Where's all the oil money going?
By
Dan Denning Feb 08, 2007
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This article was first published on 10/11/06
Investors are obsessed with China. It’s been the biggest thing in the investment world for so long that, for many, investment strategy simply means looking for a new angle on the Chinese boom. But is this really the best way to make money in today’s markets? A few years ago, the answer to this question was a very firm ‘yes’. China’s growth created a surge in demand for commodities. Productive capacity in the global commodities sector was already tight after 20 years of underinvestment. In between the tight supply and growing demand there were huge profits to be found investing in the raw materials of civilisation and the firms that mined or made them. MoneyWeek readers should have laid claim to some of those profits: we’ve been tipping the mining stocks since 2000.
So what’s different now? Demand for commodities is still robust, but as the recent correction in resource prices showed, hedge funds and ‘hot money’ had as much to do with gains in commodity shares as did Chinese demand and tight supply. Now that the hedge funds have moved on to other trends (such as private equity), we aren’t going to see the kind of spectacular gains we have in the last few years. Instead, commodities will resume the long, steady, secular bull market they began in 2000. I’m not saying you won’t do well from holding them, I’m just saying that there’s a new “next big thing” out there that you’ll probably do even better from.
Where are the petrodollars?
What is it? The first clue comes from the chart, taken from a report this summer by UBS entitled “Petrodollars: where are they and do they matter?” Normally you’d expect the vast and growing amount of dollar surpluses generated while oil made historic highs to have found their way back to America and to show up as invested in the US Treasury market (this is what has tended to happen in the past). But this time that doesn’t seem to have happened. Instead, the petrodollars are… well… they are missing.
There’s no other way to put it. According to the official statistics, the dollar flows generated by the oil trade are NOT all showing back up in the
US Treasury market. So where are they? Here it would be appropriate to trot out the usual suspects, hedge funds and private equity. Yet even once you’ve accounted for assets under management outside the bond and stockmarkets, there is still an ocean of dollars missing.
For the next clue we need to look away from the chart and to the sky. If you were in London on 9 November 2006, you might have seen a Zepplin hovering above you. The airship had been chartered by Nahkeel, a government-controlled property developer in Dubai. The airship – and I’m only visualising this myself, since I’m over in Melbourne thousands of miles away and can’t actually see it – should be circulating over London’s famous landmarks in an attempt to draw attention to what may eventually become one of the world’s greatest wonders: Palm Jumeirah. Palm Jumeirah has been the world’s largest construction site for some time – much bigger, even, than any of the many sites in China. But you have to build big when you think big. And there’s not much bigger an idea than creating a residential and commercial island in the shape of a date tree with seventeen fronds and dredging 80 million cubic metres of mud from the Gulf of Arabia to do it.
And yet Palm Jumeirah, which welcomed its first real residents on 9 November, is but the first and not even the largest of the four projects the Dubai authorities are planning. The others – Palm Jebel Ali, the World (you guessed it, an artificial island developed in the shape of a world map) and Palm Deira – will be even larger and more audacious. The whole development is being called by its backers the ‘Eighth Wonder of the World’. This name is the most modest thing about it. Palm Deira, if and when it’s ever completed, will be 14 kilometres long and eight and a half kilometres wide, creating 80 square kilometres of commercial and residential – to say nothing of surreal – space where none existed before.
Could investment in infrastructure produce a sustainable economy?
So what’s my point? That the petrodollars that we can’t trace in the markets haven’t disappeared. Rather, they are being recycled into infrastructure projects. And what that tells me is that for investors the next big thing is all about investing not in the firms that dig raw materials out of the ground, but in those that turn them into the finished structures of civilisation: the Palm Jumeirahs of the world. In Dubai, the developers claim that their huge projects make sense, in that they will set the United Arab Emirates up for the day when they can no longer live off the fat of natural gas and oil exports (the UAE has the world’s fifth largest reserves of natural gas). It is, in other words, an attempt to turn petrodollar profits into a sustainable economy for the era when the oil and gas are gone (or the profits from them are gone) and it is something that is happening across Arabia: projects on a scale that would humble a pharaoh are springing out of the hot sand of Arabia.
Whether this is visionary – effectively turning resource wealth into capital-producing assets that last longer – or the most colossal and inefficient use of capital in human history, is an intriguing question. It is also beyond the scope of this story. And the truth is, it doesn’t matter. Did the Egyptians ask the pharaoh what good a big pyramid would be? Of course not. They built it. The same will happen in Dubai. The only difference is that today the stone masons, quarries and labour (or modern-day equivalents) are all publicly traded companies that stand to make handsome profits on this and on a large library of other infrastructure projects in the Middle East and developing world.
Whether the capital is allocated efficiently or not is a debate for the academics. These things will be built either way, simply because the money is there to build them. And so is the political will: not only is the Arab world sitting on a very large pile of cash, but it’s growing. The GDP of the
22-member Arab League, according to Associated Press, actually exceeded $1trn for the first time ever in 2005.
GDP is in many ways a meaningless and symbolic number. However, I mention it here just to make a point for more suspicious readers. It is easy to assume that the Arab world is currently self-destructing, that the oil money will end up doing it no good. In fact, the opposite may be true: it may be on the cusp of a boom. And as we mentioned, even if the projects do end up becoming monuments to the audacity and stupidity of their backers (which they may or may not – I’m not judging), they will still be built. The world will see more giant Arabic, larger than life, island McMansions in the not too distant future. And the money that is being spent on them is very real. One example: MMC Corp, a Malaysian-based builder and operator of ports, recently won a contract with the Saudi Binladin group to build the Saudis a $30bn new city in the North.
It is contracts like this that interest us the most: they can fill a firm’s order book for years. More importantly, they can reward shareholders in the
next 12 months.
Investing in infrastructure: beyond the Middle East
Investing in infrastructure isn’t just about the Middle East. There are huge projects going on elsewhere as well (note the massive $5.25bn expansion of the Panama Canal discussed in last week’s MoneyWeek – see www.moneyweek.com if you missed it). Ernst and Young predict that “pure global infrastructure demand” over the next decade will be worth “well in excess of $8trn. It’s an investment idea that’s become enormously popular here in Australia through Macquarie Bank’s Infrastructure funds (it was Australia’s Macquarie Bank that led the consortium that bought Thames Water last week, for example) and is starting to pick up steam in the UK too. However, it’s the Middle East angle that I think is most interesting. The stockmarkets in the likes of Dubai and Cairo are famously volatile, making it tough for the average investors to use them to get safe exposure to Middle Eastern growth and I’ve been keeping my eyes open for another way in for some time. Infrastructure is that way in.
The logical investment question then is simple: which firms are going to make the most money out of this boom? Who are the proverbial “pick and shovel companies” of the Arab world’s great building boom? In the box below, we look at our favourite global infrastructure and construction firms
and explain why they make the grade.
Construction and infrastructure: three winning firms
The British may not be feeling that kindly towards Australian building firms, given what a mess the country’s Multiplex has made of the new Wembley Stadium project. But investors shouldn’t let this blind them to the potential of other Australian firms, many of which have an increasingly global reach in infrastructure projects. Backed by strong infrastructure spending – especially in mining – at home, Aussie firms are branching out to Asia, the Middle East and even Europe, building an order backlog and demonstrating world-class expertise on everything from transportation projects to oil, gas, mining, and pipeline projects. That means that if you want to find a way to make money out of the oil-driven building boom in the Middle East, they’re an excellent place to put your money.
Transfield Services (TSE)
Transfield Services calls itself “a leading international provider of operations, maintenance, asset management and project management services”, which “operates in Australia, New Zealand, the United States, the United Arab Emirates, Qatar, South East Asia, India and Canada across diverse industries – including mining and process, hydrocarbons, roads, rail and public transport, water, power, telecommunications, facilities management and defence. Clients include major national and international companies, as well as all levels of government.“ All this is true. It has demonstrated competence managing and growing its local business in the booming Aussie infrastructure market and has recently gone global, which is what excites me.
In early October, the company announced acquisitions that would extend its reach into the Persian Gulf Region. Specifically, Transfield announced it had purchased international services company Hofincons Infotech & Industrial Services Private Ltd in India for A$9m. Hofincons is a wholly owned subsidiary of Tyco Asia Investments Limited, with revenue of more than A$19m per year. The key part of the deal is that the firm provides operations and maintenance services to clients across India and the Gulf region. This gives Transfield a bigger footprint in India and the Gulf, two of the fastest-growing infrastructure markets on the planet. Peter Watson, Managing Director and CEO of Transfield Services, put it this way, “This acquisition also includes 3,500 skilled employees working across India and the Gulf Region. Access to a large and technically skilled workforce is a competitive advantage when labour shortage is an issue faced by so many other companies. It is our intention to draw upon this workforce to support our existing activities in Abu Dhabi and Qatar.”
Earlier in the year, Transfield also acquired Intergulf General Contracting LLC, through joint venture company Tespec, giving it another inroad into the Gulf market. Intergulf, according to the Transfield press release, provides maintenance and capital works services to the oil, gas and power industries in the United Arab Emirates and enhances the company’s skills and resource base in the Gulf Region. Tespec is a joint venture between Transfield Services and Emdad LLC, based in Abu Dhabi in the United Arab Emirates. The shares have a forward p/e for 2007 of 18.6, which, while it isn’t cheap, isn’t bad either – given the growth potential inherent in this kind of global expansion.
Leighton Holdings (LEI)
At the end of September, Australia-based Leighton Holdings (LEI) reported it had A$17bn worth of construction and development projects in hand. The markets loved the news. Business in Australia is good, with Leighton Holdings winning a $1.9bn contract for Brisbane’s Gateway project and $800m mining contract in Prominent Hill. But even if infrastructure spending in Australia slows down as the Reserve Bank of Australia tightens credit, Leighton is going to do just fine, given that it is expanding into both Asia (where, of course, infrastructure spending is also soaring) and the Gulf. Leighton’s 2006 pre-tax profits from its Asian operations alone grew by 72% to $99.8m – an enviable move by any standards. But as the firm expands further into India and the Middle East, it can expect to take on more dangerous projects where costs – and risks – are harder to control.
To compensate for some of that risk, the company is going big into China. In October, it announced a joint venture with China State Construction Engineering. It has signed a letter of intent to build the Melco International/Publishing & Broadcasting Ltd (PBL) casino project in Macau.
The project, set to cost $1.3bn all in, is called “the City of Dreams,” and while not as grandiose in ambition as the Dubai palms projects, is still ambitious – if only in terms of the construction schedule. But Leighton President Wal King says the company is up to the challenge and that the business is good. “We’re getting a good performance across the board,” King says. “The main drivers are our resource business, both in Australia and Asia, where we have a series of big mining contracts, combined with our infrastructure business, mainly in Australia, where we’ve got a series of major infrastructure projects. We also have some big infrastructure projects in Hong Kong and our emerging business in the Gulf and India, all of which will be good contributors.”
Leighton Holdings has grown its annual dividend steadily over the past five years – the shares currently yield around 3% and trade on a forward p/e for 2007 of 18 times. Again, on the face of it, 18 times isn’t cheap, but with analysts forecasting earnings growth of 17%, the shares are trading on a price to earnings growth ratio of only just over one.
Orica (ORI)
Finally, we recommend punters take a look at Orica, an Australian-based mining services company. If the name Orica sounds familiar, that’s because it bought UK-based Minova for A$857m in October. Minova is a specialist supplier of chemical products – including resin capsules, powders and injection chemicals – for use in stabilisation and ventilation systems in underground mining and civil engineering projects, such as tunnelling. Orica’s largest business is mining services – but it is also the world’s biggest maker of explosives, and the acquisition of Minova gives it a complementary business. The deal is expected to deliver an 18% return on net assets in the third year after the business has been fully integrated. The group has benefited particularly from growth in the coal-mining sector, one of its biggest customers, driven by China’s demand for energy and increased interest in the fossil fuel as a cheap alternative to oil. While oil prices remain high, demand for coal-mining services can only grow.
Orica is run globally with a presence in Australia, Asia, Europe, the former Soviet Union, Africa, the Middle East, North America and Latin America. It trades on the ASX under the symbol ORI. The shares are trading on a p/e for 2007 of around 14, and the current dividend yield is a healthy 3%.
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