Review of QCB Data on Net Foreign Assets Position of Qatar Banking Sector - Part 1

Join AA as We Dive Deep into the QCB Data  Be Sure You've Got an Extra Tank

Earlier Post Here

Introduction

Since the GCC 3+1 (Egypt) announced their “blockade” against Qatar, there has been a lot written about the negative economic impact on Qatar, some of it true and some of it seizing on negative news to invent imagined foreign policy successes.  For the latter read Gulf News. 

One point that has been emphasized is that Qatari banks have a negative net foreign asset (NFA) position.  On an aggregate basis Qatar’s banks are borrowing offshore to fund onshore assets.  This is a real vulnerability.

But …

Aggregate statistics can identify symptoms of diseases but further diagnosis is required to determine if the patient actually has a disease and how severe the disease is.  At times aggregate statistics can obscure diseases.  For example, if we assume that Qatar banks had a perfectly balanced position with FA = FL, aggregate statistics would suggest everything is fine.  But if the FA were in shares of GFH and Dana Gas to choose two sterling investments, there would likely be a real problem.  Or one bank had a positive NFA and the other a negative NFA, the potential demand for repayment would be the negative NFA of the second bank, not the net of their two positions as in the QCB NFA data.

What’s important then is taking a detailed look after parking any partisanship in the dispute.

This post will do just that. 

As noted in my introductory post, I’ll be looking at this topic using two main data sources:  QCB statistics and bank consolidated financial reports.  This post will focus on QCB reported NFA. 

QATAR CENTRAL BANK DATA

We’ll begin by looking at data published by the QCB in its “Monthly Monetary Bulletin” (MMB) and ”Quarterly Statistical Bulletin” (QSB).

To set the stage a discussion of aggregate statistics.   

Qatar Commercial Banks NFA
Billions of QAR
EOP	TFA	TFL	NFA
Dec-16	273	447	-174
May-17	268	471	-203
Jun-17	260	415	-155
Jul-17	249	388	-140
Aug-17	235	371	-136
Sep-17	234	368	-133
Net Chg	-39	-79	40

Qatar Commercial Banks NFA
Billions of USD
EOP	TFA	TFL	NFA
Dec-16	$75.1	$122.7	-$47.7
May-17	$73.6	$129.4	-$55.9
Jun-17	$71.5	$114.1	-$42.6
Jul-17	$68.3	$106.7	-$38.4
Aug-17	$64.5	$102.0	-$37.5
Sep-17	$64.3	$101.0	-$36.6
Net Chg	-$10.7	-$21.8	-$11.0

Technical Notes:

1. QAR amounts rounded to nearest billion.  USD equivalents rounded to nearest hundred million.
2. Conversion to USD equivalent at QAR 3.64 = USD 1.00.
3. Note that “Qatar Commercial Banks” includes all banks licensed to operate in the emirate including foreign banks. 
4. FA = Foreign Assets. FL = Foreign Liabilities. NFA = FA – FL.  T= Total, i.e., TFL = Total Foreign Liabilities.
5. Sources: Tables 3, 21, and 22 in the Monthly Monetary Bulletin and Tables 4, 22, and 23 in the Quarterly Statistical Bulletin.  The MMB is not published at Quarter end.

Comments:

1. The aggregate (note that word) NFA assets position of the Qatari banking sector seems rather modest in terms of the resources that the GOQ can bring to bear.
2. From FYE 2016 through September 2017 Qatar’s banks have reduced their negative NFA position by some USD 11 billion or roughly 22%.  If measured from May 2017, the reduction is about USD 19 billion or 33%. 
3. During this period, USD 11 billion equivalent in FA have been liquidated to meet repayments of FL and FL have been reduced the equivalent of USD 22 billion.  If measured from May, FA have been reduced some USD 9 billion and FL about USD 28 billion.

At first glance, the banks and GOQ seem to be handling matters well.  The pace of creditor flight in August and September appears to have slowed. But these two data points do not establish an irreversible trend.

Hopefully, there is more than one reader out there (that’s meant in more than one sense) who is thinking and, thus, thinking of saying: “Wait a minute, AA, the Qatar banks don’t owe the Net FA position, they owe the total of foreign liabilities, some USD 101 billion.  That’s a much bigger amount and would strain the GOQ’s resources a lot more.  That’s the measure to use.” 

Keep this straw man’s comment in mind as it will be a recurring theme in what follows.

Let’s turn to that topic and look at Total Foreign Liabilities (TFL) as a percentage of Total Liabilities and Equity (TLE).

Qatar Commercial Banks
TFL as Percent of TLE
EOP	TFL	TL	%
Dec-16	447	1,272	35%
May-17	471	1,323	36%
Jun-17	415	1,316	32%
Jul-17	388	1,313	30%
Aug-17	371	1,328	28%
Sep-17	368	1,347	27%

In light of the negative NFA position, these ratios are concerning.  More importantly they understate the relative importance of TFL as a percent of market funds.   To correct this let’s remove equity from the denominator.

Qatar Commercial Banks
TFL as Percent of TL  (No Equity)
EOP	TFL	TL	%
Dec-16	447	1,093	41%
May-17	471	1,131	42%
Jun-17	415	1,124	37%
Jul-17	388	1,119	35%
Aug-17	371	1,134	33%
Sep-17	368	1,153	32%

1. Note:  In adjusting TLE for equity I deducted QAR 25 billion in perpetual subordinated debt which is Tier 1 Capital, but is not accounted as capital in the QCB statistics.
2. TL also includes “Other Liabilities” which average about QAR 4 billion.  However excluding these does not materially change the percentages. So I have not.
3. The ratios are higher.  So even more cause for concern. NPA fairly dramatic picture of dependency on foreign funding. 

While this sharpens the analysis, it doesn’t provide a complete answer.

Diagnostic Questions

To get that answer ideally we need to answer at least the following questions.

Foreign Assets 

1. What are the foreign assets composed of? For example, if the banks foreign assets are substantially in liquid high credit quality instruments, then the absolute net additional funds they require to settle all foreign liabilities are much smaller, approaching the NFA position. 
2. Which banks in Qatar own the assets?  Because the QCB statistics are for the entire Qatari banking sector, they include foreign banks operating in Qatar.  How big is their share of the FA?  List of licensed banks in Qatar.

Foreign Liabilities

1. What are the foreign liabilities composed of?  How much is bank-provided funding (typically expected to be more volatile), customer deposits, and debt instruments?
2. Which banks, local or foreign, are responsible for paying these liabilities?  How does this compare to their shares of FA?  For example, if foreign banks have borrowed foreign currency to fund their QAR denominated local operations and this is a significant amount of total FL, then the problem for Qatar is less because these banks are unlikely to be affected by creditor flight.  And if it does occur, then their parents are likely to step up.  But, if this is the case, then which foreign banks hold the large FL and do they have access to funding?   There’s a difference between HSBC, Stan Chart, and BNP on the one hand and Bank Saderat on the other, though we might reasonably expect Bank Saderat to be a “samak saghir” in Qatar.
3. To whom is the money owed?   For example, if much of the TFL funding is intercompany, it is likely to be more “sticky”, unless the overseas units are under pressure themselves  On the other hand, if a significant portion of the TL are owed to GCC3+1 entities, then the problem is greater.

Additional Foreign Assets and Liabilities

1. Are there foreign assets and liabilities of the Qatari banks that are not recorded in the QCB data? These are most likely those of subsidiaries.  If contagion spreads to foreign subsidiaries, then the Qatari parents may have additional foreign currency burdens, unless they “walk away” from these subsidiaries.  On the other hand, a foreign subsidiary may be induced to make a timely deposit to help out a parent.  

Individual Bank Positions

1. As noted earlier, what are the individual positions of local Qatari banks?  Qatar Bank A which has a positive NFA position is highly unlikely going to bail out Qatar Bank B which has a negative one.  Therefore, we need to disaggregate the local banks’ TFA and TFL to individual banks.

We can answer some but not all of these questions from the QCB data. And will start doing that in the next post.

Qatar Banking Sector - How to Measure the Net Foreign Assets Position

AA Absolutely Loves Quotes Like This Though It's Hard to Match "Live Your Life" 

This is the first of four planned posts on Qatari banks’ vulnerability to cross-border foreign currency exposure in light of the measures taken by Saudi Arabia, the UAE, Bahrain and Egypt (the GCC 3 +1). 

Before getting into a detailed discussion of the numbers, it’s important to ensure that we’re measuring cross-border foreign currency exposure vulnerability properly. 

Currently analysts and the press are focused on Qatari banks’ Net Foreign Assets (NFA) position as reported by the Qatar Central Bank (QCB).  It’s a “convenient” measure:  a single number available monthly.   But sadly reality is rarely, if ever, that neat. 

To be very clear, I don’t think there is a fault in the QCB’s NFA statistics, but rather that they give only a partial picture of Qatari banks’ positions and vulnerability.

Why?

The statistics are an aggregate of the separate foreign currency positions of all the banks operating in Qatar with non-resident counterparties.

What does that mean? 

1. Net Positions Obscure Gross Positions: Assume a country whose banking sector is composed of only two banks, Bank A and Bank B.  Assume Bank A has borrowed local currency to fund foreign assets of some USD 55 billion and Bank B has borrowed foreign currency to fund local currency assets of USD 55 billion.  According to QCB’s valid methodology, NFA = 0, an apparently “happy” cross-border position.  But if foreign creditors cease lending to the country, Bank B needs to pay USD 55 billion to them. If it can’t, the central bank needs to step up unless one assumes the highly unlikely event that Bank A voluntarily liquidates its foreign assets and makes the resulting foreign currency available to Bank B.   The situation is even more complicated when as usual there are multiple banks in a country.  The net of all their individual positions obscures the position of each bank.  And it is the position of each bank that is critical to the ultimate demand for foreign currency on a country.
2. Net Positions Obscure Exposure to Specific Creditors:  When assessing creditor flight, it’s important to know where the creditors are.  In the case of Qatar, creditors in the GCC 3 +1 are most likely to take “flight”.  Other creditors less so because the crisis is at present driven by political not economic/credit issues. If exposure to the GCC 3 +1 countries is large, then the potential funding gap from their withdrawal is large.  If not, the problem may be minor. 
3. The standard NFA statistics implicitly assume that assets and liabilities are equally liquid. They “ignore” the fact that a bank’s basic business is maturity transformation – typically borrowing short and lending/investing long. On a contractual basis a good portion of assets (likely a majority) will almost certainly have maturities far in excess of liabilities.  If assets cannot be liquidated quickly because of contractual maturities, the central bank (here QCB) may have to provide additional foreign currency funding to “bridge” the maturity gap. That will be an immediate call upon the central bank’s foreign assets.  If the banks’ assets cannot be realized at par, the parent or central bank may have to provide additional funds to make up the shortfall from asset realization.  If, for example, Qatari banks hold their foreign assets in US Treasury Bills, realization at par is almost certain.  If they hold Dana Gas or GFH shares, less so, much less so.

What’s needed then is additional information on Qatari banks’ foreign currency exposure that supplements the QCB reported NFA position by factoring in the cross border foreign assets and liabilities of local Qatar banks that are not included in the NFA position, subtracting the position of overseas banks operating in Qatar (if their position is meaningful), disaggregating “net” positions into gross Foreign Assets (FA) and Foreign Liabilities (FL) by region (ideally country), and by individual Qatari bank, as well as understanding the liquidity of gross FA of individual banks.  That requires looking at the foreign asset classes the banks hold. 

We can derive some of this information from other data published by the QCB.

But we are still left with unanswered questions.

To answer those questions, we can turn to the fiscal year end consolidated financial reports of Qatari banks, though this method is admittedly imperfect. 

In the third post I’ll discuss the theoretical limitations as well as  practical constraints of using this method.  And why I chose this method as an analytical tool despite those drawbacks.  For example, not all Qatari banks provide a geographical allocation of assets and liabilities. Accounting standards do not require the provision of this data for “parent only” statements that would eliminate a key issue with using consolidated statements. That is Qatari parents have less direct access to the foreign assets of their overseas subsidiaries than to those of their foreign branches.  Also the parents are not legally liable for their subsidiaries' foreign liabilities absent having provided a guarantee. 

One final point. 

This exercise will result in estimates of Qatari banks’ vulnerability—hopefully more comprehensive than the NFA reported by QCB.  But note that both are estimates not “hard” numbers. Vulnerability is composed of two elements: structural position and market sentiment.  We can get a reasonable “fix” on the aggregate structural position, but not an exact number due to the absence of sufficiently detailed information. Pricing and timing of realization of assets remain uncertain and dependent on many factors.  Creditor sentiment—responsible for the “flight” in capital flight--is harder to specify than the structural position.  We  see creditor or market sentiment most clearly post-facto.    All these factors are uncertain and inter-react making this a complex system.  As such, it’s not capable of being modelled accurately.  Therefore, the final post will look at some scenarios to set a range of possibilities and hopefully spark some thinking by others as to how to refine the analysis.

The following three posts will detail the results of an analysis of:

1. QCB data
2. Data from individual Qatari banks’  audited annual consolidated financial statements
3. Various FX exposure scenarios 

These posts will be typical-AA excessively-detailed journeys through the data.  To whet your appetite for the long journey that follows, three teasers.  Note that the consolidated financial statement data cited below is as of 31 December, the only time that banks are required to publish detailed risk management notes.

The Qatar banking sector’s estimated foreign asset and liability exposure to other GCC states (OGCC) is minor in the context of its total foreign asset (TFA) and total foreign liability (TFL) position as of 31 December 2016.

1. Based on a sample of  7 Qatari banks consolidated financial statements, the base worst case exposure to other GCC states (OGCC)—assuming no realization of any FA held in OGCC—is estimated at some QAR 89 billion (the aggregate of all banks TFL  to OGCC) or some USD 24.5 billion. 
2. If we assume that Qatari banks will be able to realize their FA at par value, and look only at those banks with a negative NFA, the exposure is QAR 31 billion equivalent to USD 8.5 billion. 
3. If we take the aggregate position of all Qatari banks, the aggregate NFA is some QAR 18 billion or USD 4.9 billion.  For the reasons outlined above AA thinks this scenario is unlikely.
4. While we are missing detailed data for four banks, it’s unlikely that they will dramatically change these amounts.  AlKhaliji Qatar has disclosed overseas subsidiaries with gross assets of QAR 8.9 billion (USD 2.4 billion), primarily in the UAE.  QIIB and IBQ do not appear to have foreign branches or operating subsidiaries overseas.  Qatar Development Bank, the missing fourth bank, doesn’t release financials but from the QCB data we can see that it is funded primarily with equity and has a positive NFA of some USD 84 million equivalent. 
5. If we adjust the base worst case scenario for AlKhaliji's overseas subsidiaries' total assets of QAR 8 billion, the result is QAR 97 billion or USD 26.6 billion.   

An estimate of the Qatari banking sector’s aggregate NFA using individual bank consolidated financial reports results in a much lower aggregate NFA than QCB figures as of 31 December 2016. 

1. As per consolidated financials, the aggregate NFA is some USD 25 billion equivalent versus USD 48 billion equivalent from QCB data as of 31 December 2016. 
2. While the consolidated financial “result” is based on a sample and thus does not include all Qatari banks, I think it’s unlikely that the remaining banks could generate an additional negative NFA equaling USD 24 billion equivalent.  Why?  Because the total liabilities (foreign and domestic) of these banks ex-QDB equal QAR 112 billion (some USD 31 billion). It’s highly unlikely that they have foreign liabilities equal to 74% of total liabilities. As well there are likely to have some FA to offset their FL.  

Qatari banks with the aid of the Government of Qatar (GOQ) should be easily able to meet the challenge posed by the GCC 3 +1’s actions. 

1. However, if the GCC 3 +1 can create a situation in which other foreign creditors withdraw funding support, the burden on the banks and the GOQ would be substantially higher.
2. Using QCB data the worst case would be aggregate TFL of some USD 101 billion equivalent as of September 2017.  Consolidated financial report data after 31 December 2006 isn’t available for comparison.  But if we use the “spread” at 31 December 2016 between QCB’s computation of NFA and that derived from bank financial reports, the estimated consolidated finance report-derived NFA would be some USD 9 billion larger, i.e. USD 110 billion.          

Dana Gas Strikes Again - "It's Just a Contract"

The above should not be read to imply that AA considers this a minor lapse.

Dana Gas has apparently struck again, suggesting its earlier unilateral abrogation of its legal obligations under its sukuk was no fluke.  

It seems that in negotiating the settlement with the KRG, DG and Crescent Petroleum did not obtain the consent of MOL Group Hungary, a ten percent shareholder in Pearl, before finalizing the agreement with the KRG. 

As noted in earlier posts, the agreement among Pearl’s shareholders gives the minority shareholders—MOL, RWE, and OMV—certain rights including the ability to veto some decisions of Pearl. 

MOL asserts that the settlement with the KRG is a decision that requires shareholder unanimity and that it did not provide its consent.  I’ve provided excerpts from DG’s and MOL’s press releases below.  

But first some comments.

1. Counterparties considering concluding contractual arrangements with Pearl Petroleum and Dana Gas would be well-advised to carefully consider this “event” and whether it is further evidence of DG’s and PPL’s less than sterling record of honouring legal agreements. 
2. As a side comment, AA notes that behaviour of this sort, if unchecked, might lead to widespread adoption of a cavalier attitude to legal agreements on a wider basis.  Countries may even be tempted to re-read binding treaties and find imagined breaches of the spirit of an agreement. 
3. The hapless creditors in DG’s sukuk should carefully consider how to protect themselves in the ongoing restructuring negotiations.  What is the value of the word of a counterparty that appears to have a relaxed attitude towards legal obligations?  No doubt not USD 690 million.  Probably not USD 690.  
4. On the other hand, if Dana’s assertion is that MOL is using “legal technicalities” in an effort to extort benefits or to abrogate the existing Pearl shareholders’ agreement is correct (a mighty big “if”), then this would seem a case of karmic comeuppance.   Perhaps to be followed by Baghdad reopening the concession agreements when it has settled affairs with the KRG. 
5. In the arbitration proceedings will MOL be able to make a convincing case to the LCIA to DG's disadvantage that DG’s conduct with the sukuk and the shareholders’ agreement is part of a pattern of cavalier disregard and bad faith towards legal obligations? 
6. Will Abu Yusuf come up with another far-fetched distortion of Shari’ah to support DG’s actions re the KRG settlement?  If he does, will the LCIA “buy” it?
7. Are the fine courts of Sharjah standing by to issue an injunction if the LCIA proceedings seem to be going MOL's way?
8. Will DG’s shareholders providentially and of course completely of their own volition intervene in Sharjah’s fine courts to block the arbitral proceedings or award?  

Here’s the excerpt from DG’s press release. 

The Settlement Agreement with the KRG was welcomed and endorsed by Dana Gas, Crescent Petroleum, OMV and RWE, together holding 90% of the shares of Pearl. Unfortunately, MOL (a 10% shareholder of Pearl) unreasonably sought to link its endorsement of the settlement to a renegotiation of the terms by which it first secured its participation in Pearl back in May 2009 (namely its commitment to certain contingent payments) and now complains about Dana Gas and Crescent Petroleum for their handling of the settlement alongside Pearl, expressing dissatisfaction with the outcome as compared to the alternative of pursuing a final litigation and enforcement outcome against the KRG.

And from MOL’s press release.  I’ve boldfaced a key sentence which if true presents a world of trouble for DG and other shareholders. 

MOL Plc. (“MOL” or “MOL Group”) hereby notifies the market of the following:  MOL joined Pearl Petroleum Company Limited ("Pearl") in 2009 as a shareholder with a 10% stake and strong minority rights. Pearl’s shareholders include, among others, Dana Gas PJSC ("Dana Gas”) and Crescent Petroleum Company International Limited (“Crescent”). Dana Gas and Crescent, along with Pearl, entered into an agreement to settle Pearl’s long-standing dispute with the Kurdistan Regional Government of Iraq (“KRG”) on 30 August 2017 (the “Settlement Agreement”), without properly consulting MOL or obtaining requisite approval, in breach of MOL’s contractual rights. MOL accordingly served a default notice on Dana Gas and Crescent on 11 September 2017 in accordance with the mechanism agreed by and between the shareholders of Pearl. The default notice has severe legal consequences for the defaulting shareholders, their shareholdings in Pearl and their related entitlements. As announced by Dana Gas earlier today, MOL received a Request for Arbitration from Dana Gas and Crescent in the London Court of International Arbitration, disputing the validity of MOL’s default notice. MOL will take all appropriate steps to enforce and protect its rights.

Dana Gas: Creditors Negotiating With Themselves?

The Chicago Way But Not Milton Friedman's Way

As reported by Bloomberg, DG’s tragically unfortunate creditors made DG an offer to restructure the approximate USD 700 million of outstanding sukuk with the following terms:

1. An upfront repayment of USD 300 million (par value) in principal.
2. A maturity extension of three years. 
3. Maintenance of the existing interest rates:  7% on the exchangeable sukuk and 9% on the ordinary sukuk. 
4. A request for a dual listing of DG shares on the London Stock Exchange. 
5. Maintenance of the existing conversion price at AED 0.75 for the exchangeable sukuk. 
6. Payment of interest amounts due last July and this October. 

DG rejected the offer and is said to be pursuing a litigation-based strategy. Bloomberg cited an unnamed party not authorized to speak on DG’s behalf.  The FT was more categorical that the company had rejected the offer.  FT article here. 

Some comments. 

AA wonders about the creditors’ negotiating strategy.  In Middle Eastern carpet stores, the seller’s initial price is a long way from the price at which he sells.  The prospective buyer needs to have a similar negotiating strategy.  Once the buyer begins negotiations and gives his first price, it's hard to go lower. 

But DG’s creditors face a more complicated situation that buying a rug from a reputable merchant.  DG has adopted an extreme position.  Its current “offer” to the creditors is (a) you owe us money or (b) in worst case we owe you no more than USD 60 million.   

That’s what Herb Cohen would describe as a “Soviet” negotiating strategy.   The appropriate response is not to make a typical counteroffer and then split the difference because the Soviet tactic moves the frame of reference way off market terms.  

Often the counterparty (the party not adopting the Soviet style tactic) proceeds as though it’s in a “normal” negotiation, replies with a counteroffer to the extreme offer, and winds up in effect negotiating with itself to its detriment. 

DG’s creditors need to be very careful not to embark on that path. 

They’ve made an offer (their first price in rug shop terms) from which they will most likely negotiate less favorable (to themselves) terms.  So what does that mean?  A five year tenor?  A USD 100 million principal payment?  An interest rate of 3%?  All of the above. 

A Jimmy Malone (pictured above) strategy seems to be more appropriate given DG’s negotiating strategy and its less than sterling behaviour.  When you’re negotiating with someone you don’t trust, the typical rules of negotiation go out the door.  There’s no “win-win” when the other party is trying to cheat you.  

One other bit of unsolicited advice for creditors: a single word “amortization”. 

No doubt some clever mind has stated that with a three year instead of a five year tenor the average life of the sukuk has been drastically reduced – 5 to 3 years.  But –a rather large but—a bullet is a bullet.  Payment is promised in one lump sum in the future. Creditors would be better off with recurring principal payments (amortization).  Money in the hand now is much more valuable than a promise of money in the future, particularly when the integrity/ethics of the party making the promise to pay are doubtful. 

AA was particularly intrigued by the creditors’ request for a dual listing on the LSE. 

Listing this mutt on the LSE is not going to turn it into a purebred. Or magically create investor demand.  The dumb money is already present.  

Is this an attempt to try and force better corporate governance on DG or somehow bind them closer to English law?   Corporate governance is fundamentally a people issue.  Listing on the LSE doesn’t by itself change that.   Unless DG reincorporates, it is a Sharjah company with all the drawbacks of UAE law. 

Is this an attempt to scare shareholders that the creditors intend to convert the sukuk and take some or all of this “gem” of an investment from their hands, thus, prompting shareholders to put pressure on DG’s board to be more accommodative?  Not bloody likely, the shareholders are a disparate group.  From ADX trading statistics, they appear to be primarily retail investors who no doubt are right now calculating how they will spend their share of the USD 1 billion they imagine will soon be in DG’s hands. The major shareholder is a related party no doubt on board with DG’s “clever socks” strategy. 

To AA’s surprise Goldmine and Blackrock are apparently holders of DG paper.  Unless they bought their stakes at a deep discount and have a reasonable prospect of turning a profit with a fractional return of nominal principal, they should not be DG investors. 

Side note: If they purchased their stakes at a discount, then “whole” dollar creditors should understand there is a fundamental conflict between their own full price interests and  creditors whose entry price is much less. 

In defense of Goldmine and Blackrock, you might be inclined to remind AA about the role of risky securities in a well-diversified portfolio. 

AA is well-schooled in how such a portfolio can tolerate some risky securities.  DG paper certainly falls into that category.  The promised return is tempting, particularly in the current low rate environment.  But there are some risks that one shouldn’t take.  Or if one mistakenly takes them, one should exit.  Despite widespread belief to the contrary, finance theory doesn’t magically protect one from unwise investment decisions. 

Some of the "red" flags on this paper.

1. This company defaulted five years ago. 
2. Since then, its performance (ROE and ROA) and cash generation are dismal -- clear signs of likely future inability to repay. 
3. The sukuk is structured as a bullet which is not appropriate for an issuer like DG nor one that operates in squirrely markets (that’s a technical finance term). 
4. If that weren’t enough, DG is based in a country whose fine legal system motivated the government of one of its constituent emirates to set up an offshore regime, including offshore laws and an offshore court system.  It doesn’t take a law degree to figure out that legal protections for creditors are uncertain (you knew I’d slip a euphemism in somewhere) in DG’s home “court”. 
5. Exacerbating that factor, the deal is highly structured with cross-jurisdictional legal issues abounding.  The fundamental (“Islamic”) structure is not well tested in courts.  Courts in more “certain” legal jurisdictions are unfamiliar with Shari’ah and likely to defer to local courts, undermining to some extent the benefits cross-jurisdictional legal structuring was designed to confer. 

Just one or two of these factors should disqualify this paper. But all of these? One can surely find other high yield securities with less risk baggage.   

One further point for those who read the FT article cited above.  To get more insight into the KRG settlement take a look at my earlier post. And don't miss the posts in reply.  Despite a comment in the FT article about the settlement removing DG’s “ability to pay” defense, cash is not about to rain down on DG.    

Dana Gas: Comments on KRG Settlement

Unless you’ve been asleep you’ve already read about the settlement between the Kurdistan Regional Government and Pearl Petroleum announced on 30 August by Dana Gas. 

Most of the headlines focused on the USD 1 billion payment by the KRG to Pearl Petroleum and did not discuss other aspects of the transaction.  The market reacted with characteristic irrational exuberance. Hence this post.

To start a side comment. In a rather bizarre but not uncharacteristic move, DG did not confirm PPL’s receipt of the payment until 5 September after receiving “numerous market enquiries”.  Apparently, neither DG’s crack investor relations staff nor its management thought that there were parties who would be interested in knowing for certain that the KRG actually made the payment.

Not a particularly “brilliant” move to sit on such critical and positive news but sadly par for the course at DG.  Or as AA’s brother no doubt would have it, “shelled another dolly.” 

Here’s an extract from the joint KRG/PPL press release published by Dana Gas.

The agreed settlement highlights are as follows:

1. The KRG will immediately pay Pearl (PPL) a sum of US$600 million.
2. The KRG will also immediately pay Pearl a further US$400 million to be dedicated for investment exclusively for the aforesaid further development to substantially increase production.
3. Pearl will increase gas production at Khor Mor by 500 MMscf/day, a 160% increase on the current level of production (the "Additional Gas"). The Additional Gas, together with significant additional amounts of condensate, is expected to begin production in approximately two years.
4. The balance of sums awarded by the Tribunal ($1,239 million) is no longer a debt owed by the KRG and will be reclassified as outstanding cost recoverable by Pearl from future revenues generated from the HoA areas.  The profit share allocated to Pearl from future revenues generated from the HoA areas are adjusted upwards to a level similar to the overall profit levels normally offered to IOCs under the KRG's Production Sharing Contracts. This adjustment reflects the larger investment risks and costs involved in the development of natural gas resources compared to oil developments. After the recovery of costs and a return on investment by the Consortium, 78% of revenues generated from the HoA areas will be for the account of the KRG, and 22% for the account of Pearl.  
5. The Parties have clarified the Khor Mor block boundary coordinates and the KRG has awarded the Consortium investment opportunities in the adjacent blocks 19 and 20, and added these to the HoA areas, with commitments by the Consortium to make appraisal investments on these blocks, and developments if commercial oil and gas resources are found.  The KRG will purchase 50% of the Additional Gas on agreed terms to boost the gas supply to power generation plants in the Kurdistan Region.  The other 50% of the Additional Gas (250 mmscf/d) will be marketed and sold by Pearl to customers within Iraq or by export, or can be sold to the KRG as well to further boost power generation within Iraq.
6. Pearl will also expand its local training and employment programs towards achieving maximum localization and content, as well as supporting local communities through its active Corporate Social Responsibility (CSR) programmes.
7. The Parties have exchanged mutual releases, waivers, and discharges in relation to all claims in relation to the Arbitration and related court proceedings. The Parties have also amended and clarified the HoA language and terms, including extension of the term of the contract until 2049. 

Now for a closer look. 

1. DG is a 35% shareholder in PPL so at a first cut, DG’s share of the USD 1 billion payment is USD 350 million.  Sounds good, but there are at least a few wrinkles.
2. That money is at Pearl not DG, though DG will show the USD 350 million in its September financials, just as it shows its 35% share of PPL’s aggregate trade receivables.  If and until PPL transfers funds to DG, DG will not have use of the funds.
3. Also note the money in two tranches.  One of USD 210 million and one of USD 140 million.
4. Let's start with the second amount the USD 140 million. That amount will not be available for DG to use as it wishes because the USD  400 million tranche is required to be spent in the KRG to expand production, assuming of course that PPL honors its commitment to the KRG. 
5. As regards the first amount DG's USD 210 million share of the USD 600 million, how much of this DG will ultimately obtain unrestricted use of depends on Pearl's cash needs, particularly if PPL will require more than USD 400 million to fund the promised increase in production.   If the amount exceeds USD 400 million, then any funds ultimately transferred to DG and its partners for their own use will be lower than the USD 600 million discussed above. 
6. PPL has agreed to release the KRG from its obligation to pay the remaining USD 1.239 billion of the arbitral award.  However, this amount is not completely forgiven or “lost”.  It’s been transformed into a “recoverable cost”.  Under concession agreements, the operator is entitled to recover its invested costs plus a certain return (not specified here and I could not locate it in DG’s financials or other information it publishes) before the profit sharing mechanism becomes operative. 
7. What this means is that PPL and thus DG and its partners will recover this amount over time, if the Kurdistan fields produce.   PPL is thus highly incentivized to ramp up and maintain production as soon as possible.  That’s the good news. 
8. The bad news is that this is an installment payment which is estimated to begin some two years hence.  On a present value basis then PPL will recover less than the USD 1.239 nominal sum.  Depending on the timing of production, the amount may be much less. 
9. The KRG has increased DG’s share under the profit sharing agreement to 22% and has extended the concession period to 2049.  That gives PPL the opportunity for additional earnings and will counteract to some extent the present value loss on the USD 1.239 billion.  Just how much is not clear as again it will depend on the timing of cashflows. 
10. Dana will also be able to sell 50% of the Additional Gas for export neatly side stepping further exposure to the KRG's creditworthiness.
11. PL and the KRG have issued mutual releases on arbitral claims.  You will recall that earlier this year PPL was reported to be pursuing some USD 26.5 billion in claims against the KRF for alleged damages. On a positive note, the settlement of all claims may lead to an increase in KRG payments of outstanding be-whiskered trade receivables which would help DG’s cash flow but not its profit.   The stale receivables have already reduced DG’s realized profit from that reported by the operation of present value.  Nonetheless, more cash in hand would provide DG additional flexibility in conducting its operations.  Were it so inclined—an assumption for which there is scant evidence so far—the cash could be used to repay the sukuk.  This claim has been dropped as language from the preface to the press release indicate. 

The Parties have mutually agreed to fully and finally settle all their differences amicably by terminating the Arbitration and related court proceedings, and releasing all remaining claims between them, including the substantial damages asserted by the Consortium against the KRG.

While there is both some good and some not so good news for DG in the PPL settlement, on balance it probably is a net positive.  AA suspects that those who have read the news of the settlement and are expecting a cash bonanza at DG will be like the bankers who are anticipating "rich investment banking fees" in Saudi Arabia.

But Is this good news positive enough for AA to change his recommendation against investing in DG equity or debt? 

A resounding no. 

The first rule of investing is not to invest with issuers who have demonstrated that they cannot be trusted to honor obligations.   

Tulips and Bitcoin

At Least They're Real

This Tuesday self-described “no nonsense take no prisoners” Jamie Dimon lambasted Bitcoin at a New York investor conference as per press reports. 

The cryptocurrency “won’t end well,” he told an investor conference in New York on Tuesday, predicting it will eventually blow up. “It’s a fraud” and “worse than tulip bulbs.”

Indeed, at least if you buy a tulip bulb, you have something tangible.  A Bitcoin is the monetization of a wish.

Many self-described “sober investors” who buy Bitcoin offer as their “sound” rationale that governments create national currencies out of thin air without “backing” the issuance with any tangible asset and that as a result these currencies are inherently dangerous.  To avoid this “clear” danger they instead “invest” in a currency issued by a private sector entity out of thin air without “backing” by any tangible asset.  

But there are key differences that make this investment a “wise” one so they say. 

• First, aggregate issuance is limited.  
• Second, unlike a government, the private sector entity issuing Bitcoin has no legal powers or ability to support its currency’s value, instead relying on the proven performance of the “free market” for magical solutions.  A dogma that almost certainly Jamie sadly won't have time to address.

To those wise investors AA wants to offer an even more compelling opportunity: AA’s new “virtual” company that will manufacture digital electronic vehicles.  The upside is clearly unlimited as costs of manufacture and selling are low. No raw material except an odd electron here and there is used in the manufacturing process.  There are no associated shipping costs for the product.  Nor do our dealers need to hold physical inventory.

AA’s digital cars also are environmentally friendly.  There are no emissions associated with the manufacturing process or the finished product when in operation.       

Patriotic investors will be happy to note that AA is a proud participant in the current Administration’s Make America Great Again Manufacturing Program.  Our factory is based in the United States where we project that we will employ a virtual workforce of over 150,000 when full capacity is reached.  Strict sourcing standards ensure that only US electrons are used in our product.    

Disclosure: AA and a member of his direct household (Madame Arqala) hold investments in tulips between 15 and 30 bulbs planted in the elegant gardens of Chez Arqala. 

Further Pressure on Qatar. Really?

When A Story Falls Through the Cracks, Who Catches It?

If you read Gulf News regularly, you’ll have seen their article on Fitch’s downgrade of Qatar’s long term sovereign risk rating to AA- “Qatar Faces Further Pressure as Fitch Downgrades Sovereign Rating”.  

Sounds grim, perhaps even "subdued" if we apply Indian standards. 

But when context is missing, AA is there to catch what’s fallen between the cracks or perhaps in this case deliberately dropped between the cracks given GN’s demonstrated past ability to quote press releases verbatim.

Fitch did indeed downgrade Qatar’s sovereign rating.

A couple of points.  

First, AA- is still investment grade. 

Second, within the GCC context, Qatar’s sovereign rating is certainly well within range of its neighbors.  Fitch ratings page here.

COUNTRY	RATING
Bahrain	BB+
Kuwait	AA
Oman	BBB
Qatar	AA-
Saudi Arabia	A+
UAE	AA

Earlier this year, Fitch downgraded KSA several notches in one go. The pressure must be intense if one applies GN standards.  As to Bahrain, if you don’t know, BB+ is non-investment grade.  

Third, regarding my comment about taking flawless dictation from press releases, here are some quotes that GN somehow omitted.  Fitch press release here.  AA comments in red boldface.  Other boldface to highlight key points.

At an expected 146% of GDP in 2017, Qatar's SNFA [sovereign net foreign assets] are well above the 'AA' median and are sufficient to finance two decades of fiscal deficits or to repay all the estimated external liabilities of GREs, banks, and the private sector (around 90% of GDP).  Qatar's SNFA are underpinned by the foreign assets held by the QIA. Specific figures on the size, returns and asset allocation of the QIA are not publicly disclosed, but we estimate that its foreign assets amounted to USD283 billion at end-2016. We expect QIA foreign assets to fall in 2017 as a result of draw-downs to support the banking sector, which may not be completely offset by the return on QIA assets.

And here's another.

Qatar has been able to restructure its supply chain and avoid major economic and social instability. We expect only a slight up-tick in inflation (to 4% in 2017 from 2.8% in 2016). Inflation was 0.2% yoy in July 2017 (4% for food). Imports dropped 40% in June, but we expect that this will be temporary. Ports in India and Oman have replaced Dubai's Jebel Ali as transhipment points for goods destined for Qatar. Significant stockpiles of construction materials are giving the government time to examine longer-term supply options even as deliveries from quarries in Iran and Oman continue. Qatar Airways' cargo capacity has been used to maintain supplies of food and other perishable goods.

When you factor all this in, and AA hopes you do, you may have a different view of Qatar’s current situation. (Note that caveat.)

Unwarranted Hubris on the Potomac

Some Countries Have Scary Clowns Others Have Happy Ones    

This week Rachel Sylvester at The Times published a rather unflattering article on the UK’s Foreign Secretary Boris Johnson, “Our Foreign Secretary is an International Joke”.

“According to diplomatic sources, even officials at the Trump White House “don’t want to go anywhere near Boris because they think he’s a joke”. 

A rather low blow, indeed. 

AA wonders--and wonders if you do too— if officials at the TWH are self-aware enough to realize that Boris is appropriate company. 

Matthew 7:3-5  is no doubt appropriate here.