countries and companies have explicitly stated a variety of carbon reduction goals with the intent of reaching net-zero carbon anywhere between 2035-2050. While the practicality of these efforts can be debated, there is no denying that the effort is underway. 

Ironically, the goal of reaching carbon neutrality hinges on a sector that has historically been shunned by ESG investors – utilities. Eventually, many industries will play a role in reducing carbon emissions, but most of them will rely on green electricity to be truly carbon free. For example, the auto industry is increasingly focused on producing electric vehicles (EV). If the electricity used to power EVs is generated from fossil fuels such as coal, then carbon emissions have not been effectively addressed. The recent attention given to the promise of hydrogen is another example. Hydrogen has enormous potential to help reach decarbonization goals, but the production of hydrogen uses a considerable amount of electricity. To be truly carbon free, this electricity will need to be from green or renewable sources. Ultimately, the ability to achieve carbon reduction goals depends on the ability to generate clean electricity. Then downstream users in energy intensive industries such as steel, transportation, mining, and commercial construction, will continue to innovate in order to capitalize on green sources of energy. The good news is that the utility industry is well down the road in addressing carbon emissions. Initially, the industry was slow to embrace the clean energy movement – even actively resisting external pressures to change. Now, however, practically every utility company has realized the necessity of investing in clean energy, and it is a major focus across the industry. 

Evolution of the Generation Mix

As the following chart shows, the electric utility industry has invested heavily into the transition away from coal over the past decade. Over this time, coal’s contribution to electrical generation production in the United States dropped from roughly 45% to around 19%. Initially, this transition was primarily due to increasing generation from natural gas. The primary driver behind this transition was not environmental concerns but rather the economic benefit from using the cheaper natural gas that was being unleashed by the shale revolution. While natural gas is effective at reducing carbon emissions, it still falls short in reaching the goal of zero-carbon emissions. In fact, more and more people are asking the question, “Is natural gas the new coal?”

Exhibit 1: Utility Scale Generation by Fuel Type

The next biggest factor in the displacement of coal is the more recent proliferation of renewable energy generation. This has been led primarily by wind with additional contributions from solar. While wind still only accounts for approximately 8.4% of total generation, this is up from 1.9% a little over a decade ago. Solar has been slower to catch on and still only accounts for around 2.3% of utility scale generation. When including an estimate of small-scale (i.e. residential) generation, solar accounts for an estimated 3.3% of the total. 

Two other sources of generation that play a role in decarbonization are nuclear and hydro. Notably, despite the growth of wind and solar, nuclear is still the largest source of carbon-free electricity. While both nuclear and hydro are considered zero-carbon emitters, they come with other environmental concerns. Nuclear also has the added drawback of being at a cost disadvantage relative to other sources. Both sources of generation have been relatively stable over the past decade, with nuclear accounting for roughly 20% and hydro accounting for roughly 7% of total utility generation.

Relative Cost of Renewables

The biggest factor in the acceleration of renewables growth has been the rapidly declining costs of building new generation facilities. The cost of building a new facility is often stated as the levelized cost of electricity (LCOE). LCOE reflects the revenue per unit of electricity generated that would be necessary to recover the building and operating costs of a generator for a specific life cycle. The LCOE calculation includes several assumptions, such as capital costs, financing costs, fuel costs, utilization rate and fixed and variable operations and maintenance (O&M) costs. When consistently applied, however, it allows for the useful comparison across different generating technologies. 

The LCOE for renewables has declined dramatically over the past decade. While this has been aided by tax credits, renewables have increasingly become cost competitive on an unsubsidized basis. Since 2009, the unsubsidized LCOE of solar has declined 90% and the unsubsidized LCOE of wind has declined 71%, according to a study by Lazard Ltd. The primary contributor to this decline has been the significant decline in prices for photovoltaic (PV) cells and wind turbines. In addition, the LCOE for wind and solar also benefits from substantial O&M and fuel savings relative to coal, nuclear, and open/closed cycle gas turbines (OCGT and CCGT). Essentially, wind and solar generation has nearly zero marginal costs. The following chart shows the LCOE of various types of generation, clearly illustrating the attractiveness of investing in renewable generation projects.

Exhibit 2: Levelized Cost of Electricity

Not only has the LCOE of wind and solar fallen to levels substantially below that of older technologies, in many cases, new renewable projects are becoming cheaper than the marginal operating costs of many existing plants. This has been verified by anecdotal reports from companies, who find it increasingly attractive to invest in renewable projects while shutting down higher cost plants, particularly coal and nuclear. According to the EIA, since 2013, 8.4GW of nuclear generation has been retired early and another 5.1GW is scheduled to retire in 2021. The bulk (4.1GW) of the 2021 retirements will come when Exelon retires the Dresden and Byron plants in Illinois. In just 2020 alone, 9.2GW of coal plants have been retired. At the same time, 14.2GW of wind capacity, 10.1GW of solar capacity, and a net 4.5GW of natural gas generation came online.

Role of Tax Incentives

According to EIA estimates, 2020 was a record year for wind turbine installations. The total of 14.2GW surpassed the previous record of 13.2GW set in 2012. Both years benefitted from a year-end push to qualify for tax credits that were scheduled to decline or expire at the end of the year. As part of the spending bill that was passed just before the end of 2020, the tax credits were extended and enhanced. For solar projects, the investment tax credit (ITC) of 26% is extended for projects that begin construction prior to December 31, 2022 and is phased out for projects that start in subsequent years. For wind projects (and other qualifying facilities such as geothermal and biomass), the production tax credit of 60% was extended for projects that begin construction before December 31, 2021. In addition, a new ITC of 30% was created for offshore wind projects that begin construction by December 31, 2025. The extension of tax credits, along with increasing acceptance by regulators to include renewables investment in the rate base, will help the utility industry to continue making significant investments in wind and solar for the next few years. These tax incentives undoubtably make investment in renewables more attractive, but they are increasingly unnecessary; many onshore wind and solar projects have now become the cheapest source of generation in certain locations, and the returns are now often attractive on an unsubsidized basis. While utilities certainly welcome the recently passed extensions, much of the industry’s plans would have been pursued anyway.

While the year-end spending package included an extension of the tax credits and a few other incentives, it was not the comprehensive legislation that many decarbonization proponents are looking for. Things to look for in future legislation include carbon pricing/regulation and additional incentives for developing technologies such as battery storage, electric vehicles, and hydrogen infrastructure. Much of this agenda is addressed in the recently re-introduced Growing Renewable Energy and Efficiency Now (GREEN) act. The nuclear industry is particularly interested in any carbon pricing or regulation as it would likely improve the relative economics of carbon-free nuclear generation. President Biden’s recent executive orders address many of these topics, and it remains to be seen how the legislative process will play out.

Current Limitations Facing Renewables

When analyzing the LCOE of renewable technologies, the wide range of electricity prices needed to produce an acceptable return for renewables projects is especially significant. As previously mentioned, there are many factors that affect the ultimate return for an investment in renewables. A major factor (if not the major factor) is the geographic location of the project. As the following wind and solar maps from National Renewable Energy Laboratory (NREL) show, the Midwest and Southwest are renewable resource rich while the Northeast and Northwest are noticeably resource poor. While the cost of renewable energy is decreasing everywhere, the utilities with footprints in the renewable resource rich areas have the highest potential benefit from replacing coal and natural gas generation with renewables. 

Exhibit 3

While it may be debatable whether tax credits for onshore wind and solar are still necessary, the extension and improved terms of the tax credits were, however, necessary for offshore wind projects. According to American Clean Power Association, there are 14 offshore wind projects totaling 9.1GW expected to be operational by 2026. These projects have been challenged with permitting delays, and none of them were able to start construction before the previous ITC expiration of December 31, 2020. Unfortunately, offshore wind is still a few years behind onshore wind and solar on the cost curve. That said, offshore wind holds significant potential benefits for otherwise resource poor areas such as the Northeast. 

What’s Next?

While wind and solar have a clearly established role in decarbonization, other technologies must continue to develop in order to reach the zero-carbon goal. The primary drawbacks of wind and solar are the geographic limitations and the related intermittent availability of their output. As the NREL maps show, wind speed and solar intensity vary significantly across the United States. Fortunately, solar availability at least follows the daily and seasonal power demand cycle. Still, neither can be relied on to provide consistent and predictable availability. The utility industry is pursuing additional technologies to address this limitation, primarily focused on storage and hydrogen.

Adding battery storage to the existing grid is the most immediate way of addressing intermittent availability of wind and solar generation. Currently, the cost of adding utility scale battery storage is still uneconomical, but the cost is coming down rapidly. There are several companies integrating storage solutions into their operations, and growth is expected to accelerate as the cost comes down. Battery storage is bidirectional, meaning it can both distribute and absorb electricity, effectively making the switch within seconds. This attractive characteristic is particularly useful in meeting the increased demand during evening hours after the sun goes down. The drawback is that battery storage is finite, and it would require an enormous amount of storage capacity to keep the grid stable for an extended period. 

Another potential longer-term solution to the intermittent availability problem is hydrogen. While the benefits of hydrogen have been known for decades, the attention given to it seems to have exploded over the past year. The development of a hydrogen infrastructure is in the very early stages, so it will likely be well into the future before we find out if this attention is warranted. Hydrogen development has wide ranging impacts on a variety of industries. For the utility industry, it holds the potential to replace coal and natural gas as dependable baseload generation. This would be accomplished by using excess green electricity to create hydrogen during off-peak hours and then using hydrogen to power a generator when renewables are unable to meet demand. Essentially, hydrogen could become a more effective long duration energy storage option.

Investment Implications

As the recent power outages in Texas highlighted, there is a strong need for investment across all areas of our electrical infrastructure. This is even more necessary as the electrification of our economy puts increasing demands on the grid. At times, the electric utility industry may find it difficult to balance the transition to green energy, the need to enhance reliability, and the pressure to keep customer bills low. Over the next few years, this environment will present both a significant challenge and an attractive opportunity for the industry. The funding needs will be substantial as companies look to grow their rate bases through investments in grid modernization and green electricity generation. While growing the rate base is a long-term net positive for the sector, the timing of investment recovery will continue to put upward pressure on debt levels in the near term. Although investors and rating agencies will likely continue to look through this period of high investment, this is a trend to be mindful of for the next year or two. 

Historically, as a major source of carbon emissions, the utility sector has not screened well through the ESG lens. Not every company jumped on board initially, with some resisting the movement altogether. But in a distinct age of ESG prominence, most companies – if not all – have accepted that this is not a fleeting movement, going so far as to explicitly state decarbonization goals themselves. Many utility companies are still high emitters, but ESG investors are increasingly willing to look past the current absolute level of emissions and reward companies with clearly articulated plans to reduce emissions over time. 

Market summary and outlook

By Elizabeth Henderson, CFA – The Investment Grade (IG) Corporate bond market (per Bloomberg Barclays Index) experienced a historic bout of volatility in the first half of 2020, as spreads widened from a low of 93 basis points (bps) in mid-January to a high of 373 bps on March 23, ending the second quarter at 150 bps (Exhibit 1). Excess returns over Treasuries year-to-date June 30 were negative at -5.4%, but with the Treasury yield rally, total return was 5.0%. The IG market outperformed the S&P Index, which returned -3.1% and High Yield market (per Bloomberg Barclays Index) at -3.8%. 

Exhibit 1: U.S. Corporate Investment Grade OAS

The monetary and fiscal support provided to the markets and economy in March set a floor for the markets as it allowed investors to model downside risk. At that time, the market’s estimate for ratings downgrades to high yield far surpassed our analyst team’s bottom-up estimate. This gave us the ability to measure risk and invest at a time of very attractive spreads especially in the new issue market. In regards to new issue, we saw a record amount in all U.S. fixed income markets with the IG market reaching $1.2T by June, as companies looked to increase liquidity during an uncertain time. We expect a more modest $400B to be issued in the second half, and given scheduled maturities, the net amount could be as low as $45B (Source: Eric Beinstein, JP Morgan, “US High Grade Corporate Bond Issuance Review” 7/2/2020). We are expecting that to be higher as companies look to take advantage of low rates for early refinancing and tender activity, and possibly M&A if the outlook for the economy becomes more certain. 

Exhibit 2: New Issuance Hits a Record Pace 

Valuation is statistically fair with spreads normalizing over the last couple months, at a sector, industry and rating level. The market is reflecting an expectation for the economy to return to pre-COVID 19 levels in the near term. For example, a modest 6% of the IG market reflected risk of credit rating downgrades to high yield at June 30, 2020, down substantially from 25% in late March 2020 and up modestly from 4% at the end of January 2020. If the economic recovery takes longer than expected, we believe that will easily double. 

While we expect spreads to widen in that scenario, technical support is expected to remain stronger than it was in March given the improved cash positions of companies and the Federal Reserve’s corporate bond buying program. At the pace at which it has been buying, the Fed is likely to have significant flexibility under its $750B program that expires September 30, 2020 (although likely extended in a stressed environment) (Exhibit 3).

Exhibit 3: Fed Purchases Corporate Bonds and ETFs

We are closely monitoring the pace of re-opening, expecting spreads to remain highly correlated with that progress as well as the progress developing a vaccine and passing additional fiscal stimulus. After recommending an increase in corporate bond allocations for portfolios in late March and the subsequent tightening of spreads through today, we are recommending a reduction to build flexibility in portfolios to add at more attractive points. This is especially the case in industries and credits we believe will be more vulnerable if the economic rebound is more modest. While spreads had reflected this risk in April as shown in Exhibit 4, this includes sectors like: Autos, Energy, REITs, Banks and non-essential Retail and Leisure. The short end of the curve has recovered and reached pre-COVID-19 spreads, leaving little value relative to other segments of the IG fixed income market.

Exhibit 4: Sector Spreads Relative to Industrial Sector OAS

Finally, you’ll notice our newsletter this quarter is longer than usual. Given the degree of uncertainty in the market, we thought it worthwhile to provide more information on topics and sectors most directly related and/or impacted by the COVID-19 pandemic.

Vaccine: When and If

By Michael Ashley – This continues to be a very hot topic, on the minds of most people across the globe. We have seen violent spikes in certain regions of the U.S. and the world, resulting in measured shutdowns which hope to slow transmission and ultimately avoid hospital overcrowding and deaths. There continues to be lots of unanswered questions about this virus, such as “How many people have been infected that have not been tested?,” “How long do antibodies provide protection?”, and “What is the proper quarantine period for those that have tested positive?” Despite these and many more questions, the process of developing an effective vaccine moves forward. There are many vaccines in development and a relatively smaller number that are heading into Phase III trials starting in July (Moderna, Pfizer) and August (AstraZeneca). It appears we could potentially start hearing about results from these trials in the October/November time frame. In a survey to 184 C-level executives and 37 investors across the healthcare sector in May through June, 75% of respondents estimate that a vaccine will be widely available in the second half of 2021 or later. Two-thirds of respondents put the probability for a widely available vaccine at above 50%, and 49% put the likelihood of a therapeutic at greater than 50%. 

Exhibit 5: When Will a Vaccine Become Widely Available?

With over 100 vaccines in the works, we are confident that one, if not several, vaccines will be proven an effective treatment. The scale and rate at which this process is moving complicates the timeline around “when” a vaccine is available at your local drugstore or doctor’s office. There seems to be some mismanagement at the FDA and this topic could become a political issue given the upcoming election. In short, no one knows when a vaccine will be here and issues of safety have become more concerning. Even if phase III trials go as planned, there’s no guarantee that a vaccine will meet FDA guidelines and will be trusted by the world. Our view remains that an effective, usable vaccine is not readily available for use until 2021, probably not until mid-year. In the interim, we look forward to upcoming trial results this fall that are positive. 

Fiscal Stimulus: When and How Much?

By Garrett Dungee – In regards to the fiscal stimulus timeline, the deadline is quickly approaching before enhanced unemployment benefits expire at the end of the month. The Senate just returned to session on July 20th, and the House enters their August recess on 8/3, and the Senate the following week. This timeline affords a small window for both parties to reach an agreement and pass a Phase 5 stimulus package before the CARES Act programs expire. Both parties return to the Hill the second week of September, two months before the election, where the political stakes will be higher. State and local governments, hospitals, higher education facilities, small businesses, and the consumer require additional stimulus due to the public health crisis. Municipalities are close to the action on the Hill and will continue to lobby their representatives who are well aware of the issues they face. Until there’s a vaccine, it’s likely the economy will not reach its pre-COVID-19 potential. The Fed has communicated its understanding and support. But, the metaphorical ball is in the Senate’s court, and it becomes all about the narrative. Does it change from political pressure? Do we see momentum towards a stimulus bill?

The virus has remained more problematic than many assumed a month ago, especially in southern states. Due to the recent developments, we think the chances of stimulus look better compared to June, where we saw several positive economic surprises, and May, where we saw one retiring house Republican vote for the $3T Heroes Bill.  The consensus among economists suggests an additional package of around $2.4T is needed. Senate Majority Leader Mitch McConnell has confirmed that a Paycheck Protection Program (PPP) extension and more direct payments will be in the Republican bill.  So at a minimum, we could see a PPP and unemployment benefits extension in July or a retroactive extension in August.  We could also see the House stay to negotiate a more substantial relief package, or the House could compromise on a smaller bill for consumers while promising to address the state and local funding issues through the appropriations process for the new fiscal year starting in October.  AAM believes there will be additional fiscal support, although the timing is uncertain, especially given the upcoming recess periods for both the House and Senate. We believe the longer it takes for Congress to pass a package, the more damage will be done to the recovery.

Exhibit 6: End of Relief

Autos: A Volatile Sector that Continues to Face Challenges

By Afrim Ponik, CFA – The COVID-19 pandemic brought shock waves across the automotive industry, impacting original equipment manufacturers (OEMs) and part makers globally. We witnessed a significant cash outflow from the manufacturers as the accounts payable came due, while sales declined 50% or more as reported by WARD’s Automotive Group and published by Bloomberg. Having dealt with liquidity crunches before, car companies drew their revolvers down and together with the vast amounts of cash on the balance sheets, bought themselves enough time to withstand this industry shock in an impressive way. 

Following the mandatory shutdowns, we witnessed an increased demand for cars given people’s change in lifestyle, providing a nice cushion to the prices of used cars and therefore residual values, insulating the captive finance arms from taking write downs. We believe the industry did an impeccable job withstanding this shock, but demand recovery should be slow and other industry challenges loom in the horizon. We highlight electrification of drive trains, autonomous driving, stringent emission requirements, in addition to under utilized manufacturing footprint globally as current and future challenges impacting profitability and requiring significant capital spending.

Energy: A Litany of Challenges

By Patrick McGeever – In the near term, we will closely monitor how energy companies are navigating the challenges posed by the COVID-19 pandemic and the resulting economic weakness. The key items we will be focusing on are:

• production, particularly as we exit 2020; 

• capital spending discipline; 

• free cash flow generation and 

• shareholder friendly actions in this weak commodity environment. 

Many oil producers shut-in production and dramatically reduced completion activity in response to record low oil prices in the second quarter. We believe that producers have brought suspended activities back in recent weeks, but we anticipate the curtailment of drilling since March will lead to production declines of 10%-20% from 4Q19 to 4Q20. We are forecasting capital spending will contract 50%-60% from 2019 to 2020 and believe that any increase in capital spending forecasts will be viewed negatively by stakeholders. We believe free cash flow generation will be better in the second half of the year than in the first half of the year provided higher commodity prices and lower capital spending. 

Notwithstanding COVID-19 related issues, the energy industry faces a litany of challenges in the intermediate term. First, the midstream sector is amid legal challenges surrounding environmental impact studies and potential restraining orders on operations. Additionally, the probability of a change in Iranian foreign policy and therefore Iranian oil exports is growing provided the existing Presidential Polling figures, which indicate that Former Vice President Biden is leading President Trump by 5%-10% in most surveys. Furthermore, the decarbonization of the economy and Environmental, Social and Governance (ESG) forces are increasing, leading to reduced capital allocated to the sector. All of these issues are leading to much higher cost of capital for issuers in the investment grade energy sector, which will challenge even the strongest participants.

The energy sector is rightly trading wide of its historic norms and is currently approximately one standard deviation wide of Industrials according to the Bloomberg Barclays US Aggregate Index. We have been actively upgrading our energy exposure given the risks highlighted. Future investments in the sector will be in companies that can generate positive cash flow in the existing commodity environment without the need to access capital markets to fund its operations; have near term catalysts to improve its balance sheet; and/or have plans to improve ESG governance.

Insurance: Enhanced Liquidity Solves Near Term Problems

By Garrett Dungee, CFA – While it is too early to determine the extent of insured losses stemming from the COVID-19 pandemic, loss estimates by Dowling & Partners, Barclays Research, Autonomous Research, BofA Global Research, Berenberg, and Willis Towers Watson range from $30-107B. The bulk of insured losses are expected to come from non-life commercial lines, including, event cancellation, entertainment, business interruption insurance, and litigation-related expenses. Shelter in place orders meant fewer drivers on the road for personal lines, and the favorable trends are expected to continue at least in the short term. So far, several insurers have pre-announced pandemic related catastrophe losses that point to an earnings, not a capital, event for the industry. These second-quarter catastrophe charges serve to reduce, but not eliminate uncertainty for an industry that remains well-capitalized. 

For life insurance, the pandemic’s disruption to the economy remains a more significant challenge than the exposure to net mortality, however that could change if the trajectory of the virus accelerates towards a worst-case scenario. We believe longer-term, low rates will continue to be a significant headwind for the industry with lower reinvestment rates and as insurers head into their annual assumption reviews. 

Low rates, claims uncertainty, and need for additional liquidity led to a surge in issuance for the sector, almost $50B year to date, on pace to shatter $60B issued in 2019. The strong demand shown for insurance debt with oversubscribed deals points to the resiliency of the sector, and the ability to maintain access if market conditions worsen. 

Banking: Fortress Balance Sheets Bolster Against Pandemic Related Credit Costs

By Sebastian Bacchus, CFA – As we come to the end of the first week of second quarter (2Q20) bank earnings*, there are a number of preliminary observations bolstering our belief that strong balance sheets will allow the sector to remain a source of strength and support for the US economy during the pandemic driven downturn. At this point the ten largest US banks have reported earnings and for the second quarter in a row, results were driven primarily by outsized provisioning for future credit costs as the macroeconomic outlook continues to worsen. In contrast to 1Q20, provisioning by banks that have reported earnings this quarter has been focused more heavily on the commercial and commercial real estate loan books (as compared to a greater focus on consumer lending, especially unsecured consumer credit, last quarter). While we have seen variations in banks’ approach to reserving over the past two quarters, all of the banks are preparing for a protracted downturn with outlooks generally calling for ~10% unemployment levels to remain through YE20 and only gradual reductions through FY21, accompanied by a slow return to economic growth in FY21. As a result, all of the banks are growing their allowance for credit loss (ACL) toward or through 2% of loans, and the allowance is generally being sized in the context of the severely adverse loss scenarios from the recently completed Dodd-Frank Act Stress Test (DFAST), even as realized credit losses remain quite low due to ongoing Federal support for individuals and businesses.

Despite the impact of outsized provisions for loan loss, all of the banks remained profitable (with the exception of Wells Fargo) reflecting still robust pre-tax, pre-provision net revenues (PPNR). Although net interest income was impacted by the meaningful fall in front-end rates following the Fed rate cuts, offsets included strong capital markets revenues and mortgage banking revenues. Importantly, all of the banks announcing earnings this week reported strengthening regulatory capital levels, as the previously announced suspension of stock buy-backs has meaningfully reduced capital return to shareholders, allowing capital to build through retained earnings. Additionally, banks have benefited from stable or reduced levels of risk weighted assets (the denominator in the regulatory capital calculation) as balance sheet growth was primarily driven by the Paycheck Protection Program (PPP) loans which carry a zero risk weight (and zero economic risk) for the banks. We expect further capital guidance from regulators after the banks submit to a second DFAST stress test later this year that incorporates updated macroeconomic projections (most likely during 4Q20). However, we view the regulatory actions on capital return to be explicitly creditor friendly, and reflective of the regulators’ focus on preventing the pandemic from transforming a public health crisis into a financial crisis. 

While the path of the economic downturn remains uncertain, the strong levels of bank capital, strong balance sheet liquidity and growing levels of allowance for credit loss offer a bulwark against credit deterioration that would harm credit investments in the banking sector.

*Publicly reported 2Q2020 earnings releases by banks on our focus list are the source for all of the statistics.

Saudi Arabia has pegged its currency, the Riyal, to the U.S. Dollar at a rate of 3.75 since 1986. Below we highlight the rationale for the peg and the benefits it has provided to the Kingdom over the years. We also explore how weak oil prices, the Covid-19 pandemic and large fiscal deficits are undermining its economic profile. While we believe the probability of a de-peg or devaluation is currently low, we highlight issues that may lead to change in the Riyal-Dollar regime and the consequences it would lead to in the energy sector.

• A change to the Riyal-U.S. Dollar regime is a low-probability high-risk event
• Historically stable peg has provided benefits making future changes difficult and costly
• Shrinking FX reserves contribute to currency risks
• Future issues to monitor include Vision 2030, shrinking economy, change to Iran policy
• If risks materialize there is substantial downside for fixed income energy investments 

The reasons for the Riyal – U.S. Dollar peg and historical benefits 

In October 1973, in response to apparent US involvement in the Arab-Israeli War, Saudi Arabia led an Arab oil embargo against the US that led to the world’s first global oil shock. Despite the embargo ending after five months, OPEC kept prices elevated, putting significant pressure on the external finances of the US. In response, the Nixon Administration struck a deal with the Saudi government in 1974 whereby the Dollar proceeds of US purchases of Saudi oil would be reinvested by the Saudi government in US Treasuries. The Saudis also agreed to price oil in US Dollars globally. In return, the US provided the Saudis with military aid and equipment. This was the foundation of the petrodollar system which helped the US Dollar regain its global supremacy after the collapse of Bretton Woods and has linked Saudi oil revenues and savings to the US Dollar to this day. (1)

Like today, in the 1970’s the vast majority of the Saudi economy was US dollar based and its savings were being invested in US Treasuries, yet the Riyal was pegged to the International Monetary Fund’s Special drawing rights (SDR). The SDR, an artificial currency instrument at the time was calculated from a weighted basket of major currencies, including the U.S. Dollar, Deutsche Mark, the French Franc, Japanese Yen and British Pound. This currency mismatch and a roaring Saudi economy led to very high inflation, which peaked at 35% in 1975. After the oil crash in the early 1980’s, the Saudi devalued its currency and pegged it to the US Dollar at 3.75 Riyals per Dollar. It has remained pegged at this level for the past 34 years.

The Riyal-Dollar peg has provided monetary stability in that exchange rates have remained stable and inflation has rarely been higher than 5% since the current peg was established in 1986. The peg has also provided some revenue predictability, a desirable characteristic given that its economy is highly dependent on volatile oil prices. Lateral benefits include lower lending rates and credit growth. Furthermore, according to an analysis by Goldman Sachs, the cumulative current account balance since 1998 (i.e., net FX savings of the economy) is as much as $400 billion greater now than it would have been under a floating exchange rate regime. (2) 

Confidence Remains in the Riyal – U.S. Dollar regime 

A key feature to maintaining a fixed FX regime is confidence that the domestic country (in this case Saudi Arabia) holds adequate FX reserves of the pegged country (in this case U.S. dollar reserves). Taiwan, for example, was largely immune to the Asian crisis of 1997-98 due to its large holdings of foreign exchange reserves. The measure that is commonly used to evaluate this coverage is FX reserves to M1 money supply, or narrow money. 

Exhibit 1 shows that while the Saudis still have adequate coverage of narrow money (around 200% of M1), net reserves have declined to $742 billion (including sovereign Private Investment Funds) and they are expected to continue to decline given the expected budget deficits for the next several years. 

Exhibit 1: FX Reserve Coverage Deteriorating

According to the IMF, “the negative affects of the pandemic, significantly lower disposable income for oil exporters after the dramatic fuel price decline, imply a sharp recession in Saudi Arabia of –6.8%.” Additionally, the government agency suggests that Saudi Arabia will be running a budget deficit of 11.4% ($89 billion) and 5.6% ($44 billion) in 2020 and 2021, respectively. This deficit will have to be funded either by further drawing down reserves or issuing additional debt. A draw of the reserves further weakens the coverage of narrow money. Raising debt is the more likely avenue as the government said last month that it planned to raise its debt ceiling from 30% to 50% of gross domestic product as it borrows more to cope with the crises (Exhibit 2). Either approach will likely result in further downgrades of the Kingdom by the rating agencies.

Exhibit 2: Saudi Arabia External Debt as % of GDP

In response to the present economic challenges, fiscal deficits, and funding hurdles, in May 2020 the Saudi Finance Minister announced several fiscal measures to improve government finances by approximately $30 billion. These measures include the discontinuation of a cost-of-living allowance for public employees, a value-added tax that will increase from 5% to 15% as of July 2020 and substantial cuts in spending on key Vision 2030 infrastructure projects. The cost-of-living allowance represented about 10% for earnings of Saudi nationals, and its discontinuation will thus cut real incomes. 

Considerable Challenges Likely to Erode Confidence

The Kingdom faces a significant dilemma – it can continue to fund its ambitious Vision 2030 transformational plan with fiscal deficits and maintain support from its young population or delay progress, maintain near term fiscal health yet risk losing the vital support from its growing labor pool. So far, it appears as though it is choosing to plow ahead with the plan and live with meaningful fiscal deficits. 

The Kingdom’s estimated $1 trillion Vision 2030 program to diversify the economy and sustain living standards in a less oil dependent world is viewed positively from Crown Prince Mohammad bin Salman’s base of support. The Crown Prince promised that Vision 2030 would deliver economic prosperity and millions of new private sector jobs for young Saudis. If these economic benefits appear to grow more elusive, public endorsement for the Vision 2030 agenda may dissolve and threaten the strong backing from the public. However, with Saudi Arabia’s finances increasingly squeezed, funds are being diverted from the Vision 2030 plan to offset the economic slump. In early May, the Saudi’s apparently cut $8 billion from the budget as part of its austerity actions. (3)

In addition to substantial expenditures, we believe the threat of growing deficits is rising due to shrinking revenues. According to the Saudi Arabia Monetary Agency, more than 60% of private sector employment is in the Retail, Transportation and Construction industries, all are focal points of the Vision 2030 plan and all have been hit by the pandemic due to the lockdown. As the Kingdom undergoes a second wave of the virus and limits the number of people allowed to perform the annual pilgrimage, we believe those industries will experience more pain and the budget deficit will grow (Exhibit 3).

Exhibit 3: 2020 Budget Analysis

Of equal concern is the outcome of the U.S. Presidential election in November 2020, the potential changes to Iranian foreign policy and how that may affect oil prices. Many polls currently indicate Senator Joe Biden is leading President Trump by 5%-10% in the upcoming election. Should Senator Biden win the election, there is likely to be important changes to U.S. foreign policy toward Iran. Many of the leading architects of the 2015 Joint Comprehensive Plan of Action nuclear deal are senior Biden foreign policy advisors and a renegotiation of that agreement could be a key foreign policy priority. It has been reported that one plan being considered by these advisors would allow Iran to export around 700,000 barrels of oil per day. This would negatively affect oil prices and could result in another round of market share fighting between Saudi Arabia, Iran, and other OPEC+ members. 

Moreover, Biden has stated to the Council on Foreign Relations that he wants a “reassessment” of U.S. support for Saudi Arabia in the wake of the murder of journalist Jamal Khashoggi, the Saudi-led war in Yemen, and domestic human rights violations. Furthermore, he also stated he would stop arms sales to the kingdom (recall that this was one of the pillars of the original Riyal – US Dollar regime) and treat Riyadh like a “pariah” on the world stage. (4) Taken as a whole, we believe a Biden victory would likely diminish the already deteriorating economic health of Saudi Arabia.

Implications to Saudi Arabia and Energy Markets of a Change to the Riyal – U.S. Dollar Regime

We believe the likelihood is low of a de-pegging or devaluation of the Riyal given the stability the relationship has provided historically, the commitment to the peg from the Saudi Arabia Monetary Agency and the size of a cut necessary to achieve coverage of narrow money in a low oil environment. According to Goldman Sachs, over a three-year horizon, a minimum 50% devaluation would keep reserves above the narrow money level in absolute terms but under a $30 oil environment a devaluation of at least 80% would be required to stabilize the reserves. (5) The foreign exchange market is also discounting the threat of a devaluation over the next 12 months as seen by the stable forward FX rate in Exhibit 4.

Exhibit 4: 12 Month Forward FX Rate Riyal per USD

However, given the risks we have highlighted to the Saudi economy and therefore its Foreign Reserves, we believe the possibility of a devaluation will rise over the next several years particularly if oil prices remain in the $40 range or if few fiscal adjustments are made. Below we highlight consequences of a change.

According the New York Fed, generally speaking there are two implications of a devaluation: 1) it makes the pegged country exports relatively less expensive for foreigners; 2) it makes foreign products relatively more expensive for the pegged country’s consumers, thus discouraging imports. The first point is more critical to oil prices and energy markets. The second point is more critical specifically to Saudi Arabia.

Saudi Arabia’s major export, oil, is dollar based and a devaluation would have little bearing on output levels and exports. However, on the revenue side, a depreciation in the Riyal, would increase oil revenues for Saudi Arabia, as every barrel of oil sold will bring in more Riyals for a given Dollar oil price. We believe a weaker Riyal thus would enable the Saudis to maintain or increase production levels in a market share battle with other oil producers and still address their budget shortfall. Therefore, a de-peg or meaningful devaluation of the Riyal would have negative implications for oil and energy markets. A de-peg or devaluation combined with Iranian exports returning would have significantly negative implications for oil prices and the entire energy sector. This scenario likely would result in downgrades and higher yields for many investment grade energy companies and defaults for weaker positioned companies in the high yield energy sector. 

With regards to the second point from the New York Fed, Saudi imports represent a relatively high proportion of domestic consumption. Consequently, a real danger of de-pegging or devaluing the Riyal is higher inflation in Saudi Arabia. This would of course likely be followed by higher interest rates to control that inflation. Additionally, to the extent that devaluation is viewed as a sign of economic weakness, the creditworthiness of the nation may be jeopardized, it would likely dampen investor confidence and hurt the country’s ability to secure foreign investment. (6) This would conflict with the country’s desire to increase foreign direct investment as part of the Vision 2030 plan. Mitigating this concern somewhat, is that the Saudis could reduce the need to implement unpopular fiscal spending policies (like cutting Vision 2030 expenditures) and would boost aggregate demand in the economy to fight unemployment. 

Summary

Saudi Arabia is facing significant challenges in the next several years and how it chooses to address them will affect oil prices and investment grade energy companies. Expenditures to develop an economy less dependent on oil combined with shrinking oil revenue is leading to deteriorating financial conditions. A high-impact low-probability event to address shrinking reserves and expanding fiscal deficits is to de-peg or devalue its currency. While market confidence in the peg remains, there are considerable risks on the horizon that we will continue to monitor. If the risks we highlighted materialize, there are downside perils to both oil prices and investment grade energy investments.