File 016111
GEMs Paper #26: Saudi Arabia Economic Analysis and National Transformation Plan (File 016111)
Bank of America Merrill Lynch research paper analyzing Saudi Arabia's National Transformation Plan, economic diversification strategy, and investment themes for 2016-2020 period.
Summary
This GEMs research paper provides comprehensive analysis of Saudi Arabia's National Transformation Plan (NTP) and Vision 2030 reform agenda. The report examines macroeconomic policy consistency, energy sector liberalization, fiscal sustainability, and identifies six investible themes including affordable housing, healthcare access, telecommunications infrastructure, and downstream petrochemicals. Authors assess risks including unrealistic fiscal targets, commodity market tightness, and currency peg sustainability while evaluating potential market rerating opportunities through MSCI index inclusion and oil price recovery.
GEMs Paper #26Saudi Arabia: beyond oil but not so fast30 June 2016 CorrectedUnauthorized redistribution of this report is prohibited. This report is intended for amanda.ens@baml.comTransforming Saudi Arabia, but challenges aboundThe Saudi National Transformation Plan (NTP) bodes well for comprehensive reformefforts to diversify the economy in line with Vision 2030. The NTP a) identifies keysectors with high growth potential; b) starts to articulate supportive public sectorindustrial strategies; and c) seeks to foster higher value-added through enhancements toprocesses, products and organizations. Still, ambitious targets in a number of sectors areunlikely to be reached and medium-term macro sustainability is not yet clear.USD peg holds but NTP inconsistent with stable FX policyOur view is still that the USD peg holds. However, the NTP provides a mixed message.On the one hand, it blurs policymaking incentives given the need for a competitive Fx ifdiversification progresses. On the other, unrealistic fiscal targets mean consolidation islikely to fall short of easing imbalances materially without oil price recovery. Energypolicy thus likely needs to become less aggressive to support macro and FX policies.Eurobond premium required for fiscal slippage riskWe expect large and regular sovereign Eurobond issuance to support FX reserves anddomestic liquidity but to weigh on regional bond spreads if risk appetite does not holdup or fiscal balance slips. EMBIG index inclusion is unlikely, in our view. Saudi forwards,CDS and rates are likely to stay under pressure due to issuance and tight liquidity.Commodities: NTP adds to medium-term oil tightnessThe NTP suggestion that production capacity is maintained until 2020 reinforces ourconviction of medium-term oil market tightness. The NTP gas production target thatcould displace domestic crude demand and boost export capacity is challenging.Equity Strategy: six investible themes on the back of NTPWe see a number of investible themes emerging from the NTP which investors can useto identify potential beneficiaries. These themes include rising availability of affordablehousing, increased access to healthcare, down-trading as the consumer comes underpressure, a surge in telecom infrastructure and significant opportunities in thedownstream petrochemical arena. Buy-rated names with access to these themesinclude: Al Hammadi, Savola, Al Othaim, STC, Zain KSA and SABIC.Partial NTP success & MSCI inclusion could drive reratingThe Saudi market trades on a 12m fwd P/E of c.13x, an 11% discount to the long-termaverage and its lowest premium to GEMs since 2010. We believe that with earningsmomentum gradually reaching an inflection point a relatively negative outlook is alreadybeing priced in. Given our view that oil prices will gain strong momentum in 2017, evena partial success of the NTP along with CMA market reforms to expedite inclusion in theMSCI EM index could be sufficient to improve confidence and thus drive a rerating.Trading ideas and investment strategies discussed herein may give rise to significant risk and are notsuitable for all investors. Investors should have experience in FX markets and the financial resources toabsorb any losses arising from applying these ideas or strategies.>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst underthe FINRA rules.Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that takeresponsibility for this report in particular jurisdictions.BofA Merrill Lynch does and seeks to do business with issuers covered in its research reports. As aresult, investors should be aware that the firm may have a conflict of interest that could affect theobjectivity of this report. Investors should consider this report as only a single factor in makingtheir investment decision.Refer to important disclosures on page 82 to 85. Analyst Certification on page 81. Price ObjectiveBasis/Risk on page 77. 11643724GEM Fixed Income Strategy & EconomicsGlobalJean-Michel SalibaMENA EconomistMLI (UK)+44 20 7995 8568jean-michel.saliba@baml.comHootan Yazhari, CFA >>Research AnalystMerrill Lynch (DIFC)+971 4 4258218hootan.yazhari@baml.comFrancisco BlanchCommodity & Deriv StrategistMLPF&S+1 646 855 6212francisco.blanch@baml.comFaisal AlAzmeh, CFA >>Research AnalystMerrill Lynch KSA Company+966 11 299 3741faisal.alazmeh@baml.comAbdelrali El Jattari >>Research AnalystMerrill Lynch (DIFC)+971 4 4258231abdelrali.eljattari@baml.comJamie Clark, CFA >>Research AnalystMLI (UK)+44 20 7995 1300jamie.clark@baml.comAli DhaloomalResearch AnalystMLI (UK)+44 20 7996 9107ali.dhaloomal@baml.comCeline Fornaro >>Research AnalystMLI (UK)+44 20 7996 5515celine.fornaro@baml.comSee Team Page for Full List of ContributorsA Transforming WorldThis report ties into the enterprise-wide InvestmentThemes recently introduced in A Transforming World. Inparticular, the Saudi National Transformation Plan islikely to span the themes of Markets (Frontier),Government (Reform) and Earth (Energy Efficiency)ContentsMacro: charting the way forward 3Towards better governance 3Public Investment Fund to gain prominence 7Historic energy sector liberalization 10National Transformation Plan: many promises, few details 13Lessons in diversification 31Eurobond premium required for fiscal slippage risk 34Commodities: NTP adds to medium-term oil market tightness 36Equity Strategy: more clarity required, but investible themes emerging 39Six key investible themes from the NTP are emerging 40Saudi market valuation not testing 42Taking positive steps to accelerate MSCI inclusion 45A higher weighting in international indices 45Telecom: supporting a move to higher connectivity 48NTP helps increase penetration of higher margin offerings 48Health: Not Tremendously Prescriptive 51Vision 2030 a start but Needs Transparent Proposals 51Healthcare implications of National Transformation Plan 51Consumer: a necessary pain 58Prefer staples over discretionary 58Rationalization of subsidies for water and electricity 60Saudi Arabia approves 100% foreign ownership rules 61Real estate: NTP positive but not enough 64Key strategic objectives and KPIs to watch 64Land tax - gradual revenue source 65Metals & Mining: ambitious growth target 67Government focus on mining to boost jobs and growth 67Oil & gas/petchems: focus on downstream 69Focus on downstream expansion is a priority 69Refining capacity target: almost there 71Ambitious natural gas expansion 72Utility sector: sharing the capex burden and achieving cost reflective tariffs 73Eight strategic objectives aimed at being self-funding 73Defence: Vision 2030 supports defence spending 75Saudi Arabia to build out military industrial base 75Research Analysts 862 GEMs Paper #26 | 30 June 2016Macro: charting the way forwardJean-Michel SalibaMLI (UK)jean-michel.saliba@baml.comThe Saudi Vision 2030 and National Transformation Plan (NTP) present acomprehensive roadmap for change and augur for committed diversification efforts, inour view. Announced reforms can help sustain higher potential growth if fully realized asnew sectoral sources of growth are developed. Positively, the NTP borrows elementsfrom other successful strategic case studies. Still, we find a number of targetsambitious or unrealistic on the fiscal and diversification fronts, and the sequencing anddetails of the fiscal measures are left nebulous.In terms of the other pillars of the macro view, namely energy and Fx policy, the NTPpresents a mixed picture, in our view. Energy policy is likely to be less aggressive, as theNTP suggests a constant oil production capacity. To remain consistent with the targetedgovernment debt accumulation path, we estimate that oil prices have to average at leastUS$50/bbl in 2016-20 along with no growth in spending (excluding the additional costof NTP initiatives). Partial implementation could require oil prices of cUS$65/bbl.Fiscal consolidation remains imperative to support the Fx peg, in line with stability andeconomic imperatives. However, as diversification progresses, the case for increased Fxflexibility to support competitiveness could likely gradually take shape. Policy-makinggrowth-focused plans may conflict with needs to deflate Fx demand in the economy.Towards better governanceThe comprehensive economic blueprint unveiled by the Saudi Vision 2030 and theNational Transformation Plan (NTP) confirms the economic reform credentials of thecurrent administration. It is likely to improve government culture, accountability andtransparency, in our view. The NTP will be implemented across 24 government bodiesand has been presented through a number of press conferences with high-levelministerial presentations. The Governance Framework details steps to institutionalizeand coordinate implementation through restructuring the government. It proposes anumber of committees and bodies to report to the Council for Economic andDevelopment Affairs (CEDA). It also introduces an escalation mechanism to rapidlyresolve bottlenecks, which could see matters escalated to CEDA in 42 days.A wide-ranging policy-making reshuffleIn line with ongoing Saudi Vision 2030 implementation efforts, a wide-rangingrestructuring of the Saudi Cabinet and government bodies was announced in May todrive change in the government. King Salman issued 51 Royal Decrees restructuring theCabinet, various government bodies and appointing a number of officials into variousgovernment roles. A statement concurrently issued by the Royal Court suggested thesechanges are in line with the recently announced Saudi Vision 2030 and aim to supportits implementation. This follows from the January 2015 restructuring of the bodiesaffiliated to the Council of Ministers, which saw the creation of CEDA and the Councilfor Political and Security Affairs. We list a few major changes below.New Oil Minister represents technocratic experience and policy continuityThe appointment of Khalid Al-Falih to the Ministry of Energy, Industry and MineralResources is not surprising, given that former Minister of Petroleum and MineralResources Al-Naimi has previously suggested he was approaching retirement due to oldage. Al-Falih’s appointment continues the tradition of non-Royals heading the Ministry,while simultaneously holding the Chairmanship role of Saudi Aramco. Furthermore,according to local press, Al-Falih appears close to Deputy Crown Prince Mohamed binSalman, and his appointment likely confirms the recently assertive Royal influence overenergy policy, in our view. New Minister of Energy, Industry and Mineral Resources Al-Falih’s past official pronouncements are consistent with stable Saudi energy policy, inour view.GEMs Paper #26 | 30 June 2016 3Expanded role for the Oil Ministry under Vision 2030The Ministry of Petroleum and Mineral Resources has been expanded to become theMinistry of Energy, Industry and Mineral Resources. It will be dedicated for energy, inaddition to expanding to encompass responsibilities relating to electricity and industry.It will also undertake the management of the National Industrial Cluster DevelopmentProgram (NICDP). The new Minister will chair the board of directors of the RoyalCommission for Jubail and Yanbu, the Industrial Development Fund, the SaudiOrganization for Industrial Estates and Technology Zones, the Saudi Geological Survey,the King Abdulaziz City for Science and Technology, the Saudi Exports DevelopmentAuthority and the King Abdullah City for Atomic and Renewable Energy.Energy sector liberalization drives non-oil diversificationThe wider role for the Ministry of Energy, Industry and Mineral Resources is in line withthe expanded industrial responsibilities foreseen for Saudi Aramco in the Vision 2030. Itmay also suggest a continued desire to liberalize the energy sector. The NationalIndustrial Cluster Development Program (NICDP), established in October 2012 by theMinistry of Petroleum and Mineral Resources and the Ministry of Commerce andIndustry, could likely gain further importance in the industrialization strategy adopted inthe Vision 2030. The NICDP will be managed by the Ministry of Energy. It seeks toleverage Saudi Arabia’s comparative advantage in energy, petrochemicals and mineralsto create sustainable export oriented industries, initially focused on the automotive,construction material, appliances, metal processing and flexible packaging sectors.Restructuring the Cabinet and other government bodiesThe Ministry of Commerce and Industry will become the Ministry of Commerce andInvestment and sees the appointment of a new Minister. The new Minister will chair theboard of directors of the General Authority for Investment, the General Authority forSmall and Medium Enterprises and the Saudi Standards, Metrology and QualityOrganization. The Ministry of Labor will be merged with the Ministry of Social Affairs toform the Ministry of Labor and Social Development, and sees the appointment of a newMinister. The Ministry of Water and Electricity has been disbanded. The Ministry ofAgriculture was renamed the Ministry of Environment, Water and Agriculture andexpands its responsibilities into these areas. Two new Ministers for Transport andHealth were appointed. The Ministry of Hajj has been renamed the Ministry of Hajj andUmrah and sees the appointment of a new Minister.The Saudi Fund for Development will now report to the Council for Economic andDevelopment Affairs. The General Authority for Entertainment and the General Authorityfor Culture have been created. The Department of Zakat and Income Tax was renamedthe General Authority for Zakat and Income, and will report to the Ministry of Finance.New Central Bank Governor maintains commitment to USD pegSaudi Arabian Monetary Agency (SAMA) Governor Al-Mubarak has been replaced in hispost by SAMA Deputy Governor for Research and International Affairs Dr. Al-Kholifey. Anumber of officials were also appointed into various government and advisory roles.New SAMA Governor Al-Kholifey’s past policy pronouncements suggest continuedcommitment to the USD peg.Watch the Saudi Fund for DevelopmentThe Saudi Fund for Development (SFD) new direct link to the Council for Economic andDevelopment Affairs likely concentrates further authority in the Deputy Crown, in ourview. Given that the Public Investment Fund (PIF) last saw similar links being establishedprior to plans being made for it to be turned into a Sovereign Wealth Fund (SWF), thiscould suggest further strategic changes may take place at the SFD.4 GEMs Paper #26 | 30 June 2016Exhibit 1: Saudi Vision 2030 Governance ModelSource: Saudi Vision 2030A web of Strategic ProgramsSaudi Vision 2030 incorporates a number of Executive Programs and initiatives, withimplementation carried out by several government entities. The Vision continues tocentralize decision-making into CEDA, chaired by Deputy Crown Prince Mohammed binSalman, and reporting to the Council of Ministers. The Ministry of Economy andPlanning also retains an important role, with lower emphasis being put on the Ministryof Finance. The Project Management Program also suggests emphasis on ongoingreview of capital expenditures, whereby existing review served to examine their approvalprocess, and control their level. From a macro perspective, the three most importantprograms for now are: a) the re-shaping of the Public Investment Fund (PIF) into aUS$2trn Sovereign Wealth Fund (SWF); b) the new corporate strategy for Saudi Aramcoto transform it into an energy and industrial conglomerate; and, c) the NationalTransformation Plan (NTP) which encompasses medium-term growth boostinginitiatives and fiscal consolidation measures (alongside the Fiscal Balance andPrivatization Programs). We discuss these three elements in turn below.Table 1: Strategic Programs introduced by the Saudi Vision 2030Strategic ProgramCommentGovernment Restructuring ProgramSupreme Councils have already been implemented, and the Council of Political and Security Affairs and the Council ofEconomic and Development Affairs (CEDA) have been establishedStrategic Directions ProgramStrategic directions determined by state agencies and approved by the governmentRegulations Review ProgramSeveral laws have been reviewed or enacted already such as the Company Law, the Non-Governmental Organizations Law,the White Land Law, and the General Authority for Endowments (Awqaf) LawPerformance Measurement ProgramCenter for Performance Management of Government Agencies has been establishedHuman Capital ProgramAims to measure, assess, analyze and support the efficiency of civil serviceProgram for Strengthening Public Sector Governance Strategic Management Office reporting to CEDA as well as a Decision Support Center at the Royal Court are to be establishedStrategic Partnerships ProgramAims for stronger ties with economic partners to enhance exports"Daem" ProgramAims to enhance the quality of cultural activities and entertainmentPrivate Sector Growth Stimulation ProgramUnder considerationRegional Development ProgramUnder considerationFiscal Balance Program Likely target of achieving fiscal balance by 2020Project Management ProgramExpert Project Management Offices (PMOs) and a Central Delivery Unit have been establishedSaudi Aramco Strategic Transformation ProgramAims to position Saudi Aramco as a leader in more than one sectorPublic Investment Fund (PIF) Restructuring ProgramAims to transform the PIF into the largest Sovereign Wealth Fund (SWF) in the worldPrivatization ProgramComprehensive privatization program; targets under studyNational Transformation Plan Program Interim Key Performance Indicators (KPI) targets to achieve by 2020Source: Saudi Vision 2030, BofA Merrill Lynch Global ResearchGEMs Paper #26 | 30 June 2016 5Table 2: Initiatives introduced by the Saudi Vision 2030Initiative Current TargetReligious tourismNumber of yearly Umrah visitors per year (mn) 8 30Building the largest Islamic museum in the world - -CultureNumber of Saudi heritage sites registered with UNESCO 4 8Number of Saudi cities recognized in the top-ranked 100 cities in the world 0 3Household spending on cultural and entertainment activities (%) 2.9 6SocialAverage life expectancy (years) 74 80Unemployment rate (%) 11.6 7Female labour force participation (%) 22 30Household savings ratio (% of household income) 6 10Ranking in the Social Capital Index 26 10Ratio of individuals exercising at least once a week (%) 13 40Number of volunteers per year 11,000 1,000,000LocalizationLocalization of oil and gas sectors (%) 40 75Localization of defence industry (%) 2 50Renewable energy value chain (%) - -Sovereign Wealth FundPublic Investment Fund assets (SAR bn) 600 7,000EconomyGlobal ranking of the economy in terms of size 19 15Ranking in the Global Competitiveness Index 25 10Ranking in the Logistics Performance Index 49 25Private sector contribution to GDP (%) 40 65Foreign Direct Investment (% of GDP) 3.8 5.7Non-oil exports share in non-oil GDP (%) 16 50SME contribution to GDP (%) 20 35Non-profit sector contribution to GDP <1 5Improving the business environment and pursuing public-private partnerships - -Rehabilitating economic cities and restructure King Abdullah Financial District - -Establishing special zones such as logistic, tourist, industrial and financial ones - -Revise energy subsidies and redirect support to eligible citizens and economic sectors - -Ease restrictions on ownership and foreign investment in the retail sector - -FiscalNon-oil government revenue (SAR bn) 163 1,000GovernanceRanking in the Government Effectiveness Index 80 20Ranking in the E-Government Survey Index 36 5Source: Saudi Vision 20306 GEMs Paper #26 | 30 June 2016Public Investment Fund to gain prominenceThe restructuring of the Public Investment Fund (PIF) is likely to allow greater focus onachieving a diversified foreign asset base which could support in turn the build-up ofnon-oil revenues. According to Deputy Crown Prince Mohammed bin Salman,government ownership of Saudi Aramco would be transferred to the PIF, which will betransformed into a SWF that will look to increase its overseas assets (from 5% of totalto 50% of total by 2020) following its recapitalization and the proceeds of Aramco IPO.The PIF would hold on-paper a vast amount of wealth post-IPO (US$2trn, according tothe Deputy Crown Prince, the bulk of which would be Saudi Aramco) as ownership ofSaudi Aramco is transferred to the PIF, but it would only be able to deploy the cashproceeds of the monetized Aramco stake in the near-term, in our view. We think thePIF’s transformation is still at a relatively early stage for now.Room to grow PIF stature and budget contributionThe restructuring of the PIF is likely to allow further diversification of foreign assets,which will in turn increase the share of investment income in the budget over time. Weestimate that in 2015 investment income transferred to the budget stood at US$9.9bn(1.5% of GDP), which entails transfers of US$4bn from the PIF and US$5bn from SAMA.These transfers pale in comparison to the estimated budgetary contributions amongmain GCC peers. We estimate that the rate of return (investment income) on foreignassets of SAMA, government entities and the private sector averaged c2% over the past8 years, which already suggests some exposure to riskier asset classes, in our view. Asthe PIF gains importance, it will become more prominent in the examination of thebreakdown of the Saudi Net International Investment Position .Transitioning to an Abu Dhabi modelIt will be interesting to see how the restructuring of the PIF into an SWF works out inpractice. We hypothesise that it may be that, on top of the monetization of Aramco'sstake sale, PIF could get a portion of the assets of SAMA. In this scenario, we wouldeffectively transition to the Abu Dhabi and Kuwait model where the central bank holdslittle reserves and non-transparent SWFs are what matters both in terms of flow andstock. Foreign assets purchases of the PIF would also have to be managed within theoverall Balance of Payments (BoP) framework as they could lead to drains on SAMAreserves in the near term. Over time, Saudi Arabia could decide to emulate the Norwaymodel, which would entail a more prudent use and conduct of fiscal policy, in our view.Chart 1: PIF budget contributions small versus GCC SWF contributions403530252015105US$bn % of GDP % of total revenues0Qatar Abu Dhabi Kuwait Saudi Arabia DubaiSource: Haver, IMF, Saudi Ministry of Finance, BofA Merrill Lynch Global Research. 2015 data,Investment income and transfer of profits of public entities for Kuwait. Investment income frompublic enterprises (incudes Qatar Petroleum’s net income) for Qatar.Chart 2: High rate of return suggests foreign assets well diversified10Implied rate of return with respect to IIP assets (%)Implied rate of return with respect to SAMA reserve assets (%)3.0Net income balance (% of GDP, rhs)2.582.06420200120022003200420052006200720082009201020112012201320142015Source: Haver, BofA Merrill Lynch Global Research. Implied rate of return on SAMA reserve assetssimplistically assumes all investment income is earned by SAMA (instead of being earned by SAMA,government entities and the private sector).1.51.00.50.0-0.5-1.0GEMs Paper #26 | 30 June 2016 7PIF largely a domestic inward-looking entity until recentlyThe IMF reports that the PIF had assets of 11.1% of GDP in 2014 (c.SAR310bn). PIF hasforeign assets of SAR14.1bn as of end-2015. It has outstanding loans of SAR103.9bn asof 3Q15 (excluding electricity loans of SAR14bn that PIF administers). According toBloomberg, PIF had stakes in publicly listed companies on Tadawul worth SAR934bn asof April 2016. According to the MoF, PIF held equity worth SAR63.3bn in 41 Saudicompanies in total at end-2011, as well as stakes worth SAR14.9bn in a number of pan-Arab corporations.In July 2014, the cabinet authorized the PIF to establish companies inside and outsideSaudi Arabia, alone or in partnership with other institutions from the public or privatesectors. It also bought a US$1.1bn stake in a South Korean company and recentlyannounced in early June it took a US$3.5bn stake in Uber, denying in the process that itwas considering a US$3bn loan to fund the acquisition. PIF has been asked to co-investUS$10bn in Russia or the Middle East with the RIDF. Note that PIF has establishedSanabil investments with SAR20bn in capital. The PIF has paid dividends to the budgetlast year (SAR15bn). It now reports directly to the Council of Economic andDevelopment Affairs headed by the Deputy Crown Prince, after reporting to the Ministryof Finance in the past.JASTA bill not a hurdle for further Saudi investment in the USWe expect that the deep and liquid US financial markets will remain a prominentdestination for Saudi foreign asset holdings. The potential passage of the “9/11” bill(Justice Against Sponsors of Terrorism Act, JASTA) in US Congress raises the possibilitythat Saudi Arabia would choose to liquidate up to US$750bn in assets in the US,according to Saudi Foreign Minister Adel al-Jubeir. A forced and rapid liquidation of USbasedSaudi foreign assets may expose SAMA and other government entities to markto-marketlosses, and require changes to Fx reserve managementThe language of the JASTA bill as it currently stands does not suggest an imminentSaudi sell-off of US assets, in our view. The “Stay of Actions Pending StateNegotiations” section inserted into the bill allows a stay to be granted for an indefinitelyrenewable 180-day period. This would be subject to court petition by the AttorneyGeneral and repeated certification by the Secretary of State that the US is “engaged ingood faith discussions with the foreign state defendant concerning the resolution of theclaims against the foreign state”. The certification thus depends on the current andfuture US administration foreign policy inclinations, in our view. Separately, we notethat the White House spokesman said US President Obama did not support thelegislation and likely would not sign it. (A potential presidential veto may however stillbe overruled if Congress assembles the necessary two–thirds vote of each house). Wecontinue to expect a close relationship between the US and Saudi Arabia given theconfluence of interests in a broad range of matters.8 GEMs Paper #26 | 30 June 2016Table 3: Breakdown of Saudi Arabia Net International Investment Position (US$bn)2007 2008 2009 2010 2011 2012 2013 2014 2015Net International Investment Position 380 471 435 479 585 685 763 792 703% of GDP 91 91 101 91 87 93 103 105 108Net Foreign assets (excluding SAMA) 74 28 24 34 41 28 37 59 87% of GDP 18 5 6 6 6 4 5 8 13Assets 495 631 636 708 824 936 1,028 1,069 993Non-reserve assets 190 188 226 262 280 279 302 337 376by holder:Investment funds 7 4 4 5 5 5 6 8 7Commercial banks 39 41 56 52 56 57 56 67 84Public Investment Fund (PIF) foreign investment 1 2 2 4 4 5 4 4 4Saudi Fund for Development (SFD) cumulative loan disbursements 6 6 6 7 7 7 8 8 -Public Pension Agency (PPA) and General Organization for Social Insurance (GOSI) net foreign assets - 49 - - - 98 112 - -of which, managed by SAMA (e) 43 48 51 59 65 69 75 80 78PPA net foreign assets - 24 - - - 63 72 - -GOSI net foreign assets - 25 - - - 35 40 - -Development funds and other government (exc. PPA/GOSI) entities’ foreign assets managed by SAMA (e) 15 17 18 20 22 23 25 27 26Other - 69 - - - 85 92 - -by instrument:Direct investment abroad 17 20 23 27 30 34 39 45 63Portfolio investment 105 99 122 146 158 168 178 199 202Equity securities 53 50 59 79 82 92 99 111 109Debt securities 52 48 63 68 77 75 79 88 94Other investment 68 69 82 90 92 77 85 93 111Loans 3 4 4 3 3 2 2 1 1Currency and deposits 55 63 73 76 78 69 76 85 105Other assets 10 3 5 11 11 6 7 6 5SAMA Reserve assets 306 443 410 445 544 657 726 732 616Currency and deposits 93 132 111 117 148 197 191 187 204Foreign securities 211 308 286 315 380 444 519 532 400Other assets 2 3 13 13 16 16 15 13 12Liabilities -116 -160 -201 -228 -239 -251 -265 -278 -289Direct investment in reporting economy -73 -113 -148 -176 -187 -199 -208 -216 -224Portfolio investment 0 -3 -4 -4 -6 -10 -17 -17 -17Equity securities 0 0 0 0 0 -9 -15 -15 -15Debt securities 0 0 0 0 0 -1 -2 -2 -2Other investment -42 -44 -49 -48 -46 -42 -40 -45 -48Loans -13 -14 -13 -13 -12 -11 -9 -10 -12Currency and deposits -28 -28 -25 -25 -23 -20 -19 -25 -26Other assets -1 -1 -11 -10 -11 -11 -11 -11 -11memo:Identified Saudi Arabian and Middle Eastern holdings in the USSaudi Arabia US Treasury (UST) holdings 51 46 83 69 68 76 80 91 109Long-term securities 50 45 82 68 67 74 78 88 107Short-term securities 1 1 1 1 1 2 2 3 2Saudi Arabia holdings of US equities 45 42 31 36 53 65 68 78 52Saudi Arabia holdings of US Agency debt securities 8 42 14 7 5 5 7 6 6Long-term securities 8 41 14 7 5 5 7 6 6Short-term securities 0 1 0 0 0 0 0 0 0Saudi Arabia holdings of US corporate debt securities 7 14 17 12 12 9 15 19 15Long-term securities 5 9 11 9 8 6 10 13 13Short-term securities 2 5 6 3 4 3 5 5 3Middle East Foreign Direct Investment (FDI) position in the US (cost basis) 9 9 10 8 10 11 12 11 -Middle East oil exporters gross claims on US banks 81 122 106 101 136 132 134 129 120Saudi Arabia deposits in Bank for International Settlements (BIS) reporting banksCross-border deposits with BIS reporting banks 163 180 169 167 188 244 224 210 212of which, implied deposits from banks and others 102 142 128 113 135 180 174 158 170of which, deposits from nonbanks 60 39 41 54 53 64 50 52 42Saudi Fund for DevelopmentCumulative signed loans 7 8 8 9 10 11 11 12 -Cumulative disbursements 6 6 6 7 7 7 8 8 -Government entities foreign assets managed by SAMA off-balance sheet 58 66 69 79 87 92 100 107 104Deposits with banks abroad 4 5 3 2 2 6 13 10 5Foreign securities 55 61 66 77 85 85 87 97 98Source: Haver, SAMA, IMF, SFD, BofA Merrill Lynch Global Research. Middle East oil exporters consist of Bahrain, Iran, Iraq, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates.GEMs Paper #26 | 30 June 2016 9Historic energy sector liberalizationPartial privatization of energy sector assets could represent one of the cornerstones ofthe ambitious medium-term diversification strategy, and, if confirmed, serve as a highlyvisible and historic milestone. Such privatizations could ease key macro concernsregarding unsustainable debt accumulation and Fx reserves drawdown. We believe itwould also confirm the government’s macro reform credentials, its preparedness for aprolonged period of low oil prices and likely signal no near-term energy policycapitulation. The NTP suggestion of a flat production capacity through 2020 suggestsless aggressive market share strategy, in our view.Privatization of energy sector could start by 2018In a recent interview with Bloomberg, Saudi Deputy Crown Prince Mohammed binSalman outlined an array of measures the Saudi government could introduce to helpdiversify the economy, reduce its reliance on the hydrocarbon industry and ultimatelysupport medium-term fiscal consolidation in a low oil price environment. Amongst thesemeasures, the Deputy Crown Prince included a potential Initial Public Offering (IPO) ofSaudi Aramco (at the parent level, and including various subsidiaries). With close to250bn bbls of oil reserves, more than 10mn bbls per day of production and the world’s4th largest gas reserves, Saudi Aramco is the leader in hydrocarbon access among stateowned, private and public Oil & Gas (O&G) companies alike. Saudi Aramco is the world’slargest Oil & Gas Company by production and arguably the Kingdom’s most importantasset. Specifically, he outlined a plan that would see “less than 5%” of the companybeing sold to investors on the Saudi stock exchange no later than 2018 (but potentiallyas soon as 2017). Furthermore, he indicated the Kingdom is seeking to transformAramco into an “energy-industrial company”. The high profile stake sale would provide ahighly visible anchor to diversification efforts and capitalize its newly restructured SWF.Energy assets form a major and strategic sector for the economyIt is hard not to understate the central role the energy sector plays in the Saudieconomy. The hydrocarbon sector represented 43.0% of the economy in real terms in2015. Deputy Crown Prince Mohammed bin Salman suggested a US$2trn price tag forSaudi Aramco in his Bloomberg interview. Aramco is deeply intertwined with the Saudistate, and its workforce Saudization has increased over the years to 83%. Furthermore,it is the foundation of its state’s domestic and international energy policy. As such, adecision to partially privatize the energy sector will be a momentous one to be carefullyexamined by the technocratic and political leadership, in our view.More questions than answers at this stageDeputy Crown Prince Mohammed bin Salman’s initial suggestion in an interview withThe Economist that a Saudi Aramco IPO could be considered has raised marketexpectations. Ensuing comments from Aramco’s management did not make clearwhether a listing would occur, and if so, in what form (upstream versus downstream),although the Deputy Crown Prince’s subsequent Bloomberg interview suggested furtherimpetus being given to studying the matter.A listing of the entity itself may force much more transparency regarding hydrocarbonreserves (broadly unchanged for several years), lifting costs (local crude oil sales suggestcUS$5/bbl if no loss is incurred) and the fiscal regime (estimates in the press havesuggested that Aramco’s profits are taxed at 85%, with royalties set at 20%, but wealso note from fiscal data that the fiscal transfer ratio in oil revenues to the Ministry ofFinance appears to drop in years of low oil prices). It may also conflict with noncommercialventures or strategic aspects of Saudi Aramco. This would include themaintaining of spare capacity and state policy matters (including energy policy). Notefor instance that the US is the second regional destination for Saudi crude oil exports(17.5% of total Saudi crude oil exports) behind Asia. This was due to a strategicgeopolitical decision to remain an important crude oil supplier to the US and wasachieved through the buying of stakes in refineries in 1988.10 GEMs Paper #26 | 30 June 2016Chart 3: Saudi Arabia proven crude oil reservesbn bblSaudi Aramco Others30025020015010050Chart 4: Saudi Arabia proven gas reservestrn cf300Saudi Aramco Others25020015010050019621965196819711974197719801983198619891992199519982001200420072010201301979198119831985198719891991199319951997199920012003200520072009201120132015Source: SAMA, Bank of America Merrill Lynch Global ResearchSource: SAMA, Bank of America Merrill Lynch Global ResearchOil sector privatization could slow debt build-up and support Fx reservesPotential energy sector asset partial privatization could raise a substantial amount forthe Saudi government, in our view. A share sale would be a non-debt creating financingflow for the budget, which would lessen the need to borrow domestically or externally. Ashare sale could also increase Saudi Arabia’s ability to project soft power and influenceregionally and internationally. However, it would only support the build-up of Fx reservesin the case of foreign investor participation. Assuming a US$2trn valuation suggestedby the Deputy Crown Prince as the value for the SWF, the vast majority of which wouldbe Aramco through a possible 5% listing, such a listing could raise up cUS$100bn, whichwould represent the current annual government borrowing requirements and associatedFx reserves drawdown. We expect further administered energy price adjustments overthe next five years, which should increase state revenues, in our view.A share sale may also facilitate international borrowing on the back of Saudi Aramco’sbalance sheet. Saudi Aramco also announced it would look to set up a corporate debtprogram to fund its NTP initiatives, although issuance does not appear to be animmediate prospect. A corporate debt program, alongside a sovereign one, could allowthe government to simultaneously tap a new pool of liquidity through corporate bondinvestors, upstream proceeds if needed and support Fx reserves. This could be achievedwithout impacting central government debt ratios and without saturating thegovernment debt issuance room with sovereign debt investors. Saudi Aramco raised aUS$10bn syndicated loan in late March 2015 in part to fund acquisitions. The loanreplaced US$4bn in existing facilities agreed to in 2010, and includes a US$6bn fiveyeartranche with two 1-year extension options, a US$1bn 1-year renewable facility, anon-interest bearing SAR7.5bn (US$2bn) five-year tranche with two 1-year extensionoptions and a SAR3.75bn (US$1bn) 1-year tranche renewable yearly.Very roughly, taking the US$2trn Deputy Crown Prince potential valuation for Aramco,and assuming an optimal 10% net-debt-to-equity medium-term target, it would suggestthat Aramco could manage leverage of up to US$200bn (c30% of GDP) in domestic andexternal debt on its balance sheet. Within a corporate setting, possible higher gearingneeds to be justified to shareholders and could reflect financing of acquisitions or NTPcosts. From a macro angle, international issuance would support Fx reserves.Three aspects of energy policy to consider going forwardEnergy sector privatization is likely to raise questions on the future path of energypolicy, though we believe the latter will stay the course for now. We believe that arethree aspects that are central to energy policy in Saudi Arabia: a) competition for globalmarket share in upstream operations; b) future investment decisions and maintaining ofspare capacity buffer; and c) integration and expansion of downstream ventures tocreate domestic jobs, secure captive crude demand and make operations less volatile.GEMs Paper #26 | 30 June 2016 11Targeting a stable oil priceAs a matter of Saudi policy, we would expect a preference for oil market stability overvolatility, in line with recent official pronouncements. Although volatility makes it moredifficult for high cost unconventional producers to operate, volatility is also damagingfor Saudi Arabia and long-term planning domestically. For instance, no budget wasannounced for 1986 due to uncertainties in the world oil market, with monthly currentappropriations set at one-twelfth of estimated actual expenditures for the prior year.We think Saudi authorities view possible eventual sharp upward price spikes in the oilprice as damaging to both oil-consuming and oil-producing countries.Future investment decisions will be critical for oil pricesSpare capacity is an important policy parameter for Saudi Arabia. In addition to itsinfluence on prices through its ability to adjust production, Saudi can decide on the paceof its reserves development which would potentially affect future supply. There aredistinct trade-offs in this decision. If Saudi Arabia is producing at close to its maximumcapacity, it will have little control over sharp upside movements in oil prices. If excesscapacity is large, oil prices are likely to be under downward pressure.In the near-term, given the uncertainty in the market, in our view, there is likely littleincentive for Saudi Arabia to embark on a program to invest and increase capacity fromthe current level. New investments may still be made to offset declines in existingfields. Over time however, our commodities research medium-term oil balances suggestthat Saudi’s spare capacity would be eroded over time unless further increases in sparecapacity take place. Our BofAML commodities research medium-term supply-demandbalances suggest an increased call on OPEC and need to increase production capacity. In2004-09, Aramco invested cUS$100bn into its largest-ever capacity expansion program,which increased total capacity from 10mn bpd to 12.5mn bpd. For now, Aramco hassuggested it will not slow down its hydrocarbon capex program for the next three yearsas cuts were achieving through savings in drilling costs and supplier discounts.Energy policy is likely to be less aggressive going forwardWe expect a less aggressive energy policy going forward, particularly as the NTPsuggests a constant oil production capacity and an increase in gas productiondomestically. This is in line with Saudi Minister of Energy, Industry and MineralResources Al-Falih’s pronouncements during the June Ordinary OPEC meeting. While hiscomments served to project increased OPEC institutional credibility and increasedrapprochement with fellow OPEC members, he suggested that Saudi Arabia will remainresponsive to customer needs but dismissed fears that increasing Saudi market sharewould take place in an aggressive manner (that could drive prices lower again).Downstream operations - increased focusSaudi Aramco’s downstream integration drive is likely being pursued for two corereasons: (1) to support demand for Saudi crude (placing own crude in own refiningcapacity) and (2) a risk reduction mechanism in a highly volatile oil environment (havingan integrated value chain allows capture of margins from well to the forecourt,promoting stability). In reflection, Saudi Aramco is building highly sophisticatedrefineries domestically, in addition to already completed joint-ventures and stakes inrefineries abroad (China, US, Japan, South Korea, Indonesia). Domestic joint-venture (JV)refineries Satorp and Yasref added 400k bpd each of capacity in 2H14. With thecompletion of the fully-owned Jazan 400k bpd refinery in 2018/19, overall total refinerycapacity would stand at 5.7mn bpd, of which Saudi Aramco’s share would be 3.3mn bpd.This would allow Saudi Arabia to guarantee security of demand for its heavy crude,increase domestic job creation and diversification, build an export base of refinedproducts (likely middle distillates to the EU) and lower imports of refined products.12 GEMs Paper #26 | 30 June 2016National Transformation Plan: many promises, few detailsThe National Transformation Plan (NTP) released by the Saudi government is a furtherstep towards execution of Saudi Vision 2030 through a set of ambitious interim targetsto achieve by 2020 by 24 government bodies. The NTP is a comprehensive programencompassing medium-term growth boosting initiatives and fiscal consolidationmeasures. The sequencing and details of the fiscal measures are however still leftnebulous. Implementation of growth-boosting initiatives will require a challengingcrowding in of private sector investment, particularly from domestic sources.The NTP is likely to introduce a number of one-off supply-side shocks to inflationthrough its fiscal or labor measures, which could negatively impact Real EffectiveExchange Rate (REER) competitiveness. Discretionary consumption growth and realincomes are likely to remain under pressure. We find the diversification measuresencouraging, although they appear too ambitious to be met within the time frameenvisaged in the NTP, in our view. The focus on diversification could introduce mediumtermincentives to adopt a more competitive exchange rate, while also detracting fromthe binding fiscal constraint under which the government has to operate. Energy policyis likely to be less aggressive and support oil prices. Fiscal targets are difficult to reach,but medium-term oil prices of at least US$50-65/bbl could support NTP progress.Table 4: Selected macro Key Performance Indicators (KPIs) under the National Transformation PlanRegionalb’markGovernment entity Key Performance Indicator (KPI) Unit Baseline 2020 targetMinistry of FinanceTotal non-oil revenues SARbn 163.5 530 10.9 691.0Budgeted salaries and wages SARbn 480 456 N/A N/ASalaries and wages as a percentage of the budget % 45 40 30 12Approved projects according to criteria and timeline (% of total) % 0 40 30 78Credit rating - A1 Aa2 Aa2 AaaGovernment debt as percentage of gross domestic product (%) % 7.7 30 35 54Total recorded non-oil assets SARtrn 3 5 N/A N/AMinistry of Economy & PlanningTotal revenue resulting from privatization projects Under Study Under Study Under Study N/A N/AValue of water and electricity subsidy decrease SARbn 0 200 N/A N/APercentage decrease in non-oil subsidy % 0 20 N/A N/AValue of private sector contribution to GDP SARbn 993.3 Under Study 122.6 14,133.8Ministry of Energy, Industry and Mineral ResourcesValue of exports of non-oil commodities SARbn 185 330 Under Study Under StudyValue of the mining sector's contribution to GDP SARbn 64 97 13 262Local content in expenditure of public and private sectors % 36 50 Under study 57Petroleum production capacity mn bpd 12.5 12.5 3.8 11Dry gas production capacity bn cf pd 12 17.8 5.7 16Refining capacity mn bpd 2.9 3.3 1.1 1.9Ministry of Labor and Social DevelopmentUnemployment rate for Saudis % 11.6 9 Under Study 5.8Cost of employment of Saudis compared to expatriates % 400 280 N/A N/AProportion of female labor force % 23 28 Under Study Under StudyMinistry of Hajj and UmrahNumber of formal Hajj pilgrims (domestic and foreign) mn 1.5 2.5 N/A N/ANumber of Umrah Pilgrims from abroad mn 6 15 N/A N/ANumber of Umrah pilgrims (domestic and GCC nationals) mn Under Study Under Study N/A N/ACommission for Tourism and National Heritage% contribution of tourism sector to GDP % 2.9 3.1 4.9 5.4Ministry of Civil Service% decrease in the payroll and benefits expenditure % Under Study 20 Under Study 22% of workers reduction in the civil service sector % Under Study 20 Under Study 18Saudi Arabian General Investment AuthorityForeign Direct Investment (FDI) SARbn 30 70 45 481Time needed to issue work visas for new expat employees Day 30 10 10 3Time needed to issue new business permits Day 19 1 8 0.5Source: National Transformation PlanGlobalb’markGEMs Paper #26 | 30 June 2016 13Ambitious diversification agenda is not without risksDiversification initiatives will require material participation from the private sector.Vested interests and the large bureaucracy could act as a dampener on timely reformimplementation going forward. The large size of the NTP program may mean some ofits outcomes are internally inconsistent, in our view. Cultural and entertainment changescould be opposed by conservative or clerical factions. Slippage could occur due toexecution risk or reform fatigue, particularly due to the socio-economic impact of fiscalconsolidation. Any material changes to subsidies or wages could be difficult toimplement in the absence of a social safety net. While fiscal consolidation measures areunprecedented in scope, they appear too ambitious or difficult to reach and may leave afinancing gap. As such, the measures may still fall short if oil prices do not stabilize,which suggests a need for a less aggressive energy policy going forward, in our view.Government leaders continue to show focus on deliveryThe US visit of Deputy Crown Prince Mohammed bin Salman and finalization of variousMemoranda of Understanding (MoUs) with prominent US corporates helps provide ahighly visible anchor for foreign investment and instil business confidence in regards togovernment focus. It also helps boost the profile of the Deputy Crown Prince bothdomestically and internationally. This is in line with our view that the government islikely to target rapid implementation of several ‘low-hanging’ reforms to spearhead theprogram and boost confidence. Energy sector liberalization could also serve as anotherhighly visible anchor to the reform program, in our view.Table 5: Announced US corporates plans during the US visit of the Saudi Deputy Crown PrinceCompany Sector OutcomeSix Flags Entertainment Company has been allowed to operate in Saudi ArabiaPfizer Pharmaceuticals Company has been awarded a direct investment license3M Manufacturing Company has been awarded a direct investment licenseDow Chemical Chemicals Company has been awarded a direct investment licenseMicrosoft IT Memorandum of Understanding signedCisco IT Memorandum of Understanding signedApple IT Discussions on entry to Saudi market possibly under waySource: Press reports, Saudi Press Agency, BofA Merrill Lynch Global ResearchDiversification drive is a step in the right directionThe comprehensive medium-term diversification drive introduced by the NTP followsthe typical macro template, in our view. We discuss in a later section diversificationlessons from Malaysia and Norway and conclude that the NTP contains elements fromthese successful case studies. In particular, it a) identifies key sectors with relativelyhigh growth potential (mining, petrochemicals, manufacturing, retail and wholesaletrade, religious and other forms of tourism, healthcare, real estate and finance); b), itstarts to articulate supportive public sector industrial strategies, including throughlocalization policies; and, c) it seeks to foster higher-value added in the economythrough enhancements to processes, products and organizations.14 GEMs Paper #26 | 30 June 2016Chart 5: More sustained private non-oil sector growth needed in Saudi2520151050-5Oil SectorPrivate Non-Oil SectorGovernment Non-Oil SectorReal GDP growth (%yoy)Chart 6: Oil sector large; government controls 60% of real economy16.9%43.0%39.3%-10-15196919711973197519771979198119831985198719891991199319951997199920012003200520072009201120132015Oil Sector Private Non-Oil Sector Government Non-Oil SectorSource: Haver, BofA Merrill Lynch Global Research. Series uses contributions to growth from real GDPdata with 1999 base year prior to 2010.Source: Haver, BofA Merrill Lynch Global Research. Data as of 2015.Human capital is critical and takes time to buildIn our view, improvements to human capital, rather than business climate supply-sidereforms, are the critical barriers to overcome. While building the appropriately qualifiedworkforce takes time, Saudi Arabia has been making progress in this area. c25% ofSaudi tertiary graduates complete humanities and arts programs, but this is down from39.4% in 1999. Graduates from social sciences, business and law represented thelargest share of graduates at 27.2% of total in 2014, up from 15.5% in 1999. Still, as wediscuss in later sections, diversification prospects are mixed across sectors and willlikely depend in part on providing the appropriate incentives to the private sector.Chart 7: Distribution of Saudi tertiary graduates by field of study (%)40351999 2014302520151050Humanities and artsEducationSocial sciences,business, lawScienceEngineering,manufacturingHealth and welfareAgricultureOthersServicesSource: UNESCO, BofA Merrill Lynch Global ResearchMobilizing domestic resources is keyThe NTP makes clear that part of the NTP costs (40%) will need to be shouldered by theprivate sector. Out of a total estimated NTP cost of SAR447bn (US$119bn; 18.4% ofGDP), the NTP implies that the private sector will need to contribute about SAR179bnover the coming five years (US$47.6bn; 7.4% of GDP). Implementation of growthboostinginitiatives will require a challenging crowding in of private sector investment.The NTP expects only a SAR40bn increase in the level of Foreign Direct Investment(FDI), meaning that the bulk of private sector investment could have to come fromdomestic sources. While the government investment is generally in retrenchment mode,the NTP may be suggesting that selective and strategic projects are likely to go ahead.Authorities have also suggested a number of projects could be structured as Public-Private Partnerships (PPP).GEMs Paper #26 | 30 June 2016 15Chart 8: Saudi government non-hydrocarbon and private sectorinvestment growth are relatively correlated1109070503010-10Government non-oil GFCF (3yma, %yoy)Private sector GFCF (3yma, %yoy)Chart 9: Crowding in domestic private sector investment when thegovernment sector retrenches can be challenging20Government non-oil nominal GFCF (% of GDP)Private sector nominal GFCF (% of GDP)Oil prices (US$/bbl, rhs)1510512010080604020-300019731976197919821985198819911994199720002003200620092012197019731976197919821985198819911994199720002003200620092012Source: Haver, BofA Merrill Lynch Global Research. GFCF refers to Gross Fixed Capital Formation.Source: Haver, BofA Merrill Lynch Global Research. GFCF refers to Gross Fixed Capital Formation.Ambitious non-oil export and tourism targets, but little detailsThe NTP targets increasing non-oil exports by SAR145bn (US$38bn, 6.0% of GDP) toSAR330bn (US$88bn, 11.4% of 2020f GDP) over the next five years. Althoughimplementation details are lacking, we anticipate that part of the increase could belinked to the higher mining output targeted. These would nevertheless be dependent onthe global economic cycle. Higher exports of refined oil products, if all of the additionalcapacity to be installed by 2020 is exported, could add cUS$7.3bn to exports at currentprice levels (but not qualify towards non-oil exports targets under the NTP as they areclassified as hydrocarbon exports). Currently, 61% of Saudi non-oil exports representschemicals and plastics, and maintains a correlation with oil prices, and re-exportsaccount for another 17% of total non-oil exports and have little added-value.Chart 10: Chemicals, plastics, re-exports form bulk of non-oil exportsSARbn other200foodmachinery100metals150re-exports80plastics100chemicalsBrent (US$/bbl, rhs)60non-oil exports (% of total, rhs)405020Chart 11: Non-oil exports are diversified in terms of destination19%26%12%14%29%019841986198819901992199419961998200020022004200620082010201220140Asia GCC MENA EU OtherSource: Haver, BofA Merrill Lynch Global Research.Source: Haver, BofA Merrill Lynch Global Research.Likewise, the focus on religious tourism is appropriate given its importance in SaudiArabia but NTP targets appear ambitious to us with a targeted 20%yoy CAGR increasein Umrah pilgrims. Religious tourism accounted for c40% of total tourist expenditure inSaudi Arabia in 2015, bringing in proceeds of SAR33.4bn (US$8.9bn; 1.4% of GDP). Notethat, for balance of payment purposes, total tourism revenues stood instead atSAR37.9bn (US$10.1bn; 1.6% of GDP). The NTP targets would thus imply religioustourism external revenues/expenditures to increase to US$10-US$20bn (1.3-2.6% of2020f GDP). This would be helpful on the external front but not a game changer on itsown, in our view.16 GEMs Paper #26 | 30 June 2016Chart 12: Breakdown of expenditure on inbound tourist tripsSARbn80604020OtherReligiousBusinessFamily visitsHolidaysreligious tourism (% of total, rhs)80706050Chart 13: Inbound tourist trips to Saudi Arabia by country of origin1%7% 5%45%25%17%02004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015Source: SAMA, BofA Merrill Lynch Global Research.40GCC Middle East Asia Europe Africa AmericaSource: SAMA, BofA Merrill Lynch Global Research. Data as of 2015.Mixed prospects for fiscal consolidationThe apparent redistribution of part of the proceeds of the flagship fiscal measurestowards funding the NTP initiatives suggests that the fiscal consolidation efforts couldfall short of the necessary requirement to narrow imbalances materially in the absenceof a sustained oil price recovery. We calculate that the NTP targets a total netcumulative fiscal consolidation effort of SAR648bn (US$172.8bn) or c1% of GDPannually, assuming progressive and full implementation of the non-oil revenue targets.Energy policy needs to support economic transformationEnergy policy is likely to be less aggressive going forward, particularly as the NTPsuggests a constant oil production capacity as well as an increase in gas productiondomestically which could free up domestic crude for exports. To remain consistent withthe targeted government debt accumulation path, we estimate that oil prices have toaverage at least US$50/bbl in 2016-20 along with no growth in spending from 2016levels (excluding the additional cost of NTP initiatives but including implementation ofthe NTP non-oil revenue measures). Oil prices of at least cUS$65/bbl would be requiredif spending is not disciplined or revenue targets are missed by c50%, in our view.Blueprint for fiscal measures lacks detailsThe approved NTP initiatives will have a total fiscal cost of SAR268bn (US$71.5bn;11.6% of GDP) spread over five years (annually, SAR54bn equivalent to US$14.3bn or2.3% of GDP). Government financing could represent 60% of total funding needs for theNTP initiatives, with total NTP costs of SAR447bn (US$119bn; 18.4% of GDP). Againstthat, the NTP envisages raising SAR366bn in non-oil revenues and cut the wage bill by5% or SAR24bn (US$6.4bn or 1% of GDP). Non-oil revenue is seen rising to SAR530bn(US$141bn, 23% of 2016f GDP) by 2020 from SAR163.5bn (7% of GDP).Wage bill measure unclear but may carry profound social implicationsIn an unprecedented austerity measure, the share of the wage bill in total spendingwould fall by 5ppt to 40% (SAR456bn, from SAR480bn) by 2020. It is yet unclear howthis could be achieved in practice. Furthermore, note that the MoF budgetannouncement estimated the wage bill in 2015 to stand at SAR450bn, blurring thetarget. Privatizations of government entities are likely to lead to a natural drop in thepublic sector number of employees and wage bill. Yet we note that the Ministry of CivilService has two Key Performance Indicators (KPIs) directly linked to a decrease in thepayroll and benefits expenditure, and to a reduction in workers in the civil service sector.This would likely be a contentious and unpopular measure to implement, and itsimplementation and success appear challenging to us.GEMs Paper #26 | 30 June 2016 17Spending path is unclear and is flattish (excluding NTP costs) in the best caseThe spending path targeted or assumed by the NTP is unclear and does not appear tomatch realized outturns. It may suggest that spending is likely to remain flattish,excluding NTP costs. However, the indicative level spending would settle at is aroundpeak 2014 expenditures levels and well above the 2015 realized spending and 2016budgeted levels. While 2015 spending could have been understated and may be revisedhigher, at least SAR88bn from the 2015 spending is non-recurrent as it relates to theone-off Saudi Royal edicts decreed upon King Salman’s accession.Going by the indicated 2020 target for the share of the wage bill in total spending, thiswould suggest that government spending is targeted at SAR1,140bn in 2020. Thisrepresents a 2.7% increase over peak 2014 spending levels and 16.5% increase over2015 actual spending levels. Excluding the NTP annual costs, this suggests thatgovernment spending should still increase by 11% over 2015 levels and drop by 2% over2014 spending in nominal terms.In our view, given the lack of precise spending targets, one way of remaining consistentis to use the two NTP figures for wages and infer the NTP fiscal spending from thestated share of wages in total expenditures. This would suggest that fiscal expenditureswould reach SAR1,140bn in 2020, from SAR1,067bn in the base year (unstated in theNTP). This is a 6.8% increase, but excluding the NTP costs, is just 1.8% higher. As such,in the best case scenario, we think the NTP suggests flattish spending, excluding NTPcosts. If we instead take the NTP level of spending inferred to be the correct amount,this would materially widen the fiscal deficit by SAR190bn (8.0% of GDP) and would bedeeply negative for the sustainability of the fiscal and Fx stance, in our view.Fiscal adjustment burden shifts to raising revenue, oil prices and exportsThe possible flattish spending implication of the NTP would tend to indicate that thebulk of the spending cuts are now beyond us. Government projects are likely to continueto be prioritized, likely according to their economic benefits and relevance to the NTP.Flattish spending will thus shift the burden of forthcoming fiscal adjustment on raisingnon-oil revenues, raising hydrocarbon exports and a sustained recovery in oil prices.Table 6: National Transformation Plan-related spending across government entities (2016-2020)Cost (SARbn) Cost (US$bn) % of totalMinistry of Housing 59.2 15.8 22.0Royal Commission for Jubail and Yanbu 41.6 11.1 15.5Ministry of Education 24.4 6.5 9.1Ministry of Health 23.1 6.1 8.6Ministry of communications and IT 14.9 4.0 5.6Ministry of Agriculture 13.9 3.7 5.2Ministry of Water and Electricity 12.9 3.4 4.8Saudi Commission for Tourism & National Heritage 10.5 2.8 3.9King Abdulaziz City for Science and Technology 8.3 2.2 3.1Ministry of Labor 7.9 2.1 3.0General Presidency of Youth Welfare 7.8 2.1 2.9Ministry of Transport 5.6 1.5 2.1Ministry of Social Affairs 5.4 1.4 2.0King Abdullah City for Atomic and Renewable Energy 5.2 1.4 1.9Ministry of Commerce and Industry 4.3 1.1 1.6Ministry of Municipality and Rural Affairs 4.2 1.1 1.6Ministry of Finance 3.4 0.9 1.3Ministry of Culture and Information 3.3 0.9 1.2Ministry of Economy and Planning 3.3 0.9 1.2Ministry of Justice 3.2 0.9 1.2Ministry of Petroleum and Mineral Resources 2.7 0.7 1.0Saudi Arabian General Investment Authority 1.1 0.3 0.4Others 2.3 0.6 0.9Total 268.4 71.6 100.0Source: National Transformation Plan18 GEMs Paper #26 | 30 June 2016Focus on increasing non-hydrocarbon fiscal revenue could fall short of targetThe breakdown of measures to raise non-oil revenues is not given. However, the tally isclose to the US$100bn targeted in the Vision 2030 and is thus likely to includemeasures discussed then: hikes to administered energy prices, review of current levelsof fees and fines, introduction of new fees, land tax (we estimate annual revenues of1.5-2% of GDP in its first phase when fully implemented). In this regard, the NTPsuggests forthcoming privatizations, imposition of taxes on harmful products (likelytobacco and soft drinks), introduction of a Value-Added Tax (VAT) for which we estimateannual revenues of up to 2% of GDP, implementation of a unified income tax and of anincome tax on residents (although official comments later clarified there were no plansto tax nationals but stayed equivocal regarding expatriates).Although there is no direct budgetary impact, water and electricity subsidies aretargeted to decrease by SAR200bn. Non-oil subsidies are targeted to decrease by 20%by 2020. The latter, we believe, consists largely of subsidies for social and sports clubs,private education, private hospitals, and other agricultural subsidies. They werebudgeted at SAR3.9bn (US$1.0bn; 0.2% of GDP) in 2016, down from SAR15.0bn(US$4.0bn; 0.6% of GDP) in 2015. A 20% cut to these on-budget non-oil subsidies wouldthus generate minimal savings of US$0.2-US$0.8bn (0.1-0.5% of GDP) depending if thereference base year was 2015 or 2016.According to the Deputy Crown Prince pronouncements early in the year, medium-termplans are also likely to target the introduction of US$400bn of unutilized state assets(land, etc) to state-owned funds, with the latter in turn in charge of developing theminto projects and companies than can be IPOed to the public. In our view, this may belinked to the Ministry of Finance assigned KPI of increasing total recorded non-oilassets (real estate, etc) from SAR3trn to SAR5trn.The Deputy Crown Prince provided a breakdown of the government target of raisingUS$100bn in additional non-oil revenue annually by 2020. The bulk of this increase innon-oil revenue would come from the restructuring of subsidies which could generateUS$30bn per year (4.9% of GDP), according to the Deputy Crown Prince. VATimplementation, a Green Card-like program and a plan to allow corporates to hireforeign workers in excess of their official quotas could bring in US$10bn (1.6% of GDP)a year by 2020, according to the Deputy Crown Prince.Chart 14: US$100bn in additional non-oil revenue targeted by 2020Source: BloombergUS$10bnUS$10bnUS$40bnUS$10bnUS$30bnOther measuresSubsidy reformFees to excees foreign worker quotasGreen Card-like programValue-Added TaxChart 15: Government to focus on raising non-hydrocarbon revenueSARbn1,5001,000500-Source: Haver, BofA Merrill Lynch Global ResearchNon-oil revenueOil revenueOil revenue (% of total, rhs)1969197119731975197719791981198319851987198919911993199519971999200120032005200720092011201320151009080706050GEMs Paper #26 | 30 June 2016 19Chart 16: Breakdown of non-hydrocarbon fiscal revenues4035302520151050InvestmentsOther revenuesCustoms dutiesPetroleum products taxDocuments feesZakatOther income taxesSource: MoF, BofA Merrill Lynch Global Research. Data as of 2015.Non-oil revenues (SARbn)% of total non-oil revenuesTelecom revenuesFees of port servicesVisa feesGeneral service feesRents and salesMining feesChart 17: Budgeted non-oil subsidies form a small portion of spendingSARbn50454035302520151050Budgeted subsidies% of total budgeted spending (rhs)198119831985198719891991199319951997199920012003200520072009201120132015Source: SAMA, MoF, Bank of America Merrill Lynch Global Research.76543210Further energy subsidy reform is likelyThe figures announced by the Deputy Crown Prince regarding proceeds of subsidyreform suggests material changes over the next 3-4 years, with annual savings close tothe landmark first round of administered price changes in late 2015. However, hissuggestion that the changes could be accompanied by partially offsetting cash transfersto poor households suggests policy-making caution. We do not think such aredistributive system could be technically put in place in a short time span.Recall that concurrently with the 2016 budget, a first round of energy subsidy reformsaw sweeping energy, water and electricity administered price changes being institutedin late December. We estimated the natural gas price hike on petrochemical firms,domestic crude oil price hike as well as the combined gasoline and diesel price hikeintroduced could add US$2.2bn, US$2.0bn and US$3.8bn to central governmentrevenues if fully passed to the budget (a combined 1.2% of GDP). Impact of continuedsimilar policies on domestic prices would be a further 1.5-2ppt annual increase inheadline inflation, and a gradual squeeze to household incomes (where gasoline, waterand electricity likely represented c.1.5%, c0.4% and 1.6% respectively of consumerspending basket prior to the late December 2015 administered price adjustments).Table 7: Administered energy price adjustments carried out in December 2015Product Price prior to Dec 2015 Current price % changeMethane (US$/mn BTU) 0.75 1.25 66.7Ethane (US$/mn BTU) 0.75 1.75 133.3Arab light (US$/bbl) 4.24 6.35 49.8Arab Heavy (US$/bbl) 2.67 4.4 64.8Diesel (US$/bbl) 9.8 14 - 19.1 68.5Heavy Fuel Oil (HFO) 380cst 2.08 3.8 82.7Heavy Fuel Oil (HFO) 180cst 2.08 4.25 104.3Propane (USD/metric ton) - - -Naphtha (USD/metric ton) - - -Butane (USD/metric ton) - - -Natural gasoline (USD/metric ton) - - -Kerosene (US$/bbl) 25.795 octane gasoline (SAR/ltr) 0.6 0.9 50.091 octane gasoline (SAR/ltr) 0.45 0.75 66.7Source: SPA, BofA Merrill Lynch Global Research. Propane, naphtha, butane and natural gasoline used to be: price using the followingformula: Japanese Naphtha price less transportation from Saudi multiplied by 0.72. The formula now is differentiated by product and is asfollows: Japanese price of the underlying product less transportation from Saudi multiplied by 0.8.Fiscal consolidation plan looks challenging to fully achieveThe US$100bn target in additional non-oil revenue through 2020 appears difficult toreach and is likely to leave a sizeable financing gap based on the current proposals, in20 GEMs Paper #26 | 30 June 2016our view. This would thus imply that fiscal consolidation is likely to fall short ofnarrowing imbalances materially without a sustained oil price recovery.The fees on excess foreign worker quotas and the green-card like program targetedproceeds are difficult to reach, in our view. We calculate that to raise US$10bn from agreen-card like program, authorities will need to set the program fees at US$1,500 (inline with upper bound of similar programs elsewhere) and have all expatriate workersapplying to enrol in the program. This appears an unrealistic target to meet, particularlyas it is not clear how these proceeds would be recurrent yearly. As for the foreignworker quotas proceeds, we calculate that, based on private sector expatriate figuresand the stated 85% overall compliance with Nitaqat sector quotas, that the fees wouldneed to be set at a large cUS$10,500 per non-compliant worker to be consistent withthe NTP target. The large fee amount would likely be a material disincentive to privatesector corporates and a squeeze on their profits.One of the obstacles to meeting the subsidy reform target is likely to be political innature given the impact on inflation and household incomes. We calculate neverthelessthat the target could be reached through a combination of a administered priceschanges. We do not think there is major room to increase natural gas feedstock pricesto petrochemical firms, given the NTP focus on the petrochemical sector as a source offuture growth. We estimate raising natural gas prices to US spot levels in an oil priceenvironment of US$50/bbl would bring in revenues to the central government of justUS$2.5bn (0.4% of GDP) if fully passed to the budget. This is likely to suggest that thebulk of the future adjustments are likely to center on hikes to administered priceadjustments for domestic crude oil sales, diesel and gasoline. Selling domestic crude atUS$25/bbl rather than an average of US$5.4/bbl would bring in US$20.8bn in revenues.Gasoline and diesel prices could rise by the same percentage as in December 2015 tobring in additional revenues for a minimum inflation pick-up cost of 0.5ppt.The most difficult part would be meeting the US$40bn in other non-oil revenues target,in our view. Given that the latter’s breakdown was not provided, we have attempted togroup several measures being studied (according to local press) to provide a tentativedecomposition. Still, our analysis suggests the need for a further US$16.8-US$20.7bn infinancing to meet the US$40bn target. Land tax proceeds of US$11bn in the first phaseof implementation are the largest item, in our view. We calculate that a 20% sin tax ontobacco and sugary drinks would raise US$2.1bn (0.3% of GDP) at a 0.5ppt cost toinflation. A remittance tax being studied, according to local press, and could impose atax of 6% gradually decline to 2% over a number of years. At the upper bound of the taxrate (6%), we calculate that the remittance tax would raise US$2.3bn (0.4% of GDP). Wecalculate that a 10% income tax on expatriates would raise at least between US$3.9-US$7.8bn (0.6-1.2% of GDP), depending on the assumed annual overall expatriateearnings. That being said, measures to tax expatriates could be detrimental todiversification and labor force prospects and were opposed to politically in the past.GEMs Paper #26 | 30 June 2016 21Table 8: Fiscal consolidation measures through 2020 leave undisclosed financing gapFiscal measure Annual revenue raised (US$bn) Annual revenue raised (% of GDP) Impact on inflation (ppt) RemarkNon-oil revenue measures 100 15.8 - NTP targetFees on excess foreign worker quotas 10 1.6 - NTP targetGreen-card like program 10 1.6 - NTP targetVAT 10 1.6 5 NTP targetSubsidy reform 30 4.7 NTP targetNatural gas feedstock for petrochemicals 2.5 0.4 - BofA ML assumptionDomestic crude 20.8 3.3 - BofA ML assumptionGasoline 1.4 0.2 0.5 BofA ML assumptionDiesel 1.9 0.3 - BofA ML assumptionOther measures 40 6.3 - NTP targetLand tax 11 1.7 - BofA ML assumptionRemittance tax 2.3 0.4 - BofA ML assumptionIncome tax on expatriates 3.9-7.8 0.6-1.2 - BofA ML assumptionSin tax on tobacco 0.7 0.1 0.1 BofA ML assumptionSin tax on sugary drinks 1.4 0.2 0.4 BofA ML assumptionMemo:Undisclosed revenue financing gap 16.8-20.7 2.7-3.3 - BofA ML assumptionCost savings Annual savings (US$bn) Annual savings (% of GDP)20% cut to on-budget non-oil subsidies 0.2-0.8 0.1-0.5 - BofA ML assumption5% cut to the wage bill 6.4 1.0 - NTP targetCost increases Annual cost increase (US$bn) Annual cost increase (% of GDP)NTP costs (US$71.5bn) 14.3 2.2 NTP targetSource: National Transformation Plan, BofA Merrill Lynch Global ResearchChart 18: Breakdown of electricity consumption by sectorChart 19: Water consumption by sector4%2%11%16%50%Municipal,9%Industry, 3%17%Residential Commercial IndustryGovernment Other AgricultureSource: SAMA, BofA Merrill Lynch Global Research. Data as of 2015.Agriculture,88%Source: UN, BofA Merrill Lynch Global Research. Data as of 2010.Budgeted defence spending – up or downLocalization policies in the defence industry could help cut imports (total defenceimports of US$9.8bn equivalent to US$1.5bn or 6% of total imports in 2015, accordingto consultancy IHS) and conserve Fx reserves, but we expect this to be a slow andgradual process. We think that large defense imports are typically amortized over anumber of years. Defence spending is an important part of fiscal spending in SaudiArabia, accounting for c30% of total budgeted spending. Defence spending in 2016 wasbudgeted at SAR213bn (US$56.9bn; 9.0% of GDP), down from SAR307bn (US$81.8bn;12.7% of GDP) in 2015. Increased military and security projects in 2015 saw anadditional overspend of SAR20bn last year. It is unclear to us if all of the regionalmilitary costs have been recognised on-balance sheet. A negotiated settlement to theYemen conflict through the ongoing political negotiations in Kuwait could help containsecurity spending near-term.22 GEMs Paper #26 | 30 June 2016Chart 20: Budgeted spending – up or down?SARbnBudgeted Defense & Security spending% of total budgeted spending (rhs)350300250200150100500454035302520151050198119831985198719891991199319951997199920012003200520072009201120132015Source: SAMA, Ministry of Finance, Bank of America Merrill Lynch Global Research.Privatization comes back to the government’s agendaThe consideration of a privatization program is not surprising at the current juncture, inour view. Recall that the Saudi privatization program was initially started in 1999 withthe creation of the now-dissolved Supreme Economic Council, following the drop in oilprices in 1998. Small-scale privatizations took place in the early 2000s, and 2002 sawlarge privatization in the telecommunication sector and postal services.Selling public sector stakes is one of the non-debt creating financing options for thegovernment that would help minimize the direct drain on Fx reserves, encourage privatesector development and improve services delivery. That being said, given the lack ofnon-oil taxation, this would only contribute to one-off financing flows alongside savingsfrom a drop in budgetary allocations to the privatized entities, in our view.The 2015 budgetary appropriations for public institutions totalled SAR163.7bn(US$43.7bn; 19.0% of total budgeted spending and 6.8% of GDP). We calculate that thepublic institutions related to the entities that appear to have been slated forprivatization according to press reports account for budgetary appropriations ofSAR124.8bn (US$33.3bn; 5.2% of GDP. This is likely to be the upper bound of fiscalsavings possible under the privatization program. In our view, this is unlikely to berealized fully as it includes a large number of universities and because most timelinesappear to center around 2020.Table 9: Privatization / Public Private Partnerships (PPPs) plannedEntity Date Comment (press reports and Saudi Vision 2030/NTP, unless stated otherwise)Airports 2016-2020 Targeted sale of 11 airport units by 2020Saudi General Grains Organisation 1Q17 A financial advisor has been appointedSaudi Aramco by 2018 A stake of less than 5% could be soldStock exchange (Tadawul) by 2018 A financial advisor has been appointedSaudia Medical Services -Saudi Arabian Airlines appointed a financial adviser for the privatization of its unit Saudia Medical Services and had itsBoard of Directors restructured in JuneSaudi Electricity (SEC) by 2020SEC’s generation assets are likely to be split into four separate regional companies where minority stakes would be sold tomajor global utilities or sold in the public marketSaline Water Conversion Corporation (SWCC) - Investment partners are likely to be sought to buy a stake in production assets, with the holding company to be listed laterGeneral Port Authority by 2020 Commercialization program to be completed by 2020Saudi Post by 2020Saudi Post to be turned into a holding company with six subsidiaries. The NTP aims to transform it to a commercially viablecompany with government subsidies (SAR2bn) to be phased out by 2020.Education / schools - Official pronouncements have suggested this could be considered, but there does not appear to be concrete plans for nowHealthcare / hospitals -The 2030 vision suggests no privatisations in the near-term, in our view. Authorities are likely to look to improvemanagement and quality of service before considering privatisation, in our view.Road, railway and port projects - NTP suggests PPPs are planned with percentage in private sector contribution to development and operation to increaseSource: Press reports, Saudi Vision 2030, National Transformation PlanGEMs Paper #26 | 30 June 2016 23Table 10: Public institutions budget appropriationsSARbn US$bn % of GDPUniversities 55.7 14.8 2.3Saudi Arabian Airlines 28.5 7.6 1.2Saline Water Conversion Corporation 15.6 4.2 0.6General Authority of Civil Aviation (GACA) 15.5 4.1 0.6Saudi Post Organization 3.2 0.8 0.1Grain Silos and Flour Mills Organization 2.9 0.8 0.1Saudi Ports Authority 1.8 0.5 0.1Saudi Railways Organization 1.7 0.4 0.1Other 38.9 10.4 1.6Total 163.7 43.7 6.8of which, public institutions in sectors that could be privatized 124.8 33.3 5.2Source: SAMA, Ministry of Finance, Bank of America Merrill Lynch Global Research. Data as of 2015 budget.Sales of PIF assets could help replenish fiscal reserves but not Fx reservesSecondary sales of domestic assets could be a faster way than Initial Public Offerings(IPOs) and privatizations for the Ministry of Finance (MoF) to raise its fiscal reserves atSAMA, in our view. We look at this possibility to assess the potential for the MoF to useit as an option to support its fiscal reserves at SAMA and prevent a debt build-up inresponse to ongoing fiscal deficits.If this were to take place, this could occur through holdings of the PIF rather than thepension funds who are large institutional investors in the domestic equity market, in ourview. We calculate that the PIF could sell stakes worth around SAR200bn (US$53.6bn)domestically through liquidating existing minority stakes and selling down majorityholdings while retaining control. If the PIF holdings are above 50%, we assumearbitrarily that the holding is strategic, and thus calculate the current value of the stakethat the PIF (using the current stock price in the market) can sell down so it retains acontrolling 51% ownership share. If the PIF holdings are below 50%, we arbitrarilyassume that the holding is not strategic, and thus calculate the current value of thestake that the PIF holds (using the current stock price in the market) as we assume itcould be fully liquidated.The proceeds of sales domestically (without foreign participation) would increasecentral government deposits at SAMA, decrease other domestic liabilities of SAMA butkeep Fx reserves unchanged. Because of the latter, because such large coordinated salescould weigh on the market and as the PIF is targeted to become the largest SWF bySaudi authorities, we doubt this is going to be a course policy-makers are likely to beconsidering in the near term.24 GEMs Paper #26 | 30 June 2016Table 11: Public Investment Fund listed domestic assets and their monetization potential in regards to replenishing fiscal reserves at SAMAPotential value ofsecondary offering if agovernment stake is sold,but with the governmentstill retaining 51% controlPotential value ofsecondary offering ifgovernment’sexisting minoritystake is liquidatedEntity Sector Current government stake (%) Free-float (%) (US$bn)(US$bn)Saudi Basic Industries Corporation (SABIC) Chemicals PIF: 70.0%; GOSI: 5.7% 24.3% 12.3 0.0Saudi Telecom (STC) Telecom PIF: 70.0%; GOSI: 7.0%; PPA: 6.77% 16.2% 6.5 0.0Saudi Electricity (SEC) Power Government: 74.3%; Aramco: 6.9% 18.8% 5.1 0.0Saudi Ground Services Travel Saudi Arabian Airline: 52.5%; National Aviation: 14.7% 30.0% 0.4 0.0Saudi Real Estate Company Real estate PIF: 64.57% 35.5% 0.1 0.0National Commercial Bank (NCB) Banks PIF: 44.3%; GOSI: 10%; PPA: 10.04% 35.7% 0.0 9.5Maaden Mining PIF: 49.99%; GOSI: 7.98%; PPA: 7.45% 34.6% 0.0 5.9Samba Banks PIF: 22.91%; GOSI: 11.76%; PPA: 15.04% 73.2% 0.0 2.4Yanbu National Petrochemical Co (Yansab) Chemicals SABIC: 51%; GOSI: 11.92% 37.1% 0.0 2.2Saudi Arabian Fertilizer Company (SAFCO) Chemicals SABIC: 42.99%; GOSI: 12.2% 44.8% 0.0 2.0Riyadh Bank Banks PIF: 21.75%; GOSI: 16.72%; PPA: 9.18% 46.6% 0.0 1.9Southern Province Cement Cement PIF: 37.43%; GOSI: 15.82% 46.8% 0.0 1.1National shipping company Transport PIF: 22.55% 80.0% 0.0 0.9Saudi Catering Transport General Airline Services KSA: 35.7% 39.8% 0.0 0.8Kayan Chemicals SABIC: 35% 65.0% 0.0 0.6Alinma Bank Banks PIF: 10%; GOSI: 5.10%; PPA: 10.71% 74.1% 0.0 0.5Qassim cement Cement PIF: 23.35%; GOSI: 15.09%; PPA: 5.67% 79.2% 0.0 0.4Yanbu cement Cement PIF: 10%; GOSI: 12.37% 68.5% 0.0 0.2National Agriculture Development Agriculture PIF: 20% 85.1% 0.0 0.1Saudi Fisheries Agriculture PIF: 39.99% 38.5% 0.0 0.1Saudi Public Transport Transport PIF: 15.72% 100.0% 0.0 0.1Eastern Province Cement Cement PIF: 10%; GOSI: 10.65% 89.4% 0.0 0.1National Gas and Industrialization Chemicals PIF: 10.91% 88.0% 0.0 0.1Saudi Ceramic Consumer PIF: 5.94%; GOSI: 16.19% 83.8% 0.0 0.0Petro Rabigh Chemicals Aramco: 37.5%; Sumitomo: 37.5% 25.0% 0.0 0.0Total 24.3 28.6Source: Bloomberg, Bank of America Merrill Lynch Global Research. PIF = Public Investment Fund. GOSI = General Organization for Social Insurance. PPA = Public Pension Agency. Based on stock prices as of 28 June 2016.Material fiscal consolidation would be necessary to narrow macro imbalancesThere is no substitute for fiscal consolidation to maintain Fx policy unchanged. We mapout below paths for several macro variables depending on fiscal policy and oil prices,with higher oil prices easing the adjustment requirement.In a worst case scenario where US$25/bbl oil prices would persist for the next fiveyears, sustainability of the Saudi Fx policy rests on material fiscal consolidation, whichwe believe is achievable based on the mix of revenue-raising and spending restraintplans likely or announced to date. This would require a total 5-year cumulativeadjustment of SAR500bn (US$133bn; 20% of 2015 GDP or 4ppt of GDP annually) from2016 onwards, which is close to what the NTP appears to be targeting in non-oilrevenue measures (US$100bn, excluding NTP costs). We think 75% of the adjustmentcan take place through revenue-raising measures. The remainder of the adjustmentwould need to take place through capex cuts and is similar in size to the capexretrenchment of the 1980-90s. However, note that if one assumes that the 2015 budgetdeficit will be revised higher to 18.9% of GDP, this adds a need for a further 4ppt ofGDP cumulative fiscal adjustment to maintain the same trajectory of Fx reserves.An overhaul of fiscal policy will likely be requiredIn line with the 2016 budget announcement, we would expect tight budgets to bepassed. We expect a VAT with 5% yield to be implemented in 2018, alongside furtheradministered price adjustments for energy, water and electricity. Implementation of theland tax is likely, but it is unclear whether the proceeds will be ring-fenced to be usedsolely for housing projects. Using solely the recurring existing proceeds of theDecember administered price adjustments and a VAT introduction, we still see a needfor further fiscal restraint in the order of 1ppt of non-oil GDP annually. The latter wouldGEMs Paper #26 | 30 June 2016 25be equivalent to a SAR100bn cumulative spending cut, which we believe can beaccommodated from capex retrenchment. On the basis of the above, fiscal consolidationwould likely drive real GDP growth lower to an average of just around 1% of GDP. Thisestimate is based on a ST GCC fiscal multiplier of 0.2 for real spending to real non-oilGDP, in line with academic literature.Fx policy stays the course; NTP blurs medium-term incentivesWe do not believe Deputy Crown Prince Mohammed bin Salman is considering Fx reformin the near-term. We have expressed here our view that the Fx peg would hold as fiscalpolicy undergoes a sizeable multi-year adjustment. In a bearish scenario for oil prices,the NTP is unlikely to be implemented as deep budget cuts are likely to be required tosustain the Fx policy. We believe an oil price of at least US$50/bbl is broadly consistentwith full and timely NTP implementation, but fiscal policy still needs to be disciplined. Iffiscal non-oil revenue targets are missed, a higher oil price is likely to be needed.However, if the NTP is successful in diversifying the economy, it will make the costs ofrunning an overvalued exchange rate more prohibitive, particularly as the externalaccounts are likely to become more responsive to an Fx shock. It also introduces a progrowthbias for policy-makers in charge of diversifying the economy, which may conflictwith the implementation of unpopular fiscal reforms or the depth of fiscal consolidationneeded at weak levels of oil prices. The NTP diversification initiatives may suffer from atiming mismatch when it comes to net external receipts generated. This is because thesectors that would generate Fx receipts (non-oil exports, religious tourism) orlocalization policies are likely to be slow to ramp-up, while Fx demand in the economy islikely to be supported (rather than deflated) by government diversification policies. Last,the desire to build a large SWF may suggest a desire to conserve Fx reserves.Chart 21: Illustrative paths of Saudi government deposits at SAMA% of GDP6010-40US$50/bbl oil - nominal spending flatUS$50/bbl oil - modest fiscal adjustmentUS$50/bbl oil - ambitious fiscal adjustmentUS$25/bbl oil - modest fiscal adjustmentUS$25/bbl oil - ambitious fiscal adjustment2000200120022003200420052006200720082009201020112012201320142015201620172018201920202021Source: , Haver, BofA Merrill Lynch Global Research estimatesChart 22: Illustrative paths of SAMA foreign assets100 % of GDP908070605040302010US$50/bbl oil - nominal spending flat0US$50/bbl oil - modest fiscal adjustmentUS$50/bbl oil - ambitious fiscal adjustment-10US$25/bbl oil - modest fiscal adjustment-20US$25/bbl oil - ambitious fiscal adjustment199019921994199619982000200220042006200820102012201420162018202020222024Source: Haver, BofA Merrill Lynch Global Research estimates26 GEMs Paper #26 | 30 June 2016Chart 23: Illustrative paths of Saudi fiscal balanceChart 24: Illustrative paths of Saudi government debt% of GDP30% of GDP10020100-10755025-20019901992199419961998200020022004200620082010201220142016US$50/bbl oil - nominal spending flatUS$50/bbl oil - modest fiscal adjustmentUS$50/bbl oil - ambitious fiscal adjustmentUS$25/bbl oil - modest fiscal adjustmentUS$25/bbl oil - ambitious fiscal adjustmentSource: Haver, BofA Merrill Lynch Global Research estimates201820201992199419961998200020022004200620082010201220142016US$50/bbl oil - nominal spending flatUS$50/bbl oil - modest fiscal adjustmentUS$50/bbl oil - ambitious fiscal adjustmentUS$25/bbl oil - modest fiscal adjustmentUS$25/bbl oil - ambitious fiscal adjustmentSource: Haver, BofA Merrill Lynch Global Research estimates20182020Consumer to face mixed trendsLabour policies are likely to remain a major focus for the Saudi government. Low oilprices have dented the government’s direct ability to support the consumer comparedto the boom years. Furthermore, negative to flat public sector wage growth is likely todampen income and consumption trends, although Specialized Credit Institutions (SCIs)could alleviate tightening banking sector household lending standards.The NPT suggests a focus on boosting female employment as well as increasing thecost of foreign labor relative to national labor. The latter implies a negative impact oncorporate margins and profits, in the event higher labor costs are not reflected in higherconsumer prices and inflation). The negative near-term cost and efficiency implicationsof continued labour market reforms are mitigated by the fact that eventual increase inprivate sector employment of higher-paid Saudi labour should prove supportive forconsumption trends once the dust settles.The NTP targets increasing the cost of employment of Saudis compared to expatriatesfrom 400 to 280. We calculate that the ratio of private sector wages of Saudiscompared to non-Saudis stood at 3.64 and 1.29 for males and females respectively in2015. The NTP target is thus akin to increasing non-Saudi private sector wages by 43%over the period to 2020, a CAGR increase of 7.4%. This would squeeze corporate profits,lead to inflationary pressures in the economy, and lead to annual additional Fx outflowsthrough remittances of US$2.8bn (0.4% of GDP). As such, it is more likely that theemployment cost of non-Saudis is likely to be increased through measures such as feesfor government services, taxes and levies. It is unclear that the NTP target can be metsolely through this route, but it would avoid additional Fx outflows despite still having anegative impact on corporate margins and inflation, in our view.The Nitaqat Saudization program is likely to be extended in the near-future through theforthcoming launch of the “balanced Nitaqat” initiative. While employment quotas arelikely to be tightened, they will also take into account wage levels, job quality andwomen employment ratios, according to local press. A likely target is likely to beincreased job creation for Saudis in the retail sector through higher quotas, in our view.GEMs Paper #26 | 30 June 2016 27Table 12: Selected drivers of Saudi consumerDirectionCommentOil prices Volatile Indirect impact through economic activity and confidencePopulation growth Decreasing Direct impact through lower number of expatriates and national birth ratePublic sector wage growth Flat to contracting Freeze in government wage billPrivate sector wage growth Flat to minor increase Some sectors to contract (construction), others resilient (retail, staples)Saudi private sector male employment Mixed Saudization helps, but economic slowdown and supply-side factors impact negativelySaudi private sector female employment Increasing NTP aims to increase it through several measuresConsumer leverage Decreasing Banking sector liquidity and lending standards are tighteningReal estate finance Increasing NTP measures are supportive in this areaSpecialized Credit Institutions (SCIs) Flat SCIs can continue to support the economySaudization Increasing Negative impact short-term, positive impact medium-termSubsidies Decreasing Timing and breadth unclear as of yetOther fiscal consolidation measures (VAT, etc) Likely forthcoming Direct and indirect negative impact on consumerSource: BofA Merrill Lynch Global ResearchChart 25: Private sector average monthly wages are increasingSAR/month2004 2005 2006 2007 2008 20093,5002010 2011 2012 2013 2014 20153,0002,5002,0001,5001,0005000Male Female TotalSource: SAMA, BofA ML Global Research. SAMA wage data coverage appears incomplete.Chart 26: Wedge between Saudi and non-Saudi private sector salariesSAR/month7,0002014 20156,0005,0004,0003,0002,0001,0000Male Female Male FemaleSaudisNon-SaudisSource: General Organization for Social Insurance (GOSI), BofA ML Global Research.Banks and contractors will require supportive policies to realize NTP benefitsThe banking sector is targeted to benefit from the NTP initiatives through greaterdisintermediation (SMEs, real estate financing, non-oil export financing) and greaterhousehold savings. However, domestic liquidity is likely to remain structurally tight, inour view. The NTP targeted increase in non-oil fiscal revenue is likely to tightendomestic liquidity, all else being equal, as it would have the effect of extractingresources from the non-hydrocarbon private sector (as opposed to governmentdomestic spending that injects liquidity).Linked to liquidity trends and banking sector asset quality, the issue of governmentarrears to contractors is likely to take centre stage, in our view. Resolving this is likely tobe required if the capex projects under the NTP are to be executed on a timely fashion,in our view. We think the government’s proposal to issue "I Owe You' notes (IOUs) couldbe a step in this direction.Government looks to issue IOUsAccording to the press, the Saudi government has paid contractors some cash on itsarrears, and is considering to issue "I Owe You' notes (IOUs) to them. Contractors wouldreceive these notes to cover their outstanding dues, which they could hold until maturityor sell on to banks. The government has been highlighting it wanted to settle thecontractor sector dues, and recently a high-profile domestic contractor has made massredundancies. In the previous downturn in the 1980s, arrears to domestic contractorswere also likely to have been accumulated. We highlighted that the fiscal deficit waslikely under-reported last year. Also, construction was one of the fastest growing sectorlast year both in terms of domestic activity and of domestic credit.28 GEMs Paper #26 | 30 June 2016Government arrears to contractors could be significantWe estimate the range of unpaid capex for 2015 to be SAR23bn-SAR100bn (US$6bn-US$27bn or 1-4.3% of 2015 GDP). At the very minimum, unpaid capex could be aroundSAR23bn. This is the amount of additional loans taken out by construction contractorsover 2015 compared to 2014. Total construction loans were SAR106bn in 2015 versusSAR83bn in 2014. Contractors likely did not go to obtain alternative bank funding forthe same amount as the delayed payments from the government, suggesting delayedpayments should be larger than SAR23bn, in our view.By the same token, the 2015 budget outturns imply capex was down by 45% toSAR205bn versus 2014 levels of SAR370bn. This is of course unlikely as constructiongrew by 5% in real terms in 2015. Correcting the 2015 budget by the likelyunderreporting (an additional SAR100bn in spending, assuming it was all capex-related),then capex spending was likely down by SAR65bn (17%) in 2015. This would be in linewith the c15%yoy drop in construction awards as reported by MEED.In comparison, government overdues in the healthcare sector are much smaller. Basedon the disclosures of two listed healthcare groups, we estimate the growth ofgovernment receivables owed to them alone is SAR0.4bn. We estimate the total sectorgovernment overdues to private healthcare operators could be 2-3 times this level.IOUs to serve multiple purposesIOUs could support simultaneously the multiple needs of the government, domesticbanks and contractors, in our view. The government will be able to conserve fiscalreserves and restructure the maturity of its outstanding dues. Domestic banks wouldsubstitute corporate credit risk with sovereign risk and improve asset quality, whilecontractors could improve their liquidity and working capital position by cashing in earlyon the IOUs. We believe most of the contractors impacted could be domestic ones, andwe presume these IOCs would be issued in domestic currency. Furthermore, to theextent these IOUs are structured as tradable instruments, this could better distributerisk in the financial sector to those agents more capable or willing to hold it.Domestic liquidity could be eased, but Fx outflows may not subsideThe impact of IOUs on domestic liquidity will likely depend on the issuance mechanism,of which we have little visibility for now, though this could likely ease domestic liquidity.We would however expect subsequent Fx reserves losses due to an increase in demandfor Fx consequent to the liquidity injections (a 50% leakage would for instance lead toUS$13.5bn loss in Fx reserves at the high-end of the estimated arrears range).One possibility for the mechanism would be for banks to extend more secured credit tocontractors using the IOUs as collateral. In this case, domestic liquidity is likely toremain tight as the banking sector balance sheet would stay stretched. Another, perhapsmore likely, option would be for banks to accept IOUs as deposits. Contractors wouldthen be able to transfer IOUs to their trade creditors and withdraw cash regularly, withthe total amount being likely a portion of the face value of the IOUs. Banks would holdnew government instruments on the asset side of their balance sheet. This mechanismcould also be structured as a simple sale of the IOUs to domestic banks (with a haircut),which domestic banks would accommodate through equivalent changes on the assetside of their balance sheet, without the creation of additional liabilities.In the latter option, to avoid straining the banking sector liquidity, the depositswithdrawal or in effect the increased money in circulation would likely require monetaryaccommodation from SAMA, in our view. We believe this could take the form of liquidityinjection, possibly through repo operations for the IOUs. Although unconventional, thisGEMs Paper #26 | 30 June 2016 29possible source of easing of domestic liquidity would still be consistent with Article 6Saudi Arabia’s Currency Law which imposes a 100% currency backing by Fx reserves,such that that currency issued cannot exceed foreign reserve assets. The full coverrequirement would still be in force as reserve money currently represents just 14% offoreign reserve assets, down from c100% throughout the period 1996-2000.30 GEMs Paper #26 | 30 June 2016Lessons in diversificationThere are only few examples of countries that successfully managed diversificationaway from primary dependence. The examples of Malaysia and Norway suggest that asound institutional framework, robust fiscal framework, supportive public sectorindustrial policies, appropriate business climate and human capital are important factorsin enabling successful diversification away from the oil sector. A backdrop of low oilprices exacerbates diversification challenges but also provides impetus for change.Saudi comprehensive reforms follow standard template to shift gearsThe Saudi NTP broadly follows the generally accepted template of comprehensivemacro- and micro- reforms needed to diversify beyond the hydrocarbon sector, in ourview. The literature suggests successful diversification entails ideally a combination ofthree types of innovations: processes, products and organizations. Enhancement inprocesses would enhance productivity, new products would support emergence of newsectoral growth drivers, and improved micro- and macro-governance would help sustainproduction gains. The key to furthering the development path would be to move from aninitial labour- and capital-intensive phase towards a phase focused on increasingproductivity growth through higher value-added sectors.This will require the retention of white-collar workers, steady progress on institutionbuilding,an increase non-hydrocarbon FDI, horizontal and vertical integration, a broadermanufacturing base including at first through sectors with competitive advantage(downstream or energy-intensive ones), greater integration into the global value chainthrough enhanced trade relations, as well as education and business climate reform toovercome structural rigidities, in our view.Medium-term diversification may require Fx reformAs diversification progresses, the case for increased Fx flexibility and making space forautonomous monetary policy conduct is likely to gradually take shape. Presumably, sucha move would require putting in place a supportive institutional structure which iscurrently broadly lacking. It would also await improvements in productivity growth andthe development of competitive local industries to minimize a potential Dutch diseaseeffect on infant or other sectors. A fairly valued real effective exchange rate (REER)would support efficient allocation of production factors across sectors and improvecompetitiveness of the tradable goods sector.Malaysia case study highlights the role of supportive public sectorMalaysia’s diversification away from primary commodities relied on a series of NationalIndustrial Policies and Industrial Master Plans to promote the manufacturing sector.Focus was given to sectors with high export potential, and efforts were taken to createlinkages with other sectors and to deepen interconnection with other industries. Growthstrategies also aimed to develop local technological capabilities and clusters ofindustrial development, similar to the localization and industrial strategies spearheadedby the Saudi National Transformation Plan.GEMs Paper #26 | 30 June 2016 31Chart 27: The launch of government industrial policies in the 1980s helped Malaysia diversify35Manufacturing value-added (% of GDP)30Manufactured exports (% of merchandise exports, rhs)25201510501960196319661969197219751978198119841987199019931996199920022005200820112014100806040200Source: Haver, BofA Merrill Lynch Global ResearchNorway case study suggests institutions are paramountWhile it is perilous to extend lessons that could overemphasize idiosyncracies, the caseof Norway highlights, if anything, the importance of sound institutions and macromanagement when it comes to broader economic diversification. The case of Norwayhas relevance for the Gulf Cooperation Council countries (GCC), including Saudi Arabia,especially since oil discovery (late 1960s) and oil production (1970s) timelines were notthat sensibly different from the GCC.That being said, outcomes were widely different as well as the starting point sinceNorway was already a developed country with mature social, economic and politicalinstitutions at the time of the discovery of oil. This allowed a distinction between themanagement and ownership of natural resources uncommon in the GCC and severalother resource-based economies, in our view.Four ways in which the supply-side matters for economic diversificationWe believe that there are four lessons to learn from Norway’s outperformance:1) The importance of human capitalNorway’s priorities from early on were to build human capacity, investing in education,increasing labor force participation and supporting productivity growth.2) Prudent conduct of fiscal policyCurrent Norwegian oil revenue management puts considerable emphasis on stabilizingthe economy and facilitating a gradual phase-in of oil revenues over time (which crowdsout trophy projects and put onus on achieving productivity gains in the non-oil sector).Following the 1970-80s boom-bust sequence and expansion of the welfare state,Norway established in 1991 a Government Petroleum Fund to receive and invest oilrevenue (it received its first net transfer in 1996). The fiscal rule adopted in 2001targets a central government structural non-oil budget deficit equal to 4% of GPF assets(the latter assumed to be its estimated long-run real rate of return). That being said,Saudi Arabia’s infrastructure requirements could have prevented adapting this part ofNorway’s model for long, in our view.3) Institutional experienceNorway’s development has been characterized by continuous development andintegration of resource-based export-oriented industries, some of which were activesince 1950. While Norway is the world’s third largest exporter of natural gas and thesixth largest of crude oil, it is also the second largest exporter of seafood, possesses thefourth largest shipping fleet, is the sixth largest exporter of aluminium and the firstexporter of sub-sea technology products and services.32 GEMs Paper #26 | 30 June 20164) Industrial policyNorway’s active use and introduction of a national industrial strategy has helped shelterinfant industries and create linkages between the natural resource-based industries andother sectors of the economy. For two decades (1972-1994), preference was given in atransparent fashion to local content in procurement to help build supply industries, andprovisions were set in for international firms to train nationals, use domestic serviceindustries and cooperate in R&D with local institutions. Though Norway pre-dates theGCC in this development, the region shares in many ways some of these policies,leading to the emergence of national champions. The main difference appears to relateto the scope, extent and degree of innovation involved in offshoot industries at thisstage, in our view.Chart 28: Norway real GDP per capita growth outpaced GCC over thepast decades300250200150100Real GDP per capita (1970=100)NorwaySaudi ArabiaOther GCC (1980=100)Iran501970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014Source: Haver, BofA Merrill Lynch Global ResearchChart 29: Norway outperforms Saudi indicators on a per capita basis6543210Real GDP growth(%)Saudi ArabiaOil real GDPgrowth (%)NorwayNon-oil real GDPgrowth (%)Per capita non-oilreal GDP growth(%)Source: Haver, BofA Merrill Lynch Global Research. Data represents averages over 1979-2014.Chart 30: Norway’s hydrocarbon sector share in real GDP has dropped120Oil prices (US$/bbl)40100Oil sector (% of real GDP, rhs)35308025Chart 31: Human capital is Norway’s most important resource7%9%2%602040201510582%019781981198419871990199319961999200220052008201120140Discounted value of laborDiscounted petroleum rentReal capitalFinancial assetsSource: Haver, BofA Merrill Lynch Global ResearchSource: Norway Ministry of Finance, BofA Merrill Lynch Global ResearchGEMs Paper #26 | 30 June 2016 33Eurobond premium required for fiscal slippage riskWe expect large and regular sovereign eurobond issuance going forward to support FXreserves and domestic liquidity but weigh on regional bond spreads if risk appetite doesnot hold up or fiscal slips. EMBIG index inclusion is unlikely, in our view. Saudi ArabiaCDS premium to Qatar and likely larger issuance size suggests Saudi External Debt(EXD) is likely to be issued at a premium to Qatar.Saudi Arabia international bond issuance latest in wave of Gulf supplyLocal press suggests that Saudi Arabia is gearing up for a large international bondissuance program (US$10-15bn issuance target this year), which, if confirmed (thegovernment neither confirmed nor denied , should add to the sizeable sovereign bondsupply pipeline this year. So far, we have seen US$17.1bn in gross and net supply fromthe Gulf Cooperation Council (GCC) countries. Assuming Saudi Arabia issues US$15bnand accounting for planned issuance from Dubai and Bahrain and excluding Kuwait, therest of this year should see a further US$16.5bn in gross issuance and US$16.1bn in netissuance. This would bring the total gross and net GCC sovereign bond issuance toUS$33.6bn and US$33.2bn this year respectively.Seminal potential bond issuance has multi-pronged implicationsIf confirmed, this could be a seminal event and mark the first time for the Saudigovernment to issue external bonds. It would allow for participation of foreign investorsas domestic debt is being sold to Saudi banks and funds. External issuance shoulddiversify funding sources, lock in still low interest rates, support SAMA's Fx reserves andsupport domestic liquidity; the latter two macro variables have weakened this year.External issuance would also imply the presence of an underlying asset that couldtheoretically trigger CDS contracts, as opposed to the current situation.Investment grade status to be retained despite likely further rating cutsA prolonged oil price downturn is likely to continue to put downward pressure on SaudiArabia’s credit rating in the medium-term. On average, the GCC has benefited fromthree notch rating upgrades over the period 2002-10 prior to the start of the ArabSpring. Saudi Arabia was upgraded six times, from Baa3 to Aa3, by Moody's over theperiod starting from 1999, while it was upgraded two and three notches by S&P andFitch over the period starting from 2003/2004 respectively. Moody’s has thus in thepast preserved Saudi Arabia’s investment grade rating at the bottom of the cycle, asgovernment debt to GDP stood at 103% of GDP and SAMA’s foreign assets at US$17bn(10% of GDP) in 1999.EMBIG Index inclusion is unlikelyEMBIG index inclusion is unlikely, in our view. Estimated 2013 (US$25,140) and threeyearrolling GNI per capita (US$23,090) data likely suggests Saudi Arabia does not meetEMBIG income index inclusion criteria, in our view. Saudi Arabia would however likely beeligible for Barclays EM Hard Currency Aggregate Index, based on its IMF classificationas a non-advanced country (noting that the index provider has moved away from solelyusing rating for EM country classification). This suggests that Saudi policy-makers needto articulate a comprehensive, timely and credible medium-term fiscal policy tofacilitate wide take-up from domestic, regional and international investors, in our view.Pricing mattersSaudi Arabia CDS premium to Qatar, relative credit metrics and likely larger plannedissuance size suggests Saudi EXD is likely to be issued at a premium to Qatar, in ourview. The closest regional peers to Saudi Arabia (A1/A-/AA-) are likely Qatar (Aa2/AA/AA)and Abu Dhabi (Aa2/AA/AA). Qatar’s existing external debt curve makes it a potentially34 GEMs Paper #26 | 30 June 2016useful and relevant pricing benchmark in this regard, in our view. The Qatar 10-yearsovereign bond currently trades at yields of 3.0%. However, Saudi CDS has been tradingc65bps wider of Qatari CDS, which would suggest a 10-year Saudi bond yield of c3.65%.Current CDS spread levels suggest potential for some notch downgrades from SaudiArabia’s current rating, as the market prices in issuance risk, volatile oil prices, hedgingflows relative to the USD peg and the banking sector off-balance sheet wrong-wayexposure risk.Saudi forwards, rates and CDS remain under pressureDomestic rates are under pressure with the 5y IRS spread over US at historicallyelevated levels due to structurally tighter liquidity. Budget consolidation could help takesome of the pressure off as it would imply lower debt issuance needs. However, it wouldalso imply lower deposit formation in domestic banks as fiscal retrenchment will impactprivate sector economic activity. Greater risk premium, issuance pressures and tighterliquidity will also keep CDS spreads elevated until oil recovers.Hedging against SAR devaluation risks remains strategically attractive given the riskrewardratio. Data suggest a strained backdrop for external and domestic liquidityreflecting the combination of private sector dollarization, possible capital outflows,weakening deposit formation and the move higher in interbank rates. However, SAMAhas already intervened through macro-prudential tools and may do so again if needed.Chart 32: Market remains nervous on Saudi Arabia3210-1-2-3Implied appreciation in 1-yr SAR fwd (%)Oil prices (US$/bbl, rhs)Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11Jan-12Jan-13Jan-14Jan-15Jan-16Source: Bloomberg BofA Merrill Lynch Global Research.160140120100806040200Chart 33: A pronounced increase in SAR swap spreads vs USD%6Spread (rhs)SAR 5yr swapbp250USD 5yr swap5200432100Jan-02 Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Jan-16Source: Bloomberg BofA Merrill Lynch Global Research.15010050GEMs Paper #26 | 30 June 2016 35Exhibit 2: Saudi credit risk prices in rating downgradesSource: Bloomberg BofA Merrill Lynch Global Research.Commodities: NTP adds to medium-term oilmarket tightnessFrancisco BlanchMLPF&Sfrancisco.blanch@baml.comPeter HellesMLI (UK)peter.helles@baml.comThe Saudi National Transformation Plan (NTP) suggestion that production capacity is tobe maintained at the current level until 2020 reinforces our conviction of medium-termoil market tightness. We continue to see a call on OPEC of 4.1mn bpd in the next fiveyears to “balance the market”, and see oil prices of US$55-75/bbl over 2016-2020.Although the NTP incorporates a target of boosting domestic gas production by 50% to18 bcf/d by 2020 which could crowd out oil demand, we expect Saudi Arabia’s ability toswitch to reduce oil burn in power generation to 2020 to be quite limited, in our view.We see oil averaging US$55-75/bbl over 2016-2020Real Brent prices are at one of the lowest levels in decades, and will likely encouragevery strong demand growth ahead, while we see supply falling across non-cartelizedproducers. As such, we see global light sweet crude oil averaging US$55 to US$75/bblover the 2016-2020 period, depending on how much incremental production OPEC canand will supply over the next five years. We think it likely that Saudi will dig into itsuntested spare capacity to go for increased market share, though uncertainty over howmuch Saudi can and will produce remains. We also remain concerned about outputsustainability among weaker cartel members given the rapid credit profile deterioration.36 GEMs Paper #26 | 30 June 2016Chart 34: Real Brent prices are at one of the lowest levels in decades,and will likely encourage very strong demand growth ahead14012010080604020Real and nominal yearly average Brent crude oil pricesUS$/bbl070 73 76 79 82 85 88 91 94 97 00 03 06 09 12 15nominal oil priceSource: BP, Bloomberg, BofA Merrill Lynch Commodities Research2016YTDreal oil price, rebased to 2016YTD price levelChart 35: We see global light sweet crude oil averaging US$55 toUS$75/bbl over the 2016-2020 period110100908070605040Medium term oil supply & demand (2016-2020)avg oil price(US$/bbl)mn bpd growth, 2016-202 3 4 5 6 7 8 9 10supply (OPEC 2.9): lowsupply (OPEC 4.2): base*supply (OPEC 5.5): highdemandSource: IEA, BofA Merrill Lynch Commodities Research*4.2 mn b/d OPEC supply: Saudi: 1.3 mn b/d; Iraq: 0.8 mn b/d; other OPEC crude: 1.7 mn b/d; 0.4 mnb/d OPEC NGLs.Non-OPEC production will not reach 2015 levels before 2020 at the earliest…Non-OPEC producers have massively reduced capex spending, down US$290bn or 42%from 2014 to 2016, in response to the low price environment. Should capex start toincrease again in 2017, the effect on non-OPEC non-shale production is unlikely to befelt before 2020 at the earliest. Most of the decline in the short term comes from nonconventionaloutput in the US, as shale is very price sensitive within a 12-monthhorizon. With Brent prices set to increase from US$46/bbl this year to US$80/bbl in2020 in our base case, we believe US shale production will grow again, albeit at a slowerrate than in the past four years. Total non-OPEC supply is set to drop to 56.4mn bpd in2017 before rebounding to 57.5 mn bpd in 2020, a similar level as in 2015.Chart 36: With Brent prices set to increase to US$80/bbl in 2020, webelieve US shale output will grow again, albeit at a slower rateNon-OPEC oil supply growth by major country3.02.5mn b/d, YoY2.01.5BofAML f'cast1.00.50.0-0.5-1.02010 2012 2014 2016F 2018F 2020FUS Canada MexicoNorth Sea Russia KazakhstanAsia Brazil Sudan/So. Sudanothertotal non-OPECSource: IEA, BofA Merrill Lynch Commodities ResearchChart 37: Linking this with our 5-year price deck suggests marginal USshale output grows in 2017 and acceleration thereafter86420mn b/dShale production forecasts aligned with BofAML WTIprice assumptions2013 2014 2015 2016 2017 2018 2019 2020base 2016@$45/bbl 2017@$59/bbl 2018@$67/bbl 2019+@$75/bblSource: EIA, BofA Merrill Lynch Commodities Research4.1mn bpd needs to be added by OPEC by 2020, namely Saudi, Iran and IraqThe US is the only country able to ramp up production among non-cartelized players by2020, so OPEC has to come to the rescue to provide the required incremental supplies.We estimated that demand will grow by 5.9mn bpd in 2015-20. With the marketoversupply of 1.8mn bpd in 2015, OPEC needs to increase production by 4.1mn bpd inthe next five years to “balance the market”. Saudi Arabia could make up for half of thisgiven its c2mn bpd of spare capacity, and we believe it intends to at least increase itsmarket share. We would expect other OPEC countries to expand their capacity in theGEMs Paper #26 | 30 June 2016 37next five years, namely Iran and the UAE. As for Libya, the current turmoil needs tocome to an end, while the scale of any Iraqi long-term output increase remains thebiggest uncertainty.Chart 38: We estimated that demand will grow by 5.9mn bpd in 2015-2010510095908580757065mn bpdGlobal oil consumptionBofAMLfcast6087 89 91 93 95 97 99 01 03 05 07 09 11 13 15 17 19Source: IEA, BofA Merrill Lynch Commodities ResearchChart 39: Other than Saudi Arabia, some OPEC countries will also expandtheir capacity in the next five years, namely Iran the UAEKuwaitAlgeriaQatarVenezuelaAngolaEcuadorNigeriaUAELibyaIranSaudi ArabiaOPEC capacity growth, 2015-2020Fmn b/d-0.3 -0.1 0.1 0.3 0.5Source: IEA, BofA Merrill Lynch Commodities ResearchSaudi plans to keep capacity flat add to medium term tightnessSaudi Arabia has 12.5mn bpd of crude production capacity, according to thegovernment, and the country suggested within the NTP that it plans to maintaincapacity at the current level to 2020. Saudi Arabia is the only material holder of sparecrude oil production capacity around the world. Spare capacity currently sits at c2mnbpd, which is one of the lowest levels ever. Even if Saudi Arabia did start investingtoday, it would take a number of years to be completed and would unlikely be readybefore 2020 in any case. Hence, as Saudi ramps up production over the medium-term bydigging into its spare capacity, the risk premium in the oil market will rise as the marketbecomes increasingly less able to handle future supply disruptions.Chart 40: The supply side in oil faces a lot of disruptions linked togeopolitics and broad economic mismanagement6mn b/dMajor oil supply disruptions(excluding disruptions due to OPEC policy changes)5post Arab springKuwait,432Iraq,Venezuela,oil strikesNigeriaunrestIraq,Gulf War1(and oil embargo)090 91 92 93 94 95 96 97 98 99 00 01 03 04 05 06 07 08 09 10 11 12 13 14 16Iraq, civil warLibya, civil warNigeria, oil theftSyria, civil warYemen, civil warIran, US/EU embargoSource: IEA, BofA Merrill Lynch Commodities ResearchChart 41: Saudi Arabia has 12.5mn bpd of crude production capacity,and currently is c2.0 of spare capacity over current production4.54.03.53.02.52.01.5mn b/dSaudi Arabia spare crude oil production capacity1.0Jan-09 Nov-09 Sep-10 Jul-11 May-12 Mar-13 Jan-14 Nov-14 Sep-15Source: IEA, BofA ML Commodities Research. IEA estimates Saudi production capacity at 12.2mn bpdIf Saudi gas production gets off the ground, it could crowd out oil demand…The Saudi NTP plans to grow domestic gas production by 50% to 18 bcf/d by 2020, andto use most of this gas to meet a 30% rise in domestic power demand and moreoverboost gas’ share in power generation to 70%, up from 50% currently. This implies thatoil burned for power generation could drop by 30% or 300 thousand bpd by 2020, mostof which would likely be crude which is more valuable in the export market than the38 GEMs Paper #26 | 30 June 2016residual fuel oil burned. Saudi Arabia has the world’s 4 th largest gas reserves, yetreaching the 5.8 bcf/d production growth target by 2020 is not that straight forward.…though boosting gas production to the NTP target poses significant challengesThe new Wasit project, which is due to come online in 2016 and ramp up to 2.5 bcf/d by2020, meets about 40% of the gas production growth target. Other than that, SaudiArabia is focusing on getting unconventional production off the ground to meet theremaining 3.3 bcf/d of the production growth target. The timing, cost and commercialfeasibly of which this unconventional gas is highly uncertain. The 2.5 bcf/d from theWasit project is about the amount of gas that would be needed to meet incrementalpower demand and displace 300 thousand bpd of crude burn, assuming gas demanddoes not grow in other sectors, which is unlikely. Hence, it is likely that Saudi’s ability toswitch significantly to reduce oil burn in power generation to 2020 will be quite limited,explaining the new openness to consider gas imports, in our view.Chart 42: Oil burned for power generation could drop by 30% or 300thousand bpd by 2020, most of which would likely be crude1,200Saudi oil demand in power generationk bpd1,000crude burnresid800600Chart 43: Other sectors like petrochemicals and industry will see theirgas demand grow as wellSaudi natural gas consumption, 2013oil & gasextraction, 0.3bcf/dindustry, 2.6bcf/dpetchems, 0.5bcf/d40020002003200420052006200720082009201020112012201320142015powergeneration, 4.4bcf/dSource: IEA, BofA Merrill Lynch Commodities ResearchSource: IEA, BofA Merrill Lynch Commodities ResearchEquity Strategy: more clarity required, butinvestible themes emergingHootan Yazhari, CFA >>Merrill Lynch (DIFC)hootan.yazhari@baml.comMore clarity required, but high level benefits becoming evidentThe recent National Transformation Program (NTP) document provided a much awaitedarticulated roadmap through 2020 of how the government is seeking to achieve itshighly ambitious Vision. However, we believe significantly more detail is still requiredbefore the market can make more concrete conclusions on the key winners and losersfrom the program as well as quantify the impact it could have on corporate earnings(both positive and negative).Whilst at this juncture it is difficult to quantify the size of the NTP opportunity forindividual companies, we feel more confident in highlighting the sectors that we seecould benefit from Saudi Arabia ambitious plans. We have detailed the sectors that wesee as likely benefiting most in the table below. We also highlight the sectors whichcould face the most negative impact from the roll out of the NTP.GEMs Paper #26 | 30 June 2016 39Table 13: Summary of key sectors likely benefiting from and impacted by the National Transformation ProgramSectors likely benefiting from NTPPetrochemicalsHealthcareInsurance (healthcare)Real estateConsumer staplesTelecomMetals and miningDefenceRationaleWith US$ 11bn being allocated to project development, downstream chemicals second largest focus of NTP; significant increasein natural gas availability (indigenous and imported); expansion opportunitiesVolume growth opportunities for private healthcare providers (management contracts); private health insurance growing;participation in privatisations; significant increase in local pharmaceutical productionPrivate insurance coverage to increase to 31mn from 10.5mn currently; rising availability of private healthcare facilitiesHigher home ownership targeted; improved access to financing/housing subsidies to both developers and buyers; volumes set toexpand as NTP targets higher real estate sector growth; increased opportunities for private sector investmentDemand growth from religious tourists; formalisation and Saudisation of retail sector; growth in locally produced poultry sales;longer-term private sector job creationGovernment spending US$2bn to enhance FTTH and Mobile networks; focus on increasing internet usage; religious tourism willboost demandProvision of new mining licenses; potential investment opportunities for international mining companiesIncreased localization will cut imports, develop local industrial capabilities and create jobsSectors likely negatively impacted by NTP RationaleConsumer discretionary Near-term squeeze on consumer disposable income and sentiment; increased competition as foreign entities given 100%ownership entitlement; development of Saudi postal system possibly a precursor to online shopping increasePetrochemicalsPotential reduction in feedstock subsidies; potential for increased competition from international companiesReal estateLand tax on white land could impact cost base and prices in urban areas; higher competition from new entrantsAll sectorsSource: National Transformation Program, BofA Merrill Lynch Global Research,Six key investible themes from the NTP are emergingUsing this frame work we believe a number of investible themes are emerging including:Rising costs on reduced subsidies (particularly water and energy); higher wage costs; increased financing burden on privatesector as government partially shoulders NTP costs1. Ambitious plans to grow religious tourism: with Hajj visitors set to increasefrom 1.5mn to 2.5mn and Foreign Umrah Pilgrims from 6mn to 15mn perannum, we see significant potential for the travel & tourism, transport sectors,consumer discretionary and telecom services sectors to benefit.2. Down trading as pressure mounts on the consumer: With the NTP lookingto reduce subsidies on energy (including transport fuels) and water, we seepressure on the disposable income of Saudi consumers rising in the short- tomedium-term (although in the longer term, we expect higher employmentlevels, growing home ownership and accelerating growth to offset thesefactors). These issues could be further augmented by a slowdown in publicsector wage growth and growth in the proportion of residents employed by theprivate sector,In reflection, we believe that the consumer will likely become more valueconscious in the near- to medium-term as stress on consumer discretionaryspend mounts. As such, we continue to prefer the consumer staples and thegrocery retailers in this environment. We also believe the grocery retailers willbenefit from the government’s focus on formalising the sector (it is highlyfragmented currently and dominated by smaller independent stores) in aneffort to increase Saudi participation. That said, we believe consumerdiscretionary companies which offer more affordable and economic goodscould benefit as they take market share.3. Rising focus on healthcare provision: Saudi Arabia is focused on significantlygrowing accessibility to healthcare for its residents. The provisions in the NTPinclude a significant increase in medical centres (hospitals and clinics), widerprovision of private health insurance and an increase in the level of40 GEMs Paper #26 | 30 June 2016pharmaceuticals manufactured locally. We thus see potentially strongopportunities for the private hospital operators, the health insurance providersand local pharmaceutical manufacturers.4. An improvement in the availability of affordable housing for Saudinationals: The Saudi housing shortage has been a persistent issue for thecountry; with the shortfall currently standing at an estimated 1.2mn units, inour view. Looking forward, we believe this shortfall will likely intensify givenstrong demand formation. The NTP is seeking to introduce greater numbers ofaffordable housing units and greater availability of financing. Indeed, theministry of housing is looking to invest cUS$16bn in achieving these aims by2020. Whilst we do not believe these measures go far enough to fully resolvethe housing shortage, we nevertheless see material opportunities for Saudi realestate developers.5. Growth in telecom/fibre infrastructure: The NTP is seeking to greatlyenhance connectivity in the country, largely through increased usage ofinternet. Reflecting that, the government has pledged approximately US$2bnnto significantly increase the availability of high speed FTTH networks in remoteareas, increase mobile broadband coverage and density in urban centres(3G/4G) and allocate an increased amount of bandwidth to the mobile serviceproviders. We thus see significant volume growth potential for the telecomservice providers (particularly with regards to mobile data, where we see scopefor price increases). Furthermore, we expect much of the capital expenditurerequired to expand the FTTH and Mobile networks to be provided by theprivate sector, which in our view will accelerate the case to spin off their towerportfolios (as a method of funding capex expansions).6. Significant growth in downstream petrochemicals capacity and metals &mining: The NTP’s drive to diversify revenues away from the oil sector hasseen it focusing on exports of non-oil commodities. In particular, we highlightthe significant investment it has earmarked for the downstream industriesincluding petrochemicals and oil refining, as well as aggressively growing thecountry’s metal and mining operations (likely through national champion,Maaden). Examples include the expansion of the country’s base metalsproduction (e.g. bauxite and phosphates) and the construction of an oils-toolefinsproject. The further development of capital intensive industries alsoprovides some scope for Saudi Arabia to develop service industries andincrease local content provisions, in our view. These could be facilitatedthrough joint-ventures with global service providers, who may considermanufacturing plants in Saudi Arabia.How to gain exposure to NTP themesIn reflection of the themes articulated above (and in the sections that follow), wehighlight the sectors and companies which have exposure to each of these themes inthe table below. The companies highlighted in green represent the companies which arecurrently Buy rated by our fundamental analysts and also fit in with our theme ofgaining exposure to the NTP.GEMs Paper #26 | 30 June 2016 41Chart 44: Summary of sectors and companies with exposure to key NTP themes (companies highlighted in green are rated Buy and represent our top picks)Theme 1 Theme 2 Theme 3 Theme 4 Theme 5 Theme 6Religious Tourism Downtrading Healthcare provisionGrowth in AffordablehousingTelco infrastructuregrowthIncrease in none-oilcommodity exportsSectors tobenefitTravel & Tourism Consumer staples Private Hospitals Real Estate Telecoms PetrchemicalsTransport Consumer Disc. Insurance co's Construction Training & Education Metals & MiningConsumer staples Training & Education Pharma Banks IndustrialsTraining & Education Training & Education Training & Education Training & EducationBofA MLcoverage withexposureSTC Savola Al Hammadi Dar al Arkan STC SABICZAIN KSA Almarai Dallah Zain KSA MaadenSavola Al Othaim YansabAlmarai Al Hokair SafcoAl OthaimJarirOther Companies withexposureMobily Sadafco Mouwasat Emaar Economic city Mobily PetrorabighSadafco Halwani Brothers Care Saudi Banks Al Khaleej Training ZamilAl Tayyar Nadec MEAHCO Al Khaleej Training Al Khaleej TrainingDur Hospitality Saudi Marketing SpimacoSaudi Ground Serv . Al Khaleej Training BupaSaudi CateringTawuniyaAl Khaleej TrainingMed GulfSource: BofA Merrill Lynch Global ResearchSaudi market valuation not testingThe Saudi market has been one of the poorest performing emerging markets year-todate,underperforming the MSCI EM indices by approximately 10% (and c20% sinceAugust 2015). A combination of weak oil prices and their inevitable impact on the Saudieconomy including slowing economic growth, rising operational risks and fiscalconsolidation (including subsidy removals) have been the key drivers. Theunderperformance has left the market trading on a 12mth P/E of c.13x, an 11% discountto its long term average and its lowest premium to GEMs since 2010 (Saudi trades on a7% percent premium vs long run average of c. 30%). Furthermore, Saudi trades on12mth FWD P/B ratio of 1.5x, a 20% discount to long run averages, but a 15% premiumto GEMs on 1.3x, justified by the market’s higher ROE’s (Saudi’s long term P/B premiumhas been c.25%). Finally, Saudi trades on 12mth FWD EV/EBITDA multiples of 9x, ac.11% discount to long run averages.42 GEMs Paper #26 | 30 June 2016Chart 45: Saudi 12m fwd. P/E vs. EM22MSCI Saudi 12m Fwd PE191613107EM 12m Fwd PEAverage407 08 09 10 11 12 13 14 15 16Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch GlobalResearchChart 46: Saudi 12m fwd. P/B vs. EM2.7MSCI Saudi 12m Fwd PB2.5EM 12m Fwd PBAverage2.32.11.91.71.51.31.10.909 10 11 12 13 14 15 16Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch GlobalResearchChart 47: Saudi 12m fwd. EV/EBITDA17MSCI Saudi 12m Fwd EV-EBITDA1615141312111098Average706 07 08 09 10 11 12 13 14 15 16Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch GlobalResearchInterestingly, not all sectors within the Saudi market trade at a premium to GEM peers,with both consumer discretionary and consumer staples trading at a material discount.The remaining sectors all trade at a modest premium to their GEM counterparts, withthe industrial and utility sectors trading at a substantial premium on 12mth FWD P/EChart 48: Consumer sectors trade at a discount relative to GEM averages. Industrials and Utilities arerelatively expensive vs. GEM peers, other sectors trade at small premium30.025.020.015.010.05.00.0FinancialsConsumer Dscrt.MaterialsConsumer StplsTelcoIndustrialsHealth CareUtilitiesSaudi Arabia 12m fwd P/EGEM 12m fwd P/ESource: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global ResearchWeaker economic outlook largely priced in as ERR shows inflectionA further consequence of the weakening economic outlook for Saudi Arabia has beenthe collapse in market expectations, with earnings estimates having posted their longestsustained period of downgrades on record. We note however, the Saudi EarningsRevision Ratio (ERR) has reached an inflection point, with a slowdown in the rate ofearnings downgrades. (ERR is a ratio of number of companies enjoying earningsupgrades vs number of companies suffering downgrades. A ratio above one, therefore,indicates more upgrades than downgrades). Consequently, we believe the relatively untestingvaluations of the Saudi market indicate that a high level of negativity is alreadybeing priced in.GEMs Paper #26 | 30 June 2016 43Chart 49: Saudi ERR’s are showing signs of inflecting despite one of the most protracted periods ofearnings downgrades.21.81.61.41.210.80.60.40.20Jan-11More downgrades than upgradesJan-12Jan-13More upgrades than downgradesJan-14Jan-15Jan-16160140120100806040200ERR (LHS)Brent Crude (US$/bbl- RHS)Source: DataStream, I/B/E/S, Bloomberg, BofA Merrill Lynch Global ResearchOff benchmark and out of mind? Growing confidence could drive reratingWith Saudi Arabia remaining off benchmark (it is not currently part of any major indicessuch as the MSCI EM or FM), GEM funds allocation to Saudi Arabia remains relativelylow at just 0.25% (of total GEMs AUM). Whilst allocation levels are relatively high versushistory, they are still significantly below the levels implied by MSCI EM inclusion (1.4%)or suggesting a level of apathy towards the market.Chart 50: GEM fund allocation in Saudi (asset-weighted)*0.35 % GEM funds, allocation in Saudi MSCI Saudi market cap as % of MSCI EM (rhs) %0.300.250.200.150.100.051614121086420.0006 07 08 09 10 11 12 13 14 15 160Source: EPFR, BofA Merrill Lynch Global Research.*Market cap as % of MSCI EM represents and artificially constructed benchmark weightassuming that this market was a member of MSCI EM indexWith the NTP looking to diversify the Saudi economy away from the oil sector (andreduce its reliance on a higher oil prices), we believe confidence in the longer termeconomic outlook could improve, ultimately driving earnings momentum and a marketrerating. Given our view that crude oil prices will likely post growing momentum in 2017,moving substantially above US$50/bbl, even a partial success of the NTP program wouldlikely be sufficient to improve market confidence.CMA reforms (likely linked to the NTP), a potential catalyst for market reratingFurthermore, reforms being introduced by the Saudi Capital Markets Authority (CMA) toattract greater foreign participation in the Saudi market (see below) indicate Saudi is44 GEMs Paper #26 | 30 June 2016seeking an expedited path to inclusion within the major Stock indices. Given the NTP isseeking heavy involvement/investment from the private sector, we believe the measuresintroduced by the CMA to attract direct capital inflows to the country are likely linkedwith the larger NTP process. Growing confidence in the CMA’s market reforms and thepotential for inclusion in the major indices could prove to be a meaningful basis for themarket to rerate upwards.Taking positive steps to accelerate MSCI inclusionThe Saudi Capital Markets Authority recently announced extensive changes to theQualified Financial Investor (QFI) program, which should ultimately increase the ease offoreign access to the Saudi market. In particular:(1) Individual foreign investors will now be allowed to own up to 10% of the equity in acompany (up from 5%). The total limit on foreign ownership remains at 49%.(2) CMA decreased the minimum AUM of QFIs to US$1bn from US$5bn (although fundswith AUM’s below this level will be considered by the CMA).(3) CMA introduced stock lending & covered short selling;(4) CMA extended the settlement cycle to T+2 from T+0, effectively eliminating prefunding;(5) CMA effectively removed the concept of a QFI client, which would have preventedinvestors from using multiple fund managers to gain exposure to Saudi Arabia. Thishighly restrictive clause was a significant reason why many global institutions did notseek to gain QFI status; and(6) CMA significantly reduced the amount of bureaucracy required to apply for andretain QFI status.MSCI inclusion one step closer as accessibility increasesIn our view, the range of measures the CMA is looking to adopt greatly enhances theaccessibility of the Saudi Stock exchange and as such bring Saudi Arabia one step closerto inclusion in the MSCI EM index. Whilst we continue to see inclusion most likely from2019 (with an announcement in 2018), the new changes indicate that a 2018 inclusion(with an announcement in 2017) is by no means out of the question. Indeed, whilst thetiming of introduction of these new measures is likely to be 1H2017, a recent release ofthe draft proposals from the CMA suggested it could come as soon as 3Q16; althoughwe await further clarification.A higher weighting in international indicesSaudi Arabia is currently under consideration for inclusion in the MSCI EM index,potentially as soon as May/June 2018; although we believe 2019 is more likely. SaudiArabia is currently not included in any of the Major global indices and as such itsinclusion would have a profound effect on the market as it:(1) leads to significant inflows of capital in to the market from both active and passivefunds following the MSCI EM index and;(2) significantly increases interest in the Saudi market as it gains profile and is no longerseen as off benchmark.We see these factors as compatible with the NTP aim to boost capital markets.Currently Saudi would be 1.4% of MSCI EM = US$10.9bn of inflows.As per MSCI’s guidance, we use MSCI’s standalone Saudi market index as a template(released May 12th 2015) for Saudi stocks to be included in the MSCI EM index. TheMSCI Saudi index currently contains 19 stocks (all listed entities on the Tadawul market)which are likely for inclusion in the MSCI EM index (were Saudi to be included). Bytaking the total market cap of these companies and multiplying them by the foreignGEMs Paper #26 | 30 June 2016 45inclusion limit articulated by the MSCI (currently 0.2), we are able to decipher therelative weighting of Saudi Arabia if it were to be included the MSCI EM index.This analysis suggests that Saudi’s potential weighting in the MSCI EM Index (were it tobe included today) would be c1.4%. Furthermore, it would likely trigger net inflows (fromother MSCI EM markets) of US$10.9bn when including all passive and benchmarkneutralactive funds tracking MSCI EM. Importantly, our analysis is based on EPFR data,which respectively indicates US$405bn and US$354bn of active and passive fundsfollowing the MSCI EM index.Table 14: Provisional MSCI Saudi Arabia constituents stand to gain as much as $10.9bn of total passive and benchmark-neutral active funds on inclusionPotentialpassive Potentialbuying passive days(US$m) buyingTotal US$mactive +passive daysbuyingTotal daysactive +passive daysbuyingProvisional ProvisionalPotential Potentialweight in MSCI weight in MSCI ADTV active buying active daysSaudiEM (US$m) (US$m) buyingAL RAJHI BANK 9.5% 0.1% 37.2 546.5 14.7 477.7 12.8 1,024 27.5ALINMA BANK 2.0% 0.0% 223.0 116.9 0.5 102.2 0.5 219 1.0ALMARAI 4.4% 0.1% 7.7 255.8 33.1 223.6 28.9 479 62.0ARAB NATIONAL BANK 2.0% 0.0% 1.4 113.6 81.7 99.3 71.4 213 153.2BANQUE SAUDI FRANSI 2.8% 0.0% 1.3 163.1 122.7 142.6 107.2 306 229.9ETIHAD ETISALAT CO. 2.2% 0.0% 11.9 126.1 10.6 110.2 9.2 236 19.8RABIGH REFN.& PETROCH. 1.0% 0.0% 9.2 59.1 6.5 51.7 5.6 111 12.1RIYAD BANK 3.4% 0.0% 2.0 195.6 100.3 170.9 87.7 367 188.0SAMBA FINANCIAL GROUP 4.0% 0.1% 5.0 232.9 47.0 203.5 41.1 436 88.2SAUDI ARABIA FRTZ. 2.6% 0.0% 4.4 148.2 33.5 129.5 29.2 278 62.7SAUDI ARABIAN MINING 4.5% 0.1% 17.2 260.8 15.1 228.0 13.2 489 28.3SAUDI BASIC INDUSTRIES 25.3% 0.4% 170.9 1459.4 8.5 1275.6 7.5 2,735 16.0SAUDI ELECTRICITY 8.4% 0.1% 6.3 485.3 77.3 424.2 67.6 910 144.8SAUDI TELECOM 13.4% 0.2% 9.5 774.7 82.0 677.1 71.7 1,452 153.6SAVOLA GROUP 2.0% 0.0% 6.9 114.4 16.6 100.0 14.5 214 31.2YANBU NAT.PETROCH. 2.3% 0.0% 6.7 134.5 20.2 117.6 17.7 252 37.9FAWAZ ABDULAZIZ ALHOKAIR 1.0% 0.0% 5.7 55.5 9.7 48.5 8.5 104 18.1ALTAYYAR 0.8% 0.0% 33.5 44.4 1.3 38.8 1.2 83 2.5NATIONAL COMMERCIAL BANK 8.2% 0.1% 6.8 474.8 70.1 415.0 61.3 890 131.4TOTAL 5,762 5,036 10,798Source: BofA Merrill Lynch Global Research, MSCI and DataStreamChart 51: If included today, Saudi Arabia would be the thirteenth largest constituent of the MSCI EM,accounting for 1.4% of the index.CHINAKOREATAIWANINDIASOUTH AFRICABRAZILMEXICORUSSIAMALAYSIA (EM)INDONESIATHAILANDPHILIPPINESSAUDITURKEYCHILEPOLANDQATARUAECOLOMBIAPERUGREECEHUNGARYEGYPTCZECH REPUBLICSource: : BofA Merrill Lynch Global Research, MSCI and DataStream46 GEMs Paper #26 | 30 June 2016Privatisations & ownership limits could increase weightingHowever, our analysis of Saudi Arabia’s weighting could be significantly understated fortwo reasons, including: (1) our analysis currently uses a foreign ownership limit (FOL) of0.2 (as previously guided by the MSCI). This could be understating Saudi’s weightinggiven the increase in foreign ownership introduced in the CMA’s announcement. Indeed,if we increased our FOL factor to 0.4, Saudi would be 2.8% of the MSCI and couldattract US$21.3.bn of inflows; and, (2) Saudi Arabia (according to local press and theNTP) is seeking a number of privatisations in the coming 24 months, including apotential IPO of Aramco. Inclusions of these companies would likely increase Saudi’sweighting in the MSCI EM index and thus attract higher inflows to the market.Inclusion of energy assets could see Saudi accounting for 4.1% of MSCI EMBy way of example, we believe inclusion of Saudi Aramco in the Saudi market wouldprofoundly affect the weighting of Saudi Arabia in the MSCI EM in our view. Indeed, ifwe were to replicate the analysis above using the Deputy Crown Prince hypotheticalvaluation of US$2tn for Saudi Aramco and a 5% inclusion factor (given 5% or less ofSaudi Aramco would be listed according to interviews with the Deputy Crown Prince),Saudi Arabia would account for 4.1% of the MSCI EM index and likely attract cUS$31bnof inflows from passive and active funds. We note, our calculations are highly sensitiveto the inclusion factor that MSCI would ultimately use (we assume 5%, in line with itsestimated free float of 5%). An inclusion factor of 10% for example, would see SaudiArabia accounting for 6.6% of the MSCI EM index.Chart 52: If energy assets were included, Saudi Arabia would be the seventh largest constituent ofthe MSCI EM, accounting for 4.1% of the indexCHINAKOREATAIWANINDIASOUTH AFRICABRAZILSAUDIMEXICORUSSIAMALAYSIA (EM)INDONESIATHAILANDPHILIPPINESTURKEYCHILEPOLANDQATARUAECOLOMBIAPERUGREECEHUNGARYEGYPTCZECH REPUBLICSource: BofA Merrill Lynch Global Research, MSCI and DataStreamGEMs Paper #26 | 30 June 2016 47Telecom: supporting a move to higherconnectivityHootan Yazhari, CFA >>Merrill Lynch (DIFC)hootan.yazhari@baml.comTable 15: Key NTP objectives for the Ministry of Communications and Information Technology123No. Strategic objective Key Performance Indicator (KPI) Unit BaselineProvide critical resources, especially frequencyspectrum for Information telecommunicationsand Technology servicesProvide broadband services to all KSA regionsby stimulating investment in infrastructure anddeveloping tools, technical and regulatoryframeworksDevelop and activate smart governmenttransactions based on a common infrastructure2020targetRegionalb'markInt’lb’markPercentage of frequency spectrum available fortelecommunication services out of the total allocatedtelecommunication services% 42 80 NA >90Percentage of FTTH coverage in denselypopulated urban areas% 44 80 >95 >90Percentage of FTTH coverage in urban areas % 12 55 >90 >80Percentage of wireless broadband networks’ coverage (morethan 10 Mbps) in remote areas% 12 70 NA 74Maturity level of the government services transformation toe-services% 44 85 NA NAKSA’s rank in the United Nations index for the developmentof e-government% 36 25 18 114 Bridge the digital gap in the skills of ICT users Percentage of internet users in KSA % 63.7 85 90.4 87.9Source: National Transformation PlanNTP helps increase penetration of higher margin offeringsWe believe the National Transformation Plan will herald significant change for the Sauditelecom sector over the next five years. In particular, its focus on increasing access tohigh speed internet (via wireless and fibre) should underpin a material uplift in datausage and broadband penetration levels. Given these offerings represent the highestmargin services provided by the telecom service providers, we believe the move towardsa more data intensive society should be supportive for industry margins. Furthermore,with the NTP’s plans relying heavily on private sector investment (including STC), webelieve it could accelerate the spin out of tower portfolios from the three telecomplayers in the Kingdom (as a way of raising financing).Government investment set to exceed US$2bnAs part of the National transformation plan, the government is seeking to invest morethan US$2bn in the expansion of wireless (3G & 4G) and fibre infrastructure (FTTH)across the kingdom. Whilst the finer details on how this expenditure will be deployed(e.g. via grants or via direct investments?) have yet to be disclosed, details of the NTPsuggest it will be used to expand connectivity in the remote areas of Saudi Arabia (giventhe telecom companies have largely avoided such expenditure in the past given lowreturns), as well as increasing network density in developed and urban areas.Spectrum increases an indication of ambitious growthThe government is also looking to significantly enhance the availability of spectrum tothe telecom industry (from 42% to 80% of total spectrum allocated), highlighting theexpected surge in data usage in the Kingdom to 2020 and beyond. Whilst data usage inthe Kingdom has been rapidly growing in recent years on the back of high speed rollouts(3G & LTE), demand still lags global and regional averages (as indicated by data as apercentage of total mobile revenues). Ultimately, we believe this will have a number ofeffects including: (1) Saudi Arabia will further increase its focus on high speed offerings,(LTE/LTEA and eventually 5G); (2) capex cycles will likely lengthen as telecom companiesintensify their rollout of coverage; and, (3) tower density will likely have to increaseacross the key demand centres.48 GEMs Paper #26 | 30 June 2016Chart 53: Data as % of mobile service revenuesGDP/capita US$, 201550,00045,00040,000UAEKuwait UKGermany35,00030,000SaudiSpain25,00020,00015,000Argentina ChileTurkey Brazil10,0005,000Sudan NigeriaIndiaChinaRussiaSouth Africa0Moro0% 10% cco 20% 30% 40% 50%Data as % of service revenuesSource: BofA Merrill Lynch Global Research, Telegeography and company dataChart 54: Household Broadband penetrationGDP/capita US$, 201550,000Kuwait45,000UAE40,00035,00030,000Saudi25,000OmanCzech20,00015,000PolandTurkey10,000 South AfricaHungaryAlgeriaIndonesia Egypt Brazil5,000RomaniaChina RussiaIndiaTunisiaNigeria0Morocco0% Pakistan 20% 40% 60% 80%Broadband household penetrationSource: BofA Merrill Lynch Global Research, Telegeography and company dataPrivate sector participation and investment will be crucial…Whilst the government has earmarked cUS$2bn for the expansion of FTTH and wirelessinfrastructure (with a view to ultimately increasing internet usage), we believe this willlikely be insufficient to meet the needs of the NTP’s ambitious targets (based on costsof rolling out existing wireless and FTTH networks). As such, we believe the privatesector (Zain KSA, Mobily and STC) will be key contributors to the financing of theexpansion plan.…intensifying the case for creation of a Saudi tower companyThe Saudi telecom service providers have invested heavily in rolling out high speedwireless networks and, in the case of Mobily and STC, FTTH networks (not to mentionlicense costs). This has seen the balance sheets of both Mobily and Zain KSA reachingrelatively high gearing levels; thereby limiting their ability to step up capital expenditurefor a sustained period. Consequently, we believe the focus on raising capital (to fund theexpansion programmes) from the spin out of their Tower portfolios will only increase.We see Zain KSA as the key beneficiary of this given they have the most highly gearedbalance sheet amongst Saudi Telco peers.Mobile market share gains for Zain KSA and Mobily increasingly importantWhilst the Saudi government has taken steps to introduce competition in thetelecommunications industry, its moves to open the market have thus fallen short ofthis objective. Specifically, government-owned STC retains more than 60% revenuemarket share in Saudi Arabia, giving it a dominant position in the market, whilst Mobilyand Zain KSA have only managed to achieve c25% and 15% revenue market sharerespectively.This, in our view, has likely been driven by a number of factors including: (1) therelatively high cost of market entry (ie licenses) for both Mobily and Zain KSA, which haslumbered both with high operating costs; (2) high royalty costs, which amount to c16%of revenues generated in Saudi Arabia (with some exceptions, including data), arguablyinhibiting requisite marketing and infrastructure spend. We note both Mobily and ZainKSA remain loss making; and, (3) the relatively high mobile termination rates, whicharguably afford an advantage to STC and prevent Zain or Mobily from competing moreaggressively on price.For the realisation of the NTP, we believe it is important that all private sector playersare realising sufficient rates of return and FCF generation to be able to finance therequisite growth in infrastructure. We note both Mobily and Zain KSA were loss makingin 2015 and are expected to return sub 5% ROE’s in both 2016 and 2017 (according toGEMs Paper #26 | 30 June 2016 49Bloomberg consensus estimates) vs. STC at 17% (consensus). It is thus arguably crucialfor Zain and Mobily to be allowed to increase market share in the mobile arena. We thusbelieve the regulator (CITC) regulator will have to consider further steps to affordmarket share to the second and third entrants including asymmetric competitionmeasures (pricing, MTRs), license extensions or differentiated royalty rates.STC the likely beneficiary of FTTH expansionWhilst we argue that STC could lose further market share in the Mobile market as aresult of regulatory moves, we believe the negative impact will be offset by growingrevenues from FTTH, IPTV and the corporate market. Indeed, we believe STC, given itsmarket leading FTTH network and IPTV offering, will likely benefit most acutely fromthe growth in the number of FTTH customers. Furthermore, with government grantslikely to be provided for FTTH roll out in less economical areas (as part of the NTP), webelieve returns will likely not suffer from the additional capital deployment. Mobily couldalso benefit (given its well-developed FTTH infrastructure), although we expect it to lagSTC who has a first mover advantage and arguably a stronger FTTH/Triple play offering.We note, Zain KSA will unlikely participate in the rollout of the FTTH expansion given itsconstrained balance sheet and strategic focus on the wireless market. That said, thecompany could benefit from the rollout of high speed internet solutions over its wirelessnetwork (ie fixed broadband over its 4G network), particularly in areas where theconstruction of FTTH networks maybe be difficult or uneconomical.Royalty rate increases unlikely, particularly for Zain KSA and MobilyAdmittedly, an increase in royalties could be an easy way of raising much neededrevenues for the government. After all, each 1% increase could raise income by moreapproximately SAR500mn (cUS$130mn). However, we would argue that this is unlikelygiven the lack of sufficient competition in the market and the obstacles to increasedcompetition higher royalty rates would introduce. In the same vein, we also believe ithighly unlikely that the government would seek to introduce a fourth mobile operatorlicense given the lack of sufficient market capacity between the second and thirdoperators.Religious tourism a material opportunity for telecom providersSaudi Arabia’s ambitious growth targets for religious tourism provide a materialopportunity for the telecom providers in our view. More specifically, if the number ofreligious tourists (for Hajj and Umrah) increases by an estimated 10mn per annum by2020, we believe demand for roaming services (voice and data) and sim purchases willincrease significantly. Indeed, on our estimates, we see the 10mn visitors potentiallyproviding a SAR2bn-SAR4bn opportunity, representing a c4-8% uplift in total wirelessrevenues for service providers. We particularly believe Zain KSA will benefit stronglyfrom this given they provide the most competitive Pay as you go packages currently andhave the largest spare capacity on their network.50 GEMs Paper #26 | 30 June 2016Health: Not Tremendously PrescriptiveVision 2030 a start but Needs Transparent ProposalsThe Saudi government’s Vision 2030 document calls for an improvement in healthcarein Saudi Arabia. The private healthcare sector has some role to play; the NationalTransformation Plan (NTP) targets the private sector to be responsible for funding 35%of healthcare spend in 2020, up from 25% today. How it intends to do this is uncertain.We believe the incumbent private hospital operators, including listed companies (AlHammadi, Care, Dallah, MEAHCO and Mouwasat) should be beneficiaries of increasedprivate sector funding, although increased investment would be needed to meet growthin demand longer-term.Improve public facilities, work towards privatisationThe government wants to step back from financing and providing healthcare and adoptan oversight and regulatory role. Firstly the government wants to improve the quality ofcare offered in the public sector, with the eventual aim of working towards privatisationof public assets and healthcare provision. This implies no privatisations short-term.Near-term: Management contracts for public hospitalsIn the near-term the government could seek to improve healthcare provision in thepublic system by using private sector expertise, through, e.g. contracting managementof public facilities to the private sector. Individual such contracts are unlikely totransform company earnings, and the small size of existing Saudi hospital groups limitsthe depth of management available to capture large contracts, in our view.Long-term: insurance coverage up to 31m from 10.5mIn the long-term a widespread adoption of private health insurance is likely to raisevolumes, spurring an increase in private healthcare capacity, either from organicinvestment or participation in privatisations. In Saudi currently, 10.5m/31m people haveinsurance. We assume a more universal scheme would offer lower pricing than thattoday, and listed incumbents would need to make a cultural shift towards addressingthis market. Such a market could attract new competitors, domestic or foreign.Type of insurance system and reimbursement uncertainWe believe reimbursement levels would need to be known before privatisations canoccur so bidders can budget and estimate their return on capital. It is still uncertainwhether the government would seek to introduce insurance through the incumbentprivate operators (Bupa Arabia, Medgulf and Tawuniya) or set up its own insurancecompany e.g. an Abu Dhabi-style Daman. Nor whether it would subsidise premiums orsimply force the private sector to employ more Saudis.Government needs to improve private sector relationsAt present the government has not paid private hospitals for the treatment of publicpatients referred to them for over a year. Until the relationship improves, engaging withthe private sector could be difficult.Healthcare implications of National Transformation PlanThe Saudi government’s Vision 2030 document calls for an improvement in healthcarein Saudi Arabia. The private healthcare sector is likely to be a beneficiary both in theshort-term and long-term. In the short-term the National Transformation Plan (NTP)targets the private sector to be responsible for funding 35% of healthcare spend in2020, up from 25% today. In the longer-term, the Saudi government wants to removeitself from directly providing and financing healthcare, instead focussing on publichealth and the regulation of the healthcare sector. Raising private sector fundingthresholds to 35% appears possible if a number of measures are used, e.g. morerigorous enforcement of requirement that Saudis working in private sector holdinsurance could increase penetration by 6% alone. The quality targets set for the publicsector do not appear unduly onerous in theory, but execution remains key.GEMs Paper #26 | 30 June 2016 51What the Vision 2030 announcement said on healthcareTransfer the responsibility for health care provision to a network of publiccompaniesPromote competition and transparency between public and private companies toenhance the standard and quality of health care servicesPrepare for privatisation in the longer term.Work towards developing private medical insurance to improve access to medicalservices and reduce waiting timesTable 16: National transformation Plan objectives for the Ministry of HealthNo. Strategic objective Key Performance Indicator (KPI) Unit Baseline 2020 target Regionalb’markInt’lb’mark1 Increase private sector share of spending through alternative Percentage of Private sector contribution in total% 25 35 37 60financing methods and service provisionhealthcare spend2 Increase the efficient utilization of available resources Opex for every new inpatient admission SAR 33,000 33,000 39,000 NA3 Improve the efficiency and effectiveness of the healthcaresector through the use of information technology and digitaltransformation4 Increase training and development both locally andinternationallyPercentage of Saudi citizens who have a unifieddigital medical recordNumber of resident Saudi physicians who areenrolled in training programs5 Increase the attractiveness of nursing and medical support staff Number of qualified Saudis in the field of nursingas a preferred career pathand support staff for every 100,000 people6 Improve healthcare provision before hospitalization and in themain hospitals (ER & ICU)Percentage of patients who received emergency orurgent care with medical decision made (admission/transfer/ discharge) in less than 4 hours in keyhospitals% 0 70 NA 100Number 2,200 4,000 NA NAFor every70 150 460 1,106100000% 40 75 Under study 957 Improve integration and continuity in service provision by Number of primary healthcare visits per capita Number 2 4 3.4 7developing the primary care8 Improve the infrastructure, facility management, and safety Number of licensed medical facilities ( affiliated with % 40 100 100 100standards in healthcare facilitiesthe Ministry of Health and private)9 Attain acceptable waiting times across all stages of service % of appointments received in specialized medical % <40 70 Under study 83deliverydisciplines within 4 weeks (average for allspecialties in key hospitals)10 Improve governance in the health system in order to enhance % of Healthcare facilities reporting comprehensive % 10 100 NA 100accountability with regards to quality issues and patient safety performance and quality measures11 Adopt a national plan for emergency response to public healththreats per international standardsWHO emergency preparedness assessment score– average score for Riyadh, Jeddah and EasternScore CalculationIn Progress4-5 Under study UnderstudyProvince12 Identify additional sources of revenues Total revenue generated from private sector for SAR bn 0.3 4 NA NAutilizing government health resources13 Improve public health services with focus on obesity and Increase in percentage of smoking incidence % Calculation Reduce by2% 12.5* 10.5*smokingIn Progress from baselineIncrease in percentage of obesity incidence % Calculation Reduce by1% 19.4* 5*In Progress from baseline14 Improve the quality of life and healthcare service provided topatients outside hospitalsThe percentage of patients who get health careafter critical care and longterm hospitalization within4 weeks% 25 50 NA 6515 Improve quality and safety principles as well as skills of serviceprovidersSource: Saudi National Transformation PlanPercentage of hospitals that meet the US medianfor patient safety cultureSAR23bn budget allocated for the MoH’s NTP programmesThe Ministry of Health (MoH) has been allocated SAR23bn for the transformation planover the next five years, with any contribution from the private sector on top. Over half(56%) of the funds have been allocated to reform of primary healthcare and to theestablishment of electronic medical records. Only 4% of funds (SAR937m) have beenallocated to health insurance.% 10 50 NA 5052 GEMs Paper #26 | 30 June 2016Chart 55: The MoH has been allocated SAR23bn over five years under NTP7%4%5%6%32%20%26%Primary healthcare reformDevelop ER and intensive careBuilding standards of public facilitiesOtherElectronic health recordsPublic healthHealth insurance schemeSource: BofA Merrill Lynch Global Research, NTPGovernment currently payor and providerThe government currently directly funds public hospitals, which provide free healthcarefor citizens. The typical flaw with a unified system is that increased efficiency is notnecessarily sought or rewarded. Employer-provided healthcare insurance is mandatoryfor both Saudis and expats working in the private sector, as well as their dependents.Significant scope for increase in insurance coverage from 10.5m to 31m peopleSaudi currently has a population of 31m, of which 10.5m have health insurance, a 34%penetration rate. Bupa Arabia believes another 2.5m Saudis who work in the privatesector (including dependents) don’t have health insurance but should have. Assuming thegovernment increases enforcement, near-term penetration could increase to 42% of thepopulation even with extra reforms.Strain in relations between government/private sectorThe government has not paid private providers who have treated government patientsfor a year, which is hardly going to encourage the private sector's further involvement,particularly those companies that have seen the biggest increase in their receivables (AlHammadi and Dallah). However, the government can still put considerable pressure tobear on the sector to achieve its aims if it so wishes.Increased Saudisation could be used as a policyThe easiest way for the government to increase private financing of healthcare to 35%from 25% would be to raise Saudisation requirements. Under Saudisation, thegovernment sets a minimum proportion of a company’s staff that must be Saudicitizens, which differs by industry sector. Increased Saudi employment in the privatesector short-term would put the onus of financing healthcare onto employers. However,such a move would likely pressure private sector margins.Increase pressure on employers to trade down on insuranceThe impact of Saudisation as a mechanism would likely be negative for pricing althoughpositive for volumes, assuming the hospital has the capacity to accept more patients.Employers would likely seek to trade down in terms of the insurance schemes they offerin a bid to reduce their involuntarily raised expenditure. Insurers would seek better dealswith hospitals as a result and could seek restricted network arrangements to curtailGEMs Paper #26 | 30 June 2016 53costs. Hospitals would be under pressure to be more flexible on prices to avoid anypressure should lower-cost packages impact their volumes.Vision implies a long processTo us, the government's vision implies a two stage process over a long time-frame:• In the short-term: improve the quality of care offered in the public sector,potentially with the assistance of private healthcare• In the long-term: Only when public facilities have improved, privatise such facilities(although one medical city is to be privatised under a public-private partnership)• Concurrently: Prepare for a roll-out of private health insurance to finance privateprovisionAbu Dhabi and Dubai are probably not parallelsIn Abu Dhabi and Dubai, private healthcare was encouraged to avoid expats relying onpublic facilities. The large expat population in proportion to the locals (85:15) supportedthe creation of private facilities that it was then possible for the governments to fullyfund Emiratis to use. The quality of public facilities was not a cause for concern - manyEmiratis still prefer to use government facilities for more serious problems.Expat population and quality of public system differ in SaudiThe proportion of expats (33% of the population) is not large enough to drive theestablishment of a large, high quality private hospital base sufficient to serve the entireSaudi population. Additionally, the quality of both care and infrastructure in the publicsystem is seen as lacking, suggesting additional investment in facilities is required.Degree to which private sector will benefit is uncertainGiven the lack of detail provided to date, it is hard to assess the benefits, or risks to theincumbent private hospital operators in detail. We see two main ways the private sectorcan participate in healthcare reform:• Win contracts to run and improve public health facilities• Benefit from volume growth any roll-out of private health insurance could spur• Participate in privatisationsIn the long-term, volumes up but pricing down, likely to benefit nonethelessAt present there is limited supply of quality private hospitals and the incumbents are ina strong bargaining position with insurers. Greater private hospital supply, andcompetition, would likely pressure pricing, and margins in the longer-term, albeit offsetby increased volumes. Assuming only basic services are offered to most citizens underany government-driven scheme, there would still be a place for offering higher-qualityaccommodation for example, to higher-income patients.Private sector could win public hospital contractsPrivate operators could be allocated management contracts for public hospitals toimprove efficiency of existing hospitals, train public sector administrators and raiseclinical standards. Presumably reimbursement under such contracts would be based on afixed fee, potentially with performance clauses for improved outcomes or loweringcosts. More substantive contracts, where the private operator is responsible for allaspects of operating the hospital could be more accretive, but bring greater financialrisk.54 GEMs Paper #26 | 30 June 2016Table 17: Examples of management contractsCompany ContractsDallah Dallah has had two types of hospital contracts.One, which just involves management expertise, was worth SAR4.5m over five years and 10% of thehospitals income.The other was worth SAR89m over five years but in this Dallah was responsible for all staffing andsupplies and infrastructure operation and maintenance.Mouwasat Mouwasat managed Najd consulting hospital in Riyadh in return for management fees of c.SAR3m peryear; this was subsequently changed to receiving a share of revenues and net profits.NMCNMC was awarded a contract to manage a government hospital in Umm Al Quwain, UAE. The five yearcontract sees it earn $5m (SAR18m) in fees per year, subject to certain performance criteria being met.During the term of the contract NMC is to train government staff to which it will hand over administrationat expiration.Source: BofA Merrill Lynch Global Research, company reportPrivate groups may lack capacity to undertake such contractsThe private hospital groups in Saudi Arabia are small. Habib Medical Group, Mouwasatand Middle Eastern Healthcare group are the largest, with only 8, 5 and 4 hospitalsrespectively. We would question whether any company has the depth of management toundertake management of a large number of government hospitals. Potentially thegovernment could seek to import foreign expertise.Insurance roll-out likely to boost private volumesLonger-term, the roll-out of private insurance would likely have a positive impact onvolumes available for incumbent operators to capture. This will depend though on theavailable capacity of private operators at that time and level at which reimbursement isset. The current listed operators typically target high income patients and a lot of thegrowth in volumes would likely be in the low-to-middle income spectrum.Cultural shift would be needed to target larger population at lower price pointIt would require a clear cultural shift for the incumbent listed hospital operators toswitch from offering a high quality service to high income individuals to operatingfacilities that served the wider population at what we presume would be a much lowerprice point.Investment is difficult until pricing and reimbursement is clarifiedUntil reimbursement levels are clarified, existing private operators/investors will not beable to make decisions on investing in private healthcare facilities.Privatisations seem unlikely in the near-termGiven the stated intention to improve the quality of hospitals prior to privatisations, itseems unlikely there will be any near-term, although the NTP does call for privatisationof one of the medical cities in a public-private partnership. Saudi operates a number ofmedical cities, which are typically collections of hospitals that act as tertiary referralcentres. The largest of these is the King Fahad medical city in Riyadh, with 1,095 beds.It is uncertain which city is planned for privatisation. As with further investment byprivate operators in new facilities, the level of reimbursement would need to be clarifiedso potential bidders can estimate their return on investment from participating.270 public hospitals in Saudi currentlyLatest available data (2014) from the Saudi Ministry of Health discloses 270 publichospitals with 40,300 beds. Of these, 47 hospitals are in Riyadh, with 25% of thepopulation, and 13 hospitals are in Jeddah, which holds 14% of the population.Presumably these assets would be the most valuable during a privatisation process, notonly because of the population sizes, but also because the provision of beds hasn’t keptup with population growth, ensuring high demand. Both areas also host the highestnumber of private hospitals in the country.GEMs Paper #26 | 30 June 2016 55Table 18: Public and private hospital and bed distributionRiyadh Jeddah OtherPopulation 7,717,467 4,224,568 18,828,340PublicHospitals 47 13 210Beds 7,937 2,993 29,370Beds/hospital 169 230 140PrivateHospitals 34 33 74Beds 4,554 3,109 8,001Beds/hospital 134 94 108TotalHospitals 81 46 284Beds 12,491 6,102 37,371Beds/hospital 154 133 132Source: BofA Merrill Lynch Global Research, Ministry of HealthChart 56: Public and private hospital and bed distribution100%80%60%40%20%0%Riyadh Jeddah Other% population % public hospitals % public beds% private hospitals % private beds % hospitals% bedsSource: BofA Merrill Lynch Global Research, Ministry of HealthHospital quality would be key to attracting private buyersThe government has not invested in hospital infrastructure and some hospitals mayrequire substantial investment by any buyer, if they are acquired at all. One Saudihospital operator has said that there is no way it would seek to acquire governmenthospitals for that reason.Bidders would likely want to obtain scale benefits from multiple purchasesOperating hospitals has benefits of scale in terms of centralising certain non-medicalservices (e.g. purchasing, catering, laundering) and allocating central costs over a greaterrevenue base. The greatest financial benefit would come from acquiring groups ofhospitals to maximise these benefits. There would likely be cases where staff, and/orhigh net worth individuals chose to bid for individual assets.Privatisation proceeds could defray some of NTP costAmounts raised from any privatisation would reflect the degree of competition forindividual assets as well as level of reimbursement and the profits any acquirer couldgenerate. In terms of pure asset values we assume the Riyadh and Jeddah hospitals (60)would be worth more than those elsewhere (210), simply because of the greaterpopulation currently and higher expected future growth. Government hospitals are likelylower cost than that of private facilities given they are not competing on the quality ofaccommodation offered. Arbitrarily assuming US$100m for hospitals in Jeddah andRiyadh and US$50m elsewhere would imply proceeds of $16.5bn (SAR61bn). If everyhospital were sold then it could more than cover the SAR23bn allocated to the MoH forthe NTP. That seems unlikely however; there will be hospitals that require substantialinvestment and aren’t worth the indicative figures we have used above, or are in areaswhere profitability means there will be no return for the private sector at that level ofacquisition.Reforms could attract additional competitionIncumbent private hospital operators are best placed to expand and are seen as thenatural buyers of any privatised assets. However, any substantial privatisation process,or the potential created by widespread adoption of private health insurance in general,could attract interest from foreign investors or operators. We note only a small numberof international hospital groups to date have experience of successfully operating inmultiple countries (IHH, Mediclinic), and we think Saudi Arabia could be too challengingas a first step for those yet to operate outside their domestic market.Structure of insurance market needs to be setThere are a number of ways the government could roll-out private health insurancemore widely:• Set up its own insurance company56 GEMs Paper #26 | 30 June 2016• Work with existing private insurers• Use a back-door approach and just force private employers to hire more SaudisThe government could set up a state insurance companyThe government could set up a single-state insurer that is either funded through directcontributions or through general taxation. The government would likely need to getexternal help from a party knowledgeable in insurance and risk, which could be aninsurer, Saudi or otherwise. Daman, Abu Dhabi's health insurer is owned 80% by itsgovernment and 20% by German insurance company Munich Re.Existing private insurers may not have capacity if they were made responsibleThe government could decide to execute any financing scheme through existing privateinsurers, or give citizens the option of choosing either a government or private insurer.The existing private healthcare insurers in Saudi Arabia are unlikely to have theresources (both people and systems) in place to provide cover for an additional 20mpeople immediately and will need some time to prepare. Any large scale immediateexpansion could put them at risk of substantial underwriting losses that they wouldpresumably seek to have back-stopped by the government in the initial stages.Chart 57: Health insurers by share of claims (1H15)28%25%4%7%16%20%Bupa Arabia Tawuniya Medgulf Malath Axa OtherSource: BofA Merrill Lynch Global Research, CCHIGEMs Paper #26 | 30 June 2016 57Consumer: a necessary painAbdelrali El Jattari >>Merrill Lynch (DIFC)abdelrali.eljattari@baml.comThe Saudi government initiatives taken in the National Transformation Plan (NTP) willtransform the Saudi consumer landscape. We note a mixed effect on the sector:• On the positive side, we anticipate 1) job creation for Saudi nationals in the privatesector with a big focus on Small and Medium Enterprises (SMEs); 2) a strongemphasis on education; 3) an ongoing increase of the participation of women in theworkforce; 4) an increase of the percentage of self-sufficiency in broiler productionwhich should ultimately support local producers; and, 5) a significant pick-up of thereligious tourism during Haj and Umrah.• On the negative side, we anticipate 1) a rationalization of subsidies for water andelectricity; and, 2) a more competitive retail environment, more open tointernational players, attracting foreign direct investment (FDI).Prefer staples over discretionaryWhile slowing consumer credit and weaker private sector consumption growth amid ayoung population do not support Saudi spending in both staple and discretionary items,we expect staple-related stocks such as Al Othaim and Savola to be better positioned tocapture the marginal consumption. This is principally due to their exposure tonecessities (food items) in a very fragmented market. Having said that, we expect morepressure on the opex of all Saudi consumer corporates, while revenue growth outlookwill remain subdued in the short-term given the weaker consumer confidence anddisposable income.A more moderate growth outlook; Saudi female workforce drives private sectorFollowing a 12% 10-year CAGR fuelled by the rise in household income, we concludethat the retail sector will continue to play an important role in the rising participation ofthe Saudi workforce, women in particular (10,000 in 2010 vs 120,000 in 2014 accordingto the Ministry of Labor) supporting their disposable income in the long-term. Overall,the Saudi retail sector is one of the largest employers in Saudi Arabia with 1.5mnworkers (17% of the Saudi workforce) of which low-cost foreign workers represent 80%.This implies that Saudis working in the retail account for 300,000 (40% are female),doubling in 4 years.Needed reforms: better macro at the expense of microWhile we acknowledge that the targets set by the government are paving the way forthe right reforms (development of the private sectors, a more competitive economiclandscape, attraction of FDI), we expect the Saudi retail outlook to be marked by aslower growth in the coming years. In particular, we highlight few major challenges forthe effective implementation of the plan: 1) incentives to enrol Saudis into consumerrelatedjobs suggesting rising opex pressure for consumer stocks; and, 2) 20% publicpayroll cut will put pressure on Saudi disposable income in the short-term given thanc80% of the Saudi workforce is in the public sector.Key strategic objectives and Key Performance Indicators (KPIs) to watchThe National Transformation Plan (NTP) outlays several strategic objectives and relatedKPIs to watch by ministry which we believe will impact the Saudi consumer universe:• The Ministry of Economy and Planning is looking to 1) expand privatization ofgovernmental services; 2) increase the efficiency of government subsidy programs;3) establish specific zones with competitive advantages to enhance investments;58 GEMs Paper #26 | 30 June 2016and, 4) develop tourism and entertainment sector. To do so, the ministry mainlytargets to decrease the subsidy for water and electricity by SAR200bn by 2020 andto expand the private sector contribution to GDP from 40.5%.• The Ministry of Commerce and Investment is looking to 1) reinforce the protectionof the Saudi consumers; and, 2) develop SMEs by incentivizing the culture ofentrepreneurship and supporting productive families. The ministry targets by 2020to 1) more than double the number of established entities from 50k to 104k; and, 2)increase the contribution of SME to non-oil GDP from 33% to 35%.• The Ministry of Environment, Water and Agriculture is looking to 1) optimize theuse of renewable water resources for agricultural purposes; and, 2) support nationalcompanies. The ministry targets by 2020 1) to consume more than twice less waterin the agricultural sector, which should be reflected in a lower percentage of waterused in the agricultural sector relative to the total available renewable waterresources (191% vs 416% today); and, 2) to reinforce the Saudi independence tothe broiler production by increasing the percentage of self-sufficiency in broilerproduction to 60% from 42%.• The Ministry of Haj and Umrah is looking to provide the opportunity for the largestnumber of Muslims possible to perform Haj and Umrah. The Ministry targets by2020 the number of Haj pilgrims to increase from 1.5mn to 2.5mn and the numberof Umrah Pilgrims from abroad to increase from 6mn to 15mn.• The Ministry of Labor and Social Development is looking to 1) improve educationand enable more Saudi nationals to enter the job market; and, 2) to increase theparticipation of women in the workforce. The ministry targets by 2020 to 1) create1.2mn jobs in the private sector (men and women); 2) reduce the unemploymentrate to 9% from 11.6%; 3) reduce the cost of employment of Saudis compared toexpatriates to 280% from 400% today, which implies a higher cost of expatriates;and, 3) to increase the proportion of female force to 28% vs 23% today.Table 19: National Transformation Plan objectives and Key Performance Indicators (KPIs) affecting the consumer sectorStrategic objective Key Performance Indicators (KPIs) Unit Baseline 2020 target Regional b'mark Int'l b'markMinistry of Economy & PlanningIncrease efficiency of government subsidy programs Value of water and electricity subsidy decrease SARbn 0 200 N/A N/AExpand privatization of governmental services Private sector contribution to GDP % 40.5 N/A 20/27 36.4Ministry of Commerce and InvestmentBoost entrepreneurship Number of established entities (LLC) # 50000 104000 N/A 347015Boost SMEs Contribution of SME to non-oil GDP % 33 35 60 N/AMinistry of Environment, Water and AgricultureOptimize the use of renewable water resources foragricultural purposesWater used in the agricultural sector relative to totalrenewable water resources % 416 191 42.76 19.1Maintain security of vital resources of the country % of self-sufficiency in broiler production % 42 60 80 140Ministry of Haj and UmrahAccommodate larger number of Muslims to perform Haj Number of formal pilgrims (domestic and foreign) mn 1.5 2.5 N/A N/AAccommodate more Muslims to perform Umrah Number of Umrah Pilgrims from abroad mn 6 15 N/A N/AMinistry of Labor and Social DevelopmentProvide suitable jobs for citizens Number of suitable private sector job opportunities for Saudis 000 0 1200 N/A N/AProvide suitable jobs for citizens Saudi unemployment rate % 11.6 9 N/A 5.8Provide suitable jobs Cost of employment of Saudis vs expatriates % 400 280 N/A N/AEmpower women Proportion of female labor force % 23 28 N/A N/ASource: Saudi National Transformation PlanGEMs Paper #26 | 30 June 2016 59Rationalization of subsidies for water and electricityThe sweeping energy, water and electricity administered price changes introduced inDecember 2015 are a first step in the five-year fiscal consolidation and economictransformation strategy. We expect further reviews of energy, water, and electricityprices over the medium-term. Furthermore, the likely government review of currentlevels of fees and fines, introduction of new fees, application of a VAT and introductionof excise taxes on tobacco and soft drinks will also impact the Saudi consumer.Subsidy cuts on energy and utilities to add up to 1.5ppt to CPI inflation onlyWe estimate the December natural gas price hike on petrochemical firms, domesticcrude oil price hike as well as the combined gasoline and diesel price hike introducedcould add US$2.2bn, US$2.0bn and US$3.8bn to central government revenues if fullypassed to the budget (a combined 1.2% of GDP). We estimate the direct impact of thesehigher gasoline, water and electricity prices to add 1.3-1.5ppt to CPI inflation due totheir low basket weights (c.1.5%, c0.4% and 1.6% respectively). We think a 5% VAT taxcould add c2% of 2015 GDP in fiscal revenues over the medium-term.Chart 58: Consumer Price Index (CPI) basket– consumer expenditure breakdownFood and non-alcoholic beverages0.47%Tobacco6.83%2.69%3.50%5.75%21.70%Clothing and footwearHousing, water, electricity, gas, and otherfuelsFurnishings, household equipment &8.10%8.40%routine household maintenanceHealthTransport10.44%Communication2.56%9.09%20.45%Recreation and cultureEducationRestaurants and hotelsSource: Haver, BofA Merrill Lynch Global ResearchSubsidies account for 15% of Almarai’s net income; 40% are related to poultryAlmarai continues to receive subsidies from the Saudi government, amounting toSAR295mn in 2015. This represents 15% of the Almarai’s 2015 net income. Thegovernment pays subsidies based on price of subsidized feed importer, which means itmay increase or decrease naturally. Regarding the breakdown by business (poultry,dairy), it is unfixed, depending on the price of feed and ingredients. As of 2015,subsidies for poultry accounted for 40% and dairy for 60%.60 GEMs Paper #26 | 30 June 2016Saudi Arabia approves 100% foreign ownership rules• Saudi Arabia’s cabinet has approved rules governing foreign ownership of retail andwholesale businesses in the Kingdom. The regulations, which were first discussedlast year, allow foreign investors to own 100% of retail and wholesale businesses inthe country. Earlier, the ownership ceiling for foreigners was set at 75%. Thisinitiative is aimed at attracting more regional and international brands to SaudiArabia, creating more jobs, and boosting non-oil revenue. This has raised concernsregarding the sustainability of the business model of Saudi retailers.• Real estate is key to entering a market: unlike its peers, Al Hokair enjoys favourableaccess to prime locations in well-located shopping malls owned by its parentshareholder, Al Hokair Group. Fashion retailers such as Inditex continue to competefor good-quality real estate in shopping centres and on high streets.• Jarir and Extra are more vulnerable to the entry of international retailers such asApple as barriers of entry are very low for consumer electronics and appliances.Furthermore, the government emphasis on developing tourism and familyentertainments (Six Flags, Sea World) represents a potential threat to Jarir andExtra’s business models which still play an ‘entertaining’ role in Saudi Arabia.• Such initiatives would result in (1) reducing the number of stores; (2) a rapidmodernization of the sector; and, (3) a significant increase in labor productivity byadopting merchandising best practices.Rationale for liberalizationThe rationale for permitting FDI in retail trading is (1) attracting investments inproduction and marketing; (2) improving the availability of such goods for the consumer;(3) encouraging increased sourcing of goods from Saudi Arabia; and, (4) enhancingcompetitiveness of Saudi enterprises through access to global designs, technologies andmanagement practices.Typically, global retailers follow a 100%-ownership business model, which explains theirreluctance to establish their presence in Saudi Arabia because of the restrictive policyenvironment. This has been reflected in the little amount of FDI received in the Saudiretail sector.However, we do not believe that such decision will provide foreign investors more abilityto have control of a company as the current ownership ceiling of 75% already allowsthem to pass both ordinary and special resolutions.Key opportunities of 100% foreign ownership initiative:We perceive several opportunities emerging from such an initiative:1) Capital infusion: FDI is one of the major sources of investments for adeveloping country like Saudi Arabia wherein it expects investments frommultinational companies to improve economic activity, create jobs, share theirexpertise, back-end infrastructure and research and development in the hostcountry.2) Boost competition and dampen inflation: the entry of the many multinationalcorporations will promise intense competition between the differentcompanies offering their brands in a particular product market. This will resultin availability of many varieties, reduced prices, and convenient distribution ofthe marketing offers.3) Improvement of supply chain: Improvement of supply chain/distributionefficiencies, coupled with capacity building and introduction of moderntechnology will help arrest wastages, particularly in the food supply chain.GEMs Paper #26 | 30 June 2016 614) Jobs creation: the entry of foreign companies into retailing in Saudi Arabia willnot only create job opportunities but will also ensure quality in them, improvingstandards of living and life styles.Al Hokair: Eased restrictions on foreign investors: perception vs realityThe liberalization of the Saudi retail industry raised concerns among Al Hokair investorsregarding the potential loss of the Inditex franchise, which we estimate accounts for 8%of its total stores. We think this risk is overstated for the following reasons:• Relationship with parent: Unlike its peers, Al Hokair enjoys favourable access toprime locations in well-located shopping malls owned by its parent shareholder, AlHokair Group. The group owns and operates 13 shopping malls across Saudi Arabia(1.2m sqm of prime real estate) through its subsidiary Arabian Centres Company.However, we understand that rents are currently negotiated on commercial terms,thereby limiting the risk of a conflict of interest. We do not think the situation willchange.• Real estate is key to entering the market: Fashion retailers continue to competefor good-quality real estate in shopping centres and on high streets. Going forward,there is likely to be significant competition between these companies for new sites,especially in prime shopping centres, as they all require similar locations, typicallyprominent, wide-fronted premises. Zara, in particular, uses its shop windows toadvertise its products.• Local manufacturing and distribution network would add execution risks andcosts to international retailers such as Inditex: While Saudi Arabia has not yetprovided the details and conditions of the potential eased restrictions on foreigninvestors, we understand that the government is looking to attract investments,diversify its economy and improve Saudization. This means foreign retailers couldbe asked to set up local manufacturing and distribution networks within SaudiArabia, which we believe could discourage retailers such as Inditex from enteringthe market directly.More malls, less bargaining power with international retailersThe accelerating pace of mall developments in Saudi Arabia by regional competitors toAl Hokair’s parent company suggests a rising risk of diminishing bargaining power for AlHokair with its international brand partners such as Inditex. We expect Shumoul Holding55% owned by Mabanee, the Kuwaiti mall operator, to develop a 400k sqm mall inRiyadh while Dubai-based Majid Al Futtaim recently announced that it is looking todevelop two malls in Riyadh of 300k and 100k sqm of GLA respectively resulting in fourtimes more stores (300) in the next five years. Such new entrants can thenaccommodate foreign retailers (such as Inditex), which could question the sustainabilityof Al Hokair’s franchise model.Jarir: exposed to NTP innovationsWhat if Apple enters Saudi ArabiaShould Apple enter Saudi Arabia, it would negatively impact the Apple resellers such asJarir as the majority of the sales would be transferred to the Apple-branded stores. Assuch, we highlight 2 key risks to Jarir that would ultimately deteriorate earnings outlook:(1) rising competition from Apple resulting in a weaker footfall trend due to weakerelectronic sales, which are key for store traffic; and, (2) intensifying competition fromorganised retail space (malls), reducing the market share of specialist retailers such asJarir.Jarir’s earnings sensitive to electronics businessWith c40% of revenues and c20% of gross profit derived from the electronics segment,Jarir remains vulnerable to the threat of foreign retailers entering directly Saudi Arabia.62 GEMs Paper #26 | 30 June 2016We estimate that a 20% decline in electronic sales would result in a 5% direct decline ingross profit. However, this ignores the other negative effects of other productcategories due to a weaker footfall trend.More entertainment in KSA, less attraction for Jarir’s storesIn line with the guidance of the NTP, we expect Saudi Arabia to develop theentertainment sector (theme parks, cinemas). This signals the emergence of newaspirations and social changes for Saudis. While these developments will supportimplementation of Saudi Vision 2030, they will pose threats to the existing businessmodels of Saudi retailers such as Jarir and Extra that are currently substituting for thelack of entertainment opportunities in the country.GEMs Paper #26 | 30 June 2016 63Real estate: NTP positive but not enoughThe Saudi residential sector is suffering an acute housing shortage which we estimateat c1.2mn homes. Key reasons are:• 1) Land is expensive: land constitutes as much as 50% of the cost of a housingunit which is more than double the typical 20-25% in more affordable areasglobally.• 2) Affordability issue: banks are reluctant to provide mortgages to workers fromthe private sector.• 3) Limited financing: the Real Estate Development Fund (REDF) which used toprovide interest-free loans to eligible Saudis for home purchase or construction, hasbeen unable to cope with the demand for new loans and has a backlog of about450,000 applicants. The housing ministry is looking to issue Islamic bonds to helpfund the country’s REDF at the end of 2017.• 4) Overrun development costs: Long delays for construction approval and permitstranslate to overrun costs which create obstacles for developers to launcheconomically feasible projects.A persisting shortage of affordable residential supplyThe shortage of housing is not a new phenomenon – it has been ongoing for decades.The demand outlook from end-users is solid. Domestic household formation (marriages)is a large component: newly married Saudi couples need an affordable place to live. Withmarket demand growing by 105K units pa (BofAMLe), we believe the shortage of supplywill persist for the following reasons:• The limited scalability of residential projects – Dar Al Arkan is the largestresidential developer with only a 1% potential market share (delivery capability of1,100 units pa).• The capital-intensive Saudi financing model – without funding support from thegovernment and a virtually non-existent off-plan sales market, Saudi developershave to secure funding to undertake larger residential projects. Dar Al Arkan ishaving to lever up, as land sales, which were once the primary source of funding,are no longer enough to enable it to scale up.• A lack of incentives for large regional developers to enter the market – thedearth of off-plan sales has dried up the cash flows of developers and limited theirability to finance new projects and, in the worst cases, ongoing projects.Furthermore, the profitability of affordable housing projects is not compellingenough to attract developers to the Kingdom.Fragmented Saudi residential marketSome 75% of new housing supply is from individuals and micro-home builders. Thistrend highlights Saudis’ preference for building their own homes and illustrates theimmature profile of the real estate market in Saudi Arabia. Sovereign actions inneighbouring countries, like the UAE, have boosted the sector (land granted todevelopers, capital flows from international investors). We see big developers becomingmore active in the Kingdom but the effects on supply will not be immediate, in our view.So far, they represent only 15% of the total market.Key strategic objectives and KPIs to watch• The Ministry of Housing is looking to: 1) improve performance of the real estatesector and increase its contribution to the GDP; and, 2) enable citizens to obtain asuitable residence. The ministry targets by 2020 to: 1) double the real estate sector64 GEMs Paper #26 | 30 June 2016contribution to GDP from 5% to 10%; 2) reduce the average time required toapprove and license new residential real estate; 3) reduce the housing unit costfrom 10x to 5x of the gross individual annual income; and, 4) increase the realestate financing to non-oil GDP ratio from 8% to 15%.• The Saudi Commission for Tourism and National Heritage is looking to increase anddevelop hospitality facilities and tourism services. The ministry targets by 2020 toincrease the number of hotel rooms/apartments by 39% to 621.6k.Positive government ambitions but…The rise of real estate finance to non-oil GDP from 8% to 15% implies an incrementalfunding of US$32bn which could finance c212k additional units by 2020 or c53kadditional units p.a. This compares to an estimated annual demand of 181k units whichcome on the top of the existing c1.2mn shortage of housing.…needs to be combined with land tax and sukuk issuance initiativesBased on the target Key Performance Indicators (KPIs) set for the Ministry of Housing,we estimate the initiative to be supportive but not sufficient to cater to the naturalannual demand which is 3.5 times more elevated than the implied additional supplyfunded by the programme. We understand this initiative has to be combined with theland tax initiative and the potential sukuk issuance from the Ministry of Housing whichcould add further liquidity to the REDF to finance more units.Land tax - gradual revenue sourceLand tax among flagship measures adopted by the Saudi governmentWe expand more below on our understanding of the land tax initiative which wasrecently approved by the Cabinet to tackle the housing shortage and raise governmentrevenues. Saudi Arabia’s Cabinet announced in November 2015 that it will gradually levya 2.5% tax on undeveloped land plots owned by persons or private entities in urbanareas, after the country’s Shura council approved a proposal to impose taxes on the socalledwhite lands. The draft law was amended to include gradual taxes in accordancewith a specific timetable to force landlords to sell land, thus increasing land supply.The regulations adopted in mid-June define undeveloped land as all vacant landdedicated to residential use or commercial residential use within the urban boundarylimits. Fees will be applied to in a gradual series of stages; first, to owners ofundeveloped land with areas exceeding 10,000 square metres; second, to single ownersof developed land of more than 10,000 square metres in one master development plan;third, to single owners of developed land of more than 5,000 square metres in onemaster development plan; and, last, to single owners of land of more than 10,000 squaremetres in one city. The Ministry of Housing will determine the land locations where thetax will apply. The extension of the tax in later phases to developed land, fromundeveloped ones at first, will broaden the tax base and minimize tax evasion.Tax proceeds will be deposited in SAMAThe taxes and fines collected by the Ministry of Housing shall be deposited in thecentral bank, the Saudi Arabian Monetary Agency, and will be used to develop thecountry’s infrastructure for new housing projects, according to the state-owned newsagency.Law could be effective this month, but gradual implementation likelyUnder the new system, the housing ministry has been in charge of issuing executiveprocedures and rules for the new legislation within 180 days. The law will be effective180 days after publication in the official gazette. The housing ministry is finalizingnecessary amendments to the decree by end-June 2016 and aim for implementation by17 January 2017 (including a 1-3 year grace period).GEMs Paper #26 | 30 June 2016 65Tax on land: a lever to lower real estate prices in urban areasGiven that the government is giving landlords a grace period in order to either developor sell land to developers, we perceive the newly approved land tax as a lever to lowerreal estate prices. Ultimately, this would improve household affordability, reduce socialtensions and indirectly tackling energy subsidies as it frees up potential householdincome to spend on electricity and gasoline.Land tax could generate up to US$11bn/yr from the major urban citiesWe estimate that the government could potentially collect up to US$11bn per annum oftax related to undeveloped land in the top 5 urban Saudi cities which accommodatemore than 50% of the Saudi population. While the law will not be effective until end-2016, we do not expect the tax proceeds to be significant early on.Table 20: Land tax proceeds estimates for the 5 major urban citiesLand tax could generate up to US$11bn per annum in first phaseCity Selected urban land area (sqm) White land value (SARbn)Annual Land tax proceeds@ 2.5% (SARbn)Riyadh 1,300,000,000 494 12.4Jeddah 1,686,000,000 481 12Mecca 850,000,000 485 12.1Medina 293,000,000 88 2.2Dammam 200,000,000 48 1.2Total 4,329,000,000 1,595 39.9Source: SAMA, BofA Merrill Lynch estimates for white land and proceedsTable 21: NTP objectives and KPIs affecting the real estate sectorStrategic objectiveKPIUnit Baseline 2020 target Regionalb'markInt'lb'markMinistry of HousingEnable citizens to obtain a house Real estate sector contribution to GDP % 5 10 13 20Improve performance of real estate Average time required to license newsectorresidential new projectsDay/ Permit 730 60 44 26Enable citizens to obtain a house Housing unit cost multiples of grossindividual annual incomex 10 5 6.7 3Enabling citizens to obtain suitable Real estate financing to non-oil GDPhousing financing% 8 15 16 75Source: Saudi National Transformation PlanTable 22: NTP government costs related to the consumer and real estate sectorsConsumer SAR (000)Ministry of Economy and Planning 3,293,255Ministry of Commerce and Industry 4,313,050Ministry of Environment, Water and Agriculture 13,942,405Ministry of Haj and Umrah 333,600Ministry of Labor and Social Development 7,931,710Total 29,814,020Real Estate SAR (000)Ministry of Housing 59,166,666Source: Saudi National Transformation Plan66 GEMs Paper #26 | 30 June 2016Metals & Mining: ambitious growth targetFaisal AlAzmeh, CFA >>Merrill Lynch KSA Companyfaisal.alazmeh@baml.comThe NTP has focused on several areas relating to domestic drivers, i.e., housing, retail,trade and finance. However, a core part of the Saudi government’s transformationstrategy is to focus on expanding the Kingdom’s mining potential. Saudi Maaden hashistorically been Saudi’s mining champion, but the mining sector currently contributesonly around 2% to the Kingdom’s GDP. The NTP has set a high target for the sector: itscontribution to GDP growing by 50% to SAR97bn by 2020 and sector employmentincreasing by 40% to 90k. While the first target could be achieved given the amount ofcapital that is currently being deployed in the sector, the latter part is questionable inour view as capital intensive projects are not the best means for employmentgeneration.Government focus on mining to boost jobs and growthThe focus on mining is driven by the ample and growing resources available. TheKingdom’s largest mined products are phosphates, bauxite and gold. It supplies around8% of global DAP production and has the largest integrated aluminium company in theworld. Ma’aden continues to discover new gold and copper sites as well. We believe theoutlook for mining is encouraging and the contribution to GDP targeted by thegovernment could be achieved. We believe investments in this sector faces two hurdles:1. Diversification – the base metal cycle lags that of oil but is eventually driven by thesame global drivers (global growth). Furthermore, the NTP has currently set a lownumber for its capital commitments to the industry (US$82mn), achieving thetargeted diversification and job creation at the moment seems to be highlydependent on attracting private sector capital. This would require attractiveincentives schemes such as energy subsidies, tax exemptions or ease of issuingwork permits for expats. However, at the moment, these have not been addressedby the Saudi authorities.2. High capital intensity – for example, the government has spent close to US$21bnon Saudi Maaden but the company employs only around 6,000 permanent workers,of which Saudis account for nearly a third. While the build-up of this capacity doescreate a multiplier effect of almost 10x during the construction phase, most of theadded jobs are usually low income blue-collar jobs that tend not to attract Saudis.Domestic services sectors create more jobs than mining for dollars spentWe argue that capital spent on domestic services sectors is likely to yield moreemployment for dollars spent. A key example is Saptco, the Saudi Public transportCompany, which has spent around US$450mn on assets and currently employs aroundthe same number of permanent employees as Maaden, of which 1,200 are Saudis. Weacknowledge that the technology and technical transfer will be different in aninvestment like Maaden versus Saptco, yet we believe the economic efficiency of usingthe mining sector as a means of generating employment is questionable.NTP is already happening: Saudi Aramco has project to create 2,000 jobsThe plan to develop the mining industry is moving forward. Saudi Aramco has alreadyannounced its plans to build a downstream industrial complex along with GE andCividale SpA. The complex will include the first-of-its-kind high-end forging & castingmanufacturing facility and will serve the region’s maritime and energy industries. Theproject will cost around US$400mn and likely generate around 2,000 jobs.GEMs Paper #26 | 30 June 2016 67Exports will largely depend on market conditionsPart of the NTP relies on growing Saudi exports, including that of the mining industry.While it is easy build a plant, the timing of when there projects come online and how itcoincides with the cycle matters. The ability to dump will largely depend on the positionon the cost curve, which seems to be fading with the recent reduction of subsidies.The conglomerate model to continueSaudi Arabia has historically adapted the conglomerate model to build up its industrialsectors, such as petrochemicals (SABIC), metals & mining (Maaden) and steel (Hadeed).We believe the government continues to focus on this model in its NTP plan and will usea number of vehicles to expand the sectors in question: Maaden in metals & mining andthe new military company in defence.Maaden has transformed from a pure gold producer to one of the largest conglomeratesin Saudi Arabia at the moment. Through three key Joint-Ventures (JVs), the company is atop producer of DAP (Diammonium Phosphate) and gold and aluminium. The NTP clearlysets the stage for Maaden to grow even further but is unclear on how this is to beachieved and what it would mean for shareholders. Also, in our view, the all-in-onemodel has delivered subpar returns globally and the trend is towards the streamlining ofoperations and specialised vehicles. As an example, the largest petrochemical andagrichem companies, Dow and Dupont, plan to merge and then split into three differentbusinesses, providing more specialisation. We can see the advantages of the specialisedentity model as it provides cost synergies, efficiency and a clear strategy for thecompany. Also, in the conglomerate model, certain parts of the company are oftendwarfed as other revenues streams represent a larger contribution to returns. Board andmanagement could be more or solely focused on the sub-segment had if it is a standaloneentity they have to monitor and manage, in our view.Table 23: National Transformation Plan objectives in the mining sectorBaseline Target 2020 Regional benchmark Global benchmarkOverall kingdom:Number of jobs created 65k 90k 75k 210kContribution to GDP SAR64bn SAR97bn SAR13bn SAR262bnNumber of localized technologies Under study 125 NA NALess developed regions in Saudi:Number of jobs created 0 12k NA NAExpected contribution from private sector 0 SAR28bn NA NAmemo:Initiative cost to the government: SAR310mn (US$83mn)Source: Saudi National Transformation Plan68 GEMs Paper #26 | 30 June 2016Oil & gas/petchems: focus on downstreamFaisal AlAzmeh, CFA >>Merrill Lynch KSA Companyfaisal.alazmeh@baml.comFocus on downstream expansion is a priorityAn increased focus on downstream expansion is a strategic development priority inSaudi Arabia, with the aim of exploiting competitive advantages on feedstock costs andthe strategic location. Furthermore, the government sees it as a mechanism to createjob opportunities for nationals. We see the NTP natural gas target as optimistic as itfaces many hurdles, while imports could be a better alternative which authorities nowsuggest they could be open to eventually.Downstream chemicals represents the second largest focus of the NTPThe NTP is firmly focused on the integration of chemicals/refining/mining capacity intovalue-add downstream operations that would limit imports of certain products andprovide technology transfer into the Kingdom. This accompanies the government’s plansto expand its natural gas and refining capacity by 48% and 13%, respectively.The NTP includes a sizeable allocation to the Royal Commission for Jubail and Yanbu,the government body that overlooks, promotes and develops thepetrochemicals/energy-intensive/mining sectors in the Kingdom. The government plansto spend around US$10.9bn on developing various areas including: 1) the oil-to-olefins(OTC) complex in Yanbu; 2) colleges and institutes in Jubal Industrial area; 3) thenecessary infrastructure in the community area of Yanbu Industrial City; and 4) valueaddtransformation industries in Raas AlKhair Industrial City.Table 24: NTP focus for the Royal Commission of Jubail and YanbuKey focus areasUS$mnDevelopment of the OTC project 772Development of colleges and institutes in Jubail Industrial City 731Development of infrastructure in Yanbu 1,003Development of residential areas in Jubail Industrial City 642Development of Multi-Modal Logistics Hub in Yanbu Industrial City 543Development, protection and rehabilitation of public facilities in Jubail Industrial City 954Development of value-added transformation industries in Raas Alkhair Industrial City 805Construction of Housing in Jubail Industrial City 538Development of Mineral industries port in Yanbu Industrial City 556Other infrastructure and projects (38 projects, size between 100mn to 500mn) 4,557Total 11,101Source: Saudi National Transformation PlanSubsidies are likely to be neededA key obstacle to building more refining capacity and a large OTC complex is the highcapital intensity of such projects and the subsidies required to ensure an acceptable rateof return. We see the natural gas target as optimistic with many hurdles; importationcould be a better alternative. We believe the government plans to reduce subsidies inwater and electricity, but maintain them for feedstock prices as intensive natural gasproduction requires cheap gas to thrive. However, a move towards benchmarking to USgas prices is a likely and logical step, in our view. An alternative scenario would to marknatural gas prices in the Kingdom to the LNG netback out of Qatar. This would facilitatean additional US$2.5bn from the sector but would also put several companies at risk ofbecoming loss making (especially companies with a high content of heavy feed in theirinput mix). Should such a scenario take place, we believe implementation would becarried out over phases in order to allow companies to cope with the new pricing order.GEMs Paper #26 | 30 June 2016 69Table 25: Additional costs on petrochemical producers of higher feedstock pricesCurrent scheme(US$50/bbl)US Spot/(US$50/bbl)Government revenues raised(US$bn)Ethane 950 1,411 461Methane 201 457 256Propane 3,918 4,898 980Butane 789 986 197Naphtha 2,348 2,934 587Ammonia 64 132 69Feedstock cost 8,269 10,819 2,550Electricity & water 1,039 2,053 1,014Total 9,309 12,872 3,564Source: IHS Chemical, BofA Merrill Lynch Global Research. US spot refers to natural gas prices of US$2.6/mn BTU. The US$2.5bn feedstockprice rise could directly accrue to the central government through Saudi Aramco, while higher electricity and water charges would not.Moving further down the value chainDownstream operations in Saudi have historically been international Joint-Ventures (JVs)and government-owned entities like SABIC. In July 1993, the government issued a RoyalDecree that merged all the state-owned refineries, distribution activities and marketingoperations under Saudi Aramco.This resulted in a transfer of the government’s stake in three key refineries andinternational refining and petrochemical operations to one state-owned company.Today, Saudi Aramco is one of the largest crude oil refiners in the world and aims tobecome a top-three petrochemical producer through standalone petrochemicalsfacilities like Sadara, downstream integration at its many refineries, and potentialacquisitions. The recent announcement of the US split with Shell was followed bycomments that the breakup was due to different strategies by both companies withAramco increasing its focus on petrochemicals.Petrochemicals - a route to diversificationSaudi Arabia is emerging as one of the largest petrochemicals producers globally. Thecountry initially started with integrated refining leading to petrochemical productionthrough its multiple JVs in Saudi and other regions, and is now building the largestpetrochemical complex globally. One of the goals is to maximise the value of the Saudihydrocarbon chain. Ultimately, this expansion into petrochemicals should further supportthe diversification drive and thus support the stated goals for the Saudi economy.Saudi Arabia (potentially through Saudi Aramco) aims to become a leader not only incommodity chemicals, but also downstream petrochemical conversion. In the cities ofthe Jubail and Rabigh, the Ministry of Energy, Industry and Mineral Resources (alongwith Saudi Aramco) is constructing value-parks next to upstream chemical facilities. Theaim is to provide integration and the infrastructure for SMEs to operate and producevalue-added products in the Kingdom. This diversification into specialty chemicals couldincrease returns from the current US$500/ton level to around US$2000/ton by 2040,according to local press citing senior Aramco officials. Saudi Arabia could also look togrow its international refining footprint to provide further integration opportunities, aswas suggested by the recent split of the Motiva JV (Saudi is more keen to expand itsdownstream operations, whilst Shell is looking to reduce them).Two petrochemical projects are also being built. The first is the Sadara project in Jubail,which is expected to become the world’s largest integrated chemicals complex with3MMt of output. It will use naphtha as feedstock. The second is Petro Rabigh II, which isthe expansion project of the existing Petro Rabigh plant that will process 4MMt (93kb/d)of naphtha feedstock, and is planned to be launched in 2016.NTP includes the long discussed Oil-to-Olefins (OTC)Saudi’s national transformation plan includes the development of a US$770mnindustrial cluster whereby expansion to the Aramco refinery is likely to take place,providing the platform for the long discussed OTC, Oil-to-Olefins, project. Saudi70 GEMs Paper #26 | 30 June 2016authorities have highlighted in several press releases that Aramco and SABIC are lookingat potential oil-to-olefins projects. The Kingdom has a proprietary technology thatenables it to maximise the yield of olefins per ton of oil used. According to SABIC'smanagement, this project has been carried out on a small scale at test sites and it isconducting feasibility studies at a larger-scale facility. Aramco has also highlighted plansin this area. While both companies declined to comment, Bloomberg highlighted thatsources indicate they are assessing the possibility of embarking on a project together.Such a step would be the first of its kind in Saudi Arabia, with Aramco and SABICworking alongside each other on such a large scale.Refining capacity target: almost thereThe NTP aims to increase the refining capacity to 3.3mn bpd per day by 2020 from2.9mn bpd today. Saudi has recently completed and launched two large refining projectswith 400kbpd installed refining capacity each: (1) SATORP in Jubail launched in June2014; and (2) YASREF in Yanbu – first shipment made in January 2015 and inauguratedin January 2016. In addition, it is building a new refinery, Jazan, which should process400kb/d of Arabian heavy and medium crude oil; launch is expected in 2019.Table 26: Saudi Arabia government refining assetsName Location Completion Refining Saudi Aramco's Saudi Aramco's Partnercapacity, kb/d share in capacity, kb/d ownership (%)Wholly-owned domestic refineriesJeddah Jeddah 1967 90 90 100% n/aYanbu Yanbu 1979 240 240 100% n/aRiyadh Riyadh 1981 126 126 100% n/aRas Tanura Ras Tanura 1986 550 550 100% n/aTotal 1,006 1,006Domestic refining JVs:SAMREF Yanbu 1983 400 150 50.0% ExxonMobilSASREF Jubail 1986 305 114 50.0% ShellPetro Rabigh I Rabigh 1990 400 150 37.5% Sumitomo (37.5%, free float 25%)SATORP Jubail 2014 400 250 62.5% Total (37.5%)YASREF Yanbu 2015 400 250 62.5% Sinopec (37.5%)Total 1905 914Total in Saudi Arabia 2,911 1,920International refining JVs:S-Oil South Korea 1991 669 424 63.4% S-OilMotiva USA 2002 1070 535 50.0% ShellShowa Shell Japan 2004 445 67 15.0% ShellFujian China 2007 280 70 25.0% Sinopec, ExxonMobilTotal 2464 1096Total capacity globally 5,375 3,016Source: Saudi Aramco, Energy Policy, BofA Merrill Lynch Global ResearchTable 27: Saudi Arabia petroleum product output in 2014 (mn bpd)Saudi Aramco LPG Naphtha Gasoline Jet Fuel Diesel Fuel oil Asphalt Totalownership (%)Wholly-owned domestic refineriesJeddah 100% 0.9 2.9 4.0 0.0 2.4 9.2 6.4 25.8Yanbu 100% 2.4 3.2 11.5 -0.4 29.3 30.9 0.0 77.0Riyadh 100% 1.8 0.0 10.9 2.7 19.2 0.0 6.5 41.2Ras Tanura 100% 5.0 15.0 43.9 7.8 76.1 32.5 7.2 187.4Subtotal 10.1 21.1 70.3 10.0 127.1 72.6 20.1 331.3Saudi Aramco share in domestic JVsSAMREF 50% -1.1 0.0 25.0 11.1 18.8 14.4 0.0 68.2SASREF 50% 1.3 11.7 2.2 9.4 14.2 13.3 0.0 52.2Petro Rabigh 38% 1.3 7.3 6.9 4.9 11.7 13.4 0.0 45.5SATORP 63% 1.3 3.9 11.1 8.2 31.6 7.5 0.0 63.7Subtotal 2.9 22.9 45.2 33.7 76.3 48.6 0.0 229.5Total 13.0 44.0 115.6 43.7 203.4 121.2 20.1 560.9Source: Saudi Aramco, BofA Merrill Lynch Global ResearchGEMs Paper #26 | 30 June 2016 71Chart 59: Saudi government refining assets (effective stake in k bpd)1,006Chart 60: Saudi refining breakdown per region (effective stake)23%2,46491456%21%Domestic fully ownedShare in domestic JVsDomestic fully ownedShare in domestic JVsShare in JVs overseasShare in JVs overseasSource: Saudi Aramco, BofA Merrill Lynch Global ResearchSource: Saudi Aramco, BofA Merrill Lynch Global ResearchExports are geared towards Asia and Far EastSaudi Arabia exported c.1mbpd of oil products in 2014, mainly to Asia and the Far East(56%), other Middle Eastern countries (19%) and Western Europe (12%).Chart 61: Oil product export volumes split per region in 20141% 1%11%Chart 62: Saudi Arabia oil product slate in 201420.113.0 44.056%19%12%203.4121.2115.643.7North America South America Western EuropeMiddle East Middle Africa Asia and Far EastSource: Ministry of Energy, Industry and Mineral Resources.LPG Naphtha Gasoline Jet FuelDiesel Fuel oil AsphaltSource: Company data, BofA Merrill Lynch Global ResearchAmbitious natural gas expansionThe NTP also focuses on expanding natural gas production. The government aims togrow the existing production by 48%, largely through non-traditional routes. Accordingto the minister of Energy, Industry and Mineral Resources, natural gas accounts for 50%of energy production and the target is to increase this to 70% by 2020 throughexpanding local production or importing if necessary. The government’s priority will beto explore the option of local production, although imports were, for the first time, notexcluded. We consider this as an interesting development as importing LNG into Saudicosts the same as producing it internally through non-traditional routes, in our view. TheSaudi statement acknowledges that Saudi Arabia is willing to be open to the possibilityshould imports provide a more economic means for this purpose.Table 28: National Transformation Plan objectives in the petrochemicals, oil, and refining sectorsBase line Target 2020 Regional benchmark Global benchmarkOil production capacity (mn bbls/day) 12.5 12.5 3.8 11Dry gas production capacity (bn scf per day) 12 17.8 5.7 16Refining capacity 2.9 3.3 1.1 1.9memo:Initiative cost to the government (total SAR491mn or US$131mn):EnergySAR216mnOil & GasSAR200mnGas networkSAR75mnSource: Saudi National Transformation Plan72 GEMs Paper #26 | 30 June 2016Utility sector: sharing the capex burden andachieving cost reflective tariffsAli DhaloomalMLI (UK)ali.dhaloomal@baml.comEight strategic objectives aimed at being self-fundingThe electricity sector is mentioned in eight strategic objectives of the NTP 2020. Thetwo most important measures in our view are the one related to subsidies cuts and theone on the liberalisation of the sector which should free out financial resources to fundthe future capex burden as well as the other targets under the NTP. This is even morerelevant as the NTP doesn’t provide any additional funding for the sector.Unanswered questions as to impact on electricity sectorWhile we think these initiatives should be welcomed as they would reduce the financialburden on Saudi Electricity Company (SEC) from its ambitious capacity expansion plan(SAR240bn / US$64bn to be spent over the 2016-21, mostly in generation), somequestions remain unanswered, especially in regards to SEC’s capital structure andfinancial sustainability on a standalone basis. It remains unclear if the proceeds from thedisposals of the minority stakes in the GenCos will be used to fund future capex plans orto alleviate SEC’s commercial debt (US$16.3bn as of FYE15) and government andgovernment-related debt and payables (c.US$46bn as of FYE16). Also, it remains unclearif on the back of the NTP, SEC would start paying its current payables (fuel sourcedfrom Aramco, electricity sourced from SWCC and fees owed to municipalities) instead ofaccruing these amounts as it does now.1. Saving SAR200bn annually by cutting the water and electricity subsidies: Thecurrent print of the NTP doesn’t give any detail about how this target will be splitbetween water and electricity subsidies, but we note that the plan aims to reach fullcost reflective water tariffs by 2020 (from 30% cost coverage at the moment).Recall that starting from January 1st, electricity prices have been increased by aweighted average of close to 20%, with residential prices (half of the consumption)now ranging SAR 0.05-0.30 / KWh vs SAR 0.05-0.26 previously. The highestincreases are for the commercial sector, the governmental entities and theagricultural sector. SEC’s management recently indicated to us that they expect aneutral impact over the long term from this decision as it mirrors an increase infeedstock price charged by Aramco. However, over the short to medium term, SECcash flows are expected to benefit from the tariff decision given that the companybooks all its fuel costs in payables without disbursing any amount to Aramco.2. Increasing the percentage of power generation through strategic partners to100% from 27% now: We believe that the aim here is to bring industrial orfinancial partners in all SEC’s and Saline Water Conversion Corporation (SWCC)generation units, in line with the electricity sector reform which expected to beimplemented by late 2016 / early 2017. According to SEC’s management, the mostlikely scenario involves SEC’s generation assets to be split into four separateregional GenCos where minority stakes would be sold to major global utilities orsold in the public market.3. Increasing the efficient use of “fuel” in power generation to 40% from 33%now: We think that this objective entails increasing the share of efficient combinedcycle gas turbines (CCGT) plants. Given that SEC currently represents 73% of thecountry’s installed capacity and that 19% of its electricity is generated via efficientcombined cycle gas turbines (CCGT), this means that 71% of the remaining tierparty capacity is “efficient”. We note that another 39% of SEC’s installedgeneration capacity is made of less efficient open cycle gas turbines (OCGT).GEMs Paper #26 | 30 June 2016 734. Increasing the reserve to peak demand to 12% from 10% now: This reservemargin was just at 2.3% back in 2012 and SEC was assigned a target of 10% whichmanagement expects to fulfil. In light of the recent improvements and SEC’sambitious capacity expansion plan (SAR240bn / (US$64bn in capex over the 2016-21), the target looks realistic to us.5. Reducing the outages of more than 5min to 3.0 per year from 6.4 per year nowand the average outage time to 120 minutes from 262 minutes now. This goalwill likely be achieved through the ongoing investments in expanding and improvingSEC’s transmission and distribution network (half of the overall capex incurred in2015 went to these two segments).6. Increasing the access to electricity to 99.5% of the population from 99% now:It is hard to quantify the cost of this objective, but we believe that it entailsincreasing the reach to the remote Eastern and Southern regions of the countrywhere the economics of expanding the transmission network are not relevant.7. Reach 86 GW of installed capacity vs. 69 GW at the end of 2015 (incl. 50 GWat SEC alone): The target is in line with SEC own current ambitious expansion plan(22.8GW to be added over five years to reach 68.3 GW by the end of 2018) andfactors in additional capacity from SWCC and IPPs as well.8. Generate 4% of the electricity from renewables (equiv. to 3.45 GW): we wouldexpect the projects to be primarily based on onshore wind and solar. It is likely thatthese projects will be fully developed by IPPs under long term power purchaseagreements where SEC would be the offtaker and assume the higher cost of theelectricity from these ReIPP. While SEC has currently no renewable generationcapacity at all, it has recently invited expressions of interest for potential leaddevelopers for two 50MW solar photovoltaic projects, which we see as a (modest)step towards the NTP target. Based on the KACARE study on grid impact, SaudiArabia’s electricity network should be able to integrate up to 14GW of renewablescapacity by 2020. Finally, we note that ACWA Power, the largest privately-ownedutility company in Saudi Arabia and one of the main IPP players in the country(along with Engie), has developed a proven expertise in wind and solar projectsinternationally. ACWA is likely to be one of the main players in the upcomingliberalisation plans.Chart 63: SEC’s debt and payables to the gov.& GREs grew at 17.4% CAGR since 2009(US$bn)5040302010Chart 64: Saudi Arabia power generationinstalled capacity split in 2015 (total: 69 GW)10%18%72%Chart 65: Saudi Electricity Company (SEC) fuelmix for electricity generation19%39%1%41%0200420052006200720082009201020112012201320142015Saudi Electricity Company (SEC)Saline Water Conversion Corp. (SWCC)IPPs and othersHeavy & light fuelNatural Gas - CCGTNatural Gas - OCGTOtherMunicipality fee payablesSWCC purchased power payablesSaudi Aramco net payables for fuel costGovernment soft loansLong-term government payablesSource: SEC, BofA Merrill Lynch Global ResearchSource: SEC, BofA Merrill Lynch Global ResearchSource: SEC74 GEMs Paper #26 | 30 June 2016
Defence: Vision 2030 supports defencespendingCeline Fornaro >>MLI (UK)celine.fornaro@baml.comBenjamin Heelan >>MLI (UK)benjamin.heelan@baml.comSaudi Arabia is increasing its regional role as a Security and Defence nation in theMiddle East region. The 2030 Vision includes a higher local content in defenceprocurement which can be achieved through new contract awards and increasedcooperation with large Original Equipment Manufacturers (OEMs). BAE is bestpositioned, in our view: it has been the in the country since 1966 with 5,000 localemployees and Saudi Arabia represents 21% of BAE’s group sales.Saudi Arabia to build out military industrial baseDefence is one of the key industries that Saudi is pinpointing for investment as part ofits future strategy plans, and one where it is well placed to become a global leader, inour view. Saudi Arabia has one of the largest defence budgets globally, and we expectits focus on defence investment to remain broadly intact regardless of the price of oil.Due to regional tensions, defence spending will likely remain high for the foreseeablefuture, in our view. Saudi Vision 2030 and the associated National Transformation Plan(NTP) will likely increase focus on use of defence to achieve their economicdiversification goals. This is likely to take place through capability deployment andemployment in partnership with long term defence partners. Saudi authorities aim toraise the locally-sourced defence procurement from 2% today to 50% in 2030.Much of the countries’ defence spending is for foreign imports. According toconsultancy IHS, 1 out of every 7 dollars spent on defence imports in 2015 was spent bySaudi Arabia, which was predicted by IHS to increase its defence imports by 52%yoy toUS$9.8bn in 2015.In our view, Saudi strategy to increase locally manufactured defence content is justified,given their level of purchasing power with international contractors. However, this couldtrigger a round of new contracts’ awards to set up new terms. The State owned Taqniacompany has been signing some contracts with international companies but thisremains very limited at this stage.Saudi commitment to defence spending positive for European DefenceSaudi Arabia’s Ministry of Finance 2016 defence budget spending remains high atSAR213bn (cUS$57bn) which is 25% of the total budget. In 2015, the budgeted defencespending reached SAR307bn (US$82bn). Despite the large decrease in headline defenceand security expenditure, budgetary figures suggest the allocation for the Ministry ofInterior, Ministry of National Guard, Ministry of Defence, General IntelligenceDirectorate, and Saudi Royal Guard Regiment could be heavily supported from elsewherein the budget, if required. Figures released by the Ministry of Finance suggest thatSAR183.0bn of the state budget for 2016 - c21% of total budgeted spending - will beallocated through a new 'Budget Support Provision' that is to be used "to give moreflexibility to the budget and redirect capital and operational expenditure in line withnational priorities and to fulfil spending requirements". In our view, the commitment todefence spending is positive for companies who have presence in the area, BAE (Buy,600p) & Thales (Buy, €87).BAE Systems ties to Saudi Arabia go as far back as 1966, when the company wascontracted to Lightning and Strikemaster aircraft and equipment in a programme calledthe ‘Magic Carpet’. In 1985, a new government-to-government (UK/Saudi Arabia)agreement was signed covering supply and support of Tornado, Hawk and PC-9 aircraft.A new government-to-government agreement, known as the Saudi British Defence CooperationProgramme, was inaugurated at the start of 2007. Salam Project, whichGEMs Paper #26 | 30 June 2016 75provides for the acquisition of 72 Typhoon aircraft in a programme aimed at themodernisation of the Saudi Armed Forces, was launched in September 2007. Thiscarries substantial packages of work and expertise transfers, aimed at developing theSaudi industrial defence sector. BAE Systems has made a major commitment to thetraining of local nationals to bring them into management, technical and other qualifiedpositions. Saudis constitute 21% of BAE’s group sales, 57% of the total BAE Systems'workforce in Saudi Arabia making the Company one of the largest private sectoremployers of Saudis with 5,000 employees based locally. The UK and Saudi havediscussed in the past moving the final assembly of some of the 72 Typhoons in SaudiArabia but it failed. Now, the two countries may be trying to have locally producedHawks on the back of the 22 trainer order at the end of 2015, according to local press.Thales (10% of group sales in the Middle East, mainly in defence) has an establishedpresence in the Kingdom of Saudi Arabia, with 750 employees and a diversified portfolioof activities. The company has built a mature relationship with Saudi Arabia based onsolid, country-wide partnerships. Thales’s major commercial successes include theShahine and Crotale air defence contracts with logistic support. In naval defence, Thalesis the prime contractor for the Sawari II contract (three frigates), that follows on fromthe successful Sawari I programme (four frigates) for which Thales now provides logisticsupport. In 2007, Thales was selected by the Saudi Arabian Ministry of Defence tosupply a major electronic protection system to the Royal Saudi Air Force.US contractors such as Lockheed Martin (supplier of F16 jets, C130J transport planes),General Dynamics (military vehicles) and Raytheon (missiles) have some local presencein Saudi Arabia, but BAE is by in large the largest and historical local presence.76 GEMs Paper #26 | 30 June 2016Table 29: Stocks mentionedName Symbol Opinion Q-R-Q Price POAl Hammadi XBQYF Buy C-1-7 SAR 40.19 SAR 64.0Al Othaim XWPJF Buy C-1-7 SAR 99.99 SAR 121.0BAE SYSTEMS BAESF Buy A-1-7 GBP 483.4 GBP 600BAE SYSTEMS BAESY Buy A-1-7 USD 26.17 GBP 34.26SABIC XAUBF Buy C-1-8 SAR 80.87 SAR 99.5Saudi Telecom XUTUF Buy C-1-7 SAR 63.95 SAR 81.0Savola XSAVF Buy C-1-7 SAR 35.95 SAR 46.0THALES THLEF Buy C-1-7 EUR 73.5 EUR 87.0YANSAB XUYNF Buy C-1-7 SAR 40.28 SAR 48.0Zain KSA XOCTF Buy C-1-9 SAR 7.83 SAR 12.2Almarai XALRF Neutral B-2-7 SAR 53.7 SAR 61.0Jarir XJRIF Neutral C-2-7 SAR 118.64 SAR 134.0SAFCO XDUAF Neutral C-2-8 SAR 59.73 SAR 72.0Dallah Healthcare XJEFF Underperform C-3-7 SAR 86.12 SAR 79,0Dar Al Arkan XARKF Underperform C-3-9 SAR 6.49 SAR 7.0Extra XYDUF Underperform C-3-7 SAR 26.72 SAR 24.0Source: BofA Merrill Lynch Global ResearchPrice objective basis & riskAl Hammadi (XBQYF)Our SAR64 PO for Al Hammadi is based on our DCF-derived valuation. This is equivalentto 32x FY17E EPS. Strong earnings growth means out-year valuations appear muchmore reasonable than near-term valuations (e.g. implied 13x FY20E EPS). Companyspecific risks are: lower-than-expected growth resulting from delays in executing onexpansion plans, inability to raise prices to offset cost inflation, failure to managegrowth without impacting margins, pricing pressure from insurers, new competition,sustained delays to government payments, and any potentially dilutive acquisitions.General/macro risks are: sustained low oil prices and any resultant slow-down in theeconomy, civil unrest, ongoing failure of the government to pay bills.Al Othaim (XWPJF)We use a combination of DCF, DDM and peer group analysis to value Al Othaim. Wehave taken a weighted average of values implied by our DCF, DDM and peer groupanalyses. We attribute a 50% weight to the DCF and 25% weights for both the DDM andthe P/E multiple, which points to a PO of SAR121. We attribute a greater weight to theDCF valuation as we believe food retailers offer good visibility on cash flow generation.In the case of Al Othaim, we think DCF better reflects the stock's growth opportunity.We assume a perpetuity growth rate of 2% and WACC of 9.1% in our DCF.The downside risks to our investment case are:- Weaker-than-expected margin performance- Cannibalisation effect in Saudi Arabia- Competition: We expect competition to intensify among the large organized players,such as Savola-owned Panda which have aggressive retail expansion plans growth plan- Saudization: Most of Al Othaim's labors are low level staff working in the warehousesand branches which depends heavily on expatriate labors. This suggests the Saudizationof the staff could put further pressure on margins.Almarai (XALRF)We arrive at our SAR61/share price objective using a combination of P/E multiples andDCF valuation, taking the average yielded by the two methods. More specifically:GEMs Paper #26 | 30 June 2016 77On a multiples basis, we value Almarai on 21x 2017E EPS, a 15% premium to Global(blue chip) food producer averages. We believe that at this level it is fairly valued givenit is trading at a premium to its historical trading average and the weaker consumeroutlook.Our DCF analysis yields a valuation of SAR59/share, based on a WACC of 8% andterminal growth rate of 3.5%.Risks to our PO are company specific factors such as plant outages, disease outbreaksin its biological assets, delays in the investment program and factors affecting suppliers.Macro level risks are commodity prices, government regulation, subsidy removals andprice pressures from growing competition.BAE SYSTEMS (BAESF / BAESY)Our PO of 600p (US$34.26/ADR) is an average based on DCF, 2016-17E P/E andEV/EBITA and Sum-of-Parts. We regard as BAE's peers Lockheed Martin, LLL, GeneralDynamics, Northrop Grumman, Raytheon, QinetiQ, Cobham, Ultra Electronics.Our DCF valuation (8.7% WACC and 1.8% long-term growth rate in line with defencepeers and 10.7% long term margin) implies a 550p share price. Our SOP suggests atvaluation range of 592-595p, using peer group EV/EBITA multiples of 12.7-13.7x andEV/sales of 1.2x. Applying EU and US peers multiples on EV/EBITA and P/E yields avaluation range of 671-679p.At 600p BAE would be trading on 14.6x 2016E P/E and at 13.9x 2016E EV/EBITA. ThisP/E is in the middle of the historical range of c.20x to c.6x, and the EV/EBITA is near thehigh end of the historical range of c.12x to c.4x.Upside risks are: 1) An export contract for Typhoons, in particular an order for 60+airplanes from Saudi, 2) USD strength against the UK, 3) development of a large scaleand long term conflict.Downside risks are: 1) significant decrease to the US or UK defence budgets, below ourcurrent assumptions, 2) significant weakness of the US$ vs Sterling.Dallah Healthcare (XJEFF)We set a SAR79 price objective for Dallah, which is equivalent to 23x FY17E EPS. Weexpect earnings to double between FY15A and FY20E as beds triple. The multipletherefore falls quickly and on FY20E earnings, when some of this growth is likely tohave come through, the stock trades in-line with other hospital stocks, both EM andSaudi.Upside risks are: greater price increases than assumed in forecasts, faster uptake ofnew capacity, accretive M&A activity.Down side risks are: Slowdown in the economy, lower-than-expected growth resultingfrom delays in executing on expansion plans, inability to raise prices to offset costinflation, failure to manage growth without impacting marginsDar Al Arkan (XARKF)Our PO of SAR7.0/share is based on sum-of-the-parts methodology. Weemploy a WACC of 10.7%, derived from a COE and COD of 11.1% and 9.0%,respectively. Our SOTP includes (1) the NPV of the current development portfolioto 2016E, (2) the NPV of recurring cash flows from investment portfolio + the NPVof its terminal value minus incremental capex to complete the investmentprogramme, (3) the NPV of land sales from the developed land bank, and (4) thebook value (valued at cost) of DAAR s remaining land bank.Downside risks: (1) Deterioration of demand for land would increasethe perceived liquidity risk (2) Deterioration of credit environment (3) Emergence78 GEMs Paper #26 | 30 June 2016of sub-developers which would inflate the acq. cost of land and consequentlydepreciate the residual value of land due to lower margins (4) Mismanagement ofcash flows: a mismanagement of the resources (overspending in CAPEX for landfor example) could arise liquidity concerns because of over-exposure to landsales mkt. Upside risks: A lower-than-expected borrowing cost: Weforecast an incremental cost of debt of 9%, A improvement in the creditenvironment sensitive to exogenous factors such as liquidity and the risk appetiteof the international mkt. would lower DAAR s cost of funding, We see upsidevaluation risk in the value of the land bank should the company manages todevelop housing units with the support of the Ministry of Housing. debt-financedacquisition to boost its recurring income.Extra (XYDUF)We derive a PO of SAR 24 using a DCF valuation model which we believe best capturesdiffering capital costs and growth profiles across the MENA region. Key assumptions arean 11% WACC and a 2% perpetuity growth rate. Upside/downside risks to our PO arebetter/worse returns from better/worse like-for-like sales and shorter/longer break eventimes from new international markets.Jarir (XJRIF)We derive a PO of SAR134 using a DCF valuation model which we believe best capturesthe company's plan to add c.60% new stores by 2017. Key assumptions are: - a 5-yearCAGR in sales of 11% followed by an five-year CAGR of 6% and a perpetuity growth rateof 2%, - an average EBIT margin of 13%, - a WACC of 9.5% with a beta of 0.9x. OurWACC is calculated using a RFR of 5.0% and an ERP of 6.0%. We used a 2% terminalgrowth rate.The risks to our PO are company-specific issues such as a failure to deliver the expected11% top-line growth or a faster-than-expected deterioration in electronics margins. Inaddition, there are risks associated with a slowdown in the economy or consumerspending.Saudi Arabian Fertilizer Company (XDUAF)We apply a justified P/E multiple to derive SAFCO's PO of SAR72. The P/E is based on anormalized RoE of 30.2%, Cost of Equity of 10.4% and payout of 93.5%.Upside risks to our price objective are: (1) delays in global nitrogen fertilizers capacityexpansions, which would result in a tighter supply of urea and effectively higher prices,(2) Stronger demand for fertilizers and effectively prices, (3) An increase in the marginalproducer cost that effectively leads to a higher urea price floor.Downside risks are: (1) lower prices of urea due to weaker than expected demand, (2)Delay in SAFCO 5 expansion project, (3) an increase in natural gas cost.Saudi Basic Industries Corporation (XAUBF)We apply a justified P/E multiple to derive SABIC's PO of SAR99.5. The P/E is based on anormalised RoE of 15.8%, Cost of Equity of 11.5% and payout of 65.0%Downside risks to our price objective are a decline in the supply of low-cost feedstock, alower-than-expected recovery in petrochemicals prices, delays in the ramp-up of newlyestablished subsidiaries, or weakness in steel demand in Saudi Arabia.Saudi Telecom Company (STC) (XUTUF)We derive our SAR81/share PO for STC on a sum of the parts basis, using a combinationof DCF and market valuations for its core subsidiaries and associates, adjusting forownership stakes. Specifically, we use DCF to value its core operations in Saudi Arabia(9.5% WACC), Viva Kuwait (10.5% WACC), and other subsidiaries (10.1% WACC). WeGEMs Paper #26 | 30 June 2016 79assume a terminal growth rate of 2% across all of the markets, starting from 2023. ForSTC's associates, we value its holdings in Oger Telecom and Binariang using acombination of our Research team's valuation (for Oger's stake in Turk Telecom) andbook value. We then add STC's net cash position at YE 2015 in deriving our PO.Risks to our PO come from potential market share loss as both Mobily and Zain KSA,plus several MVNO's are aiming to take market share from STC domestically, followingrecent cut in MTR's. Additionally, we see ongoing risk from FX exposure at theirsubsidiary investments, especially their indirect stake in Turk Telekom.Savola (XSAVF)Given the diversified nature of the Savola group, we use a sum of the parts valuation inderiving our SAR46/share price objective for Savola. Specifically, we:Value the food business on 12x 2016 earnings, a 30% discount to global peers onaccount have having slightly slower growth and risks presented by having a significantposition in Iran (which accounts for 13% of revenues).Value retail(Panda) at 15x 2016 earnings, a c.10% discount to global peers on account ofhaving slower near term growth. we believe near term growth will be impacted bycontinued aggressive expansion and slowing demand trends in the Saudi market(following the introduction of the 2016 budget).The investments business is valued using a variety of methods. For its stake in Almarai,we value it in line with our price objective for the shares. Savola's interests in otherlisted entities (Herfy, KEC and EEC) are valued at current market valuation given we donot have research coverage on the names. The stakes in none listed entities includingthe real estate book and private equity holdings are valued at 2x book value (YE2015).Downside risks to our PO include higher cost escalation than we forecast, furtheradverse moves in commodity prices , adverse FX movements in countries outside ofSaudi Arabia where Savola does business and any disruptions to its material Iranianbusiness.THALES (THLEF)To derive our Thales price objective of €87, we use a 2017E sum of the parts valuation,using Rockwell Collins, Raytheon, Northrop Grumman, Ultra, and the EU Civil Aerospacepeer group as peers for the Aerospace/defence segments, and Ansaldo STAS as a peerfor the transport business.At €87 Thales would trade on 18.1x 2017E P/E and 12.3x EV/EBITA which we think isappropriate given balance sheet/ portfolio optionality and building order momentum.Upside/Downside risks to our price objective are: 1) changes in the company's free float,2) assets swap and portfolio changes could add more value than we currently estimate3) lower/more French defence cuts than we currently estimate.YANSAB (XUYNF)We apply a justified P/E multiple to derive YANSAB's PO of SAR48. The P/E is based ona normalized RoE of 14.5%, Cost of Equity of 11% and payout of 70%Downside risks to our price objective are: 1. Lower-than-expected demand for polyesterwould adversely impact MEG prices and effectively earnings 2. Unexpected change infeedstock prices could negatively impact earnings 3. Unexpected shutdowns that wouldresult in lower production.80 GEMs Paper #26 | 30 June 2016Zain KSA (XOCTF)We use a DCF valuation model to derive our price objective of SAR 12.2. Keyassumptions are a discount rate of 11.0%, underpinned by a risk free rate of 5.5%, acost of equity of 29% and a 6.5% cost of debt. We explicitly forecast free cash flowsuntil 2022 and then assume perpetuity growth of 3%, as we do when valuing other Gulfoperators. Our forecasts take in to account the repayment of the deferred royalty loanafforded to Zain in 2013 (repayments starting from 2021).Downside risks are greater pricing pressure from MVNOs, the loss of its appeal againsta SAR620mn tax claim, an unfavourable ruling against Zain KSA in its arbitration processwith Mobily and an inability to grow market share and margins, which in turn wouldthreaten capital requirements.Analyst CertificationWe, Abdelrali El Jattari, Ali Dhaloomal, Anton Fedotov, Benjamin Heelan, Celine Fornaro,Faisal AlAzmeh, CFA, Francisco Blanch, Hootan Yazhari, CFA, Jamie Clark, CFA and Jean-Michel Saliba, hereby certify that the views each of us has expressed in this researchreport accurately reflect each of our respective personal views about the subjectsecurities and issuers. We also certify that no part of our respective compensation was,is, or will be, directly or indirectly, related to the specific recommendations or viewexpressed in this research report.Special DisclosuresSome of the securities discussed herein should only be considered for inclusion inaccounts qualified for high risk investment.GEMs Paper #26 | 30 June 2016 81DisclosuresImportant DisclosuresCredit opinion historyBahrain / BHRAINSovereign Date^ Action RecommendationBahrain / BHRAIN 12-Nov-2015 Initial MarketweightTable reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of thereport under the heading "BofA Merrill Lynch Credit Opinion Key."Dubai / DUGBSovereign Date^ Action RecommendationDubai / DUGB 12-Nov-2015 Initial Marketweight08-Jan-2016 Downgrade Underweight28-Apr-2016 Upgrade MarketweightTable reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of thereport under the heading "BofA Merrill Lynch Credit Opinion Key."Qatar / QATARSovereign Date^ Action RecommendationQatar / QATAR 12-Nov-2015 Initial Marketweight08-Jan-2016 Downgrade Underweight26-Feb-2016 Upgrade Marketweight25-May-2016 Restricted NATable reflects credit opinion history as of previous business day’s close. ^First date of recommendation within last 36 months. The investment opinion system is contained at the end of thereport under the heading "BofA Merrill Lynch Credit Opinion Key."BofA Merrill Lynch Credit Opinion KeyBofA Merrill Lynch Global Research provides recommendations on an issuer’s bonds (including corporate and sovereign external debt securities), capital securities, equity preferreds and CDS asdescribed below. Convertible securities are not rated. An issuer level recommendation may also be provided for an issuer as explained below. BofA Merrill Lynch Global Research creditrecommendations are assigned using a three-month time horizon.Issuer Recommendations: If an issuer credit recommendation is provided, it is applicable to bonds and capital securities of the issuer except bonds and capital securities specificallyreferenced in the report with a different credit recommendation. Where there is no issuer credit recommendation, only individual bonds and capital securities with specific recommendationsare covered. CDS and equity preferreds are rated separately and issuer recommendations do not apply to them.BofA Merrill Lynch Global Research credit recommendations are assigned using a three-month time horizon:Overweight: Spreads and /or excess returns are likely to outperform the relevant and comparable market over the next three months.Marketweight: Spreads and/or excess returns are likely to perform in-line with the relevant and comparable market over the next three months.Underweight: Spreads and/or excess returns are likely to underperform the relevant and comparable market over the next three months.BofA Merrill Lynch Global Research uses the following rating system with respect to Credit Default Swaps (CDS):Buy Protection: Buy CDS, therefore going short credit risk.Neutral: No purchase or sale of CDS is recommended.Sell Protection: Sell CDS, therefore going long credit risk.Sovereign Investment Rating Distribution: Global Group (as of 31 Mar 2016)Coverage Universe Count Percent Inv. Banking Relationships* Count PercentBuy 5 12.82% Buy 2 40.00%Hold 28 71.79% Hold 12 42.86%Sell 6 15.38% Sell 6 100.00%* Issuers that were investment banking clients of BofA Merrill Lynch or one of its affiliates within the past 12 months. For purposes of this Investment Rating Distribution, the coverage universe includes only Sovereignissuer recommendations. A Sovereign issuer rated Overweight is included as a Buy, a Sovereign issuer rated Marketweight is included as a Hold, and a Sovereign issuer rated Underweight is included as a Sell.FUNDAMENTAL EQUITY OPINION KEY: Opinions include a Volatility Risk Rating, an Investment Rating and an Income Rating. VOLATILITY RISK RATINGS, indicators of potentialprice fluctuation, are: A - Low, B - Medium and C - High. INVESTMENT RATINGS reflect the analyst’s assessment of a stock’s: (i) absolute total return potential and (ii)attractiveness for investment relative to other stocks within its Coverage Cluster (defined below). There are three investment ratings: 1 - Buy stocks are expected to have a totalreturn of at least 10% and are the most attractive stocks in the coverage cluster; 2 - Neutral stocks are expected to remain flat or increase in value and are less attractive thanBuy rated stocks and 3 - Underperform stocks are the least attractive stocks in a coverage cluster. Analysts assign investment ratings considering, among other things, the 0-12month total return expectation for a stock and the firm’s guidelines for ratings dispersions (shown in the table below). The current price objective for a stock should bereferenced to better understand the total return expectation at any given time. The price objective reflects the analyst’s view of the potential price appreciation (depreciation).Investment rating Total return expectation (within 12-month period of date of initial rating) Ratings dispersion guidelines for coverage cluster*Buy ≥ 10% ≤ 70%Neutral ≥ 0% ≤ 30%Underperform N/A ≥ 20%* Ratings dispersions may vary from time to time where BofA Merrill Lynch Research believes it better reflects the investment prospects of stocks in a Coverage Cluster.82 GEMs Paper #26 | 30 June 2016INCOME RATINGS, indicators of potential cash dividends, are: 7 - same/higher (dividend considered to be secure), 8 - same/lower (dividend not considered to be secure) and 9 - paysno cash dividend. Coverage Cluster is comprised of stocks covered by a single analyst or two or more analysts sharing a common industry, sector, region or other classification(s). A stock’scoverage cluster is included in the most recent BofA Merrill Lynch report referencing the stock.Price charts for the securities referenced in this research report are available at http://pricecharts.baml.com, or call 1-800-MERRILL to have them mailed.Credit Opinion History Tables for the securities referenced in this research report are available at http://pricecharts.baml.com, or call 1-800-MERRILL to have them mailed.One or more analysts responsible for covering the securities in this report owns stock of the covered issuer: Genel Energy.MLPF&S or an affiliate was a manager of a public offering of securities of this issuer within the last 12 months: Qatar.The issuer is or was, within the last 12 months, an investment banking client of MLPF&S and/or one or more of its affiliates: BAE SYSTEMS, Dubai, Qatar, Qatar (Central Bank), SABIC, SaudiTelecom, THALES, Yansab.MLPF&S or an affiliate has received compensation from the issuer for non-investment banking services or products within the past 12 months: BAE SYSTEMS, Bahrain, Bahrain (Treasury),Dubai, Qatar, Qatar (Central Bank), SABIC, Yansab.The issuer is or was, within the last 12 months, a non-securities business client of MLPF&S and/or one or more of its affiliates: BAE SYSTEMS, Bahrain, Bahrain (Treasury), Dubai, Qatar, Qatar(Central Bank), SABIC, Yansab.In the US, retail sales and/or distribution of this report may be made only in states where these securities are exempt from registration or have been qualified for sale: Al Hammadi, Al Othaim,Almarai, BAE SYSTEMS, Dallah Healthcare, Dar Al Arkan, Extra, Jarir, SABIC, SAFCO, Saudi Telecom, Savola, THALES, Yansab, Zain KSA.MLPF&S or an affiliate has received compensation for investment banking services from this issuer within the past 12 months: BAE SYSTEMS, Dubai, Qatar, Qatar (Central Bank), SABIC, THALES,Yansab.MLPF&S or an affiliate expects to receive or intends to seek compensation for investment banking services from this issuer or an affiliate of the issuer within the next three months: BAESYSTEMS, Dubai, Qatar, Qatar (Central Bank), SABIC, Saudi Telecom, THALES, Yansab.MLPF&S or one of its affiliates has a significant financial interest in the fixed income instruments of the issuer. If this report was issued on or after the 15th day of the month, it reflects asignificant financial interest on the last day of the previous month. Reports issued before the 15th day of the month reflect a significant financial interest at the end of the second monthpreceding the report: BAE SYSTEMS, Qatar.MLPF&S or one of its affiliates is willing to sell to, or buy from, clients the common equity of the issuer on a principal basis: BAE SYSTEMS.MLPF&S or one of its affiliates trades or may trade as principal in the debt securities (or in related derivatives) that are the subject of this research report: Bahrain, Bahrain (Treasury), Dubai,Qatar.The issuer is or was, within the last 12 months, a securities business client (non-investment banking) of MLPF&S and/or one or more of its affiliates: BAE SYSTEMS, Bahrain, Bahrain (Treasury),Dubai, Qatar, Qatar (Central Bank), SABIC, THALES, Yansab.BofA Merrill Lynch Research Personnel (including the analyst(s) responsible for this report) receive compensation based upon, among other factors, the overall profitability of Bank of AmericaCorporation, including profits derived from investment banking. The analyst(s) responsible for this report may also receive compensation based upon, among other factors, the overallprofitability of the Bank’s sales and trading businesses relating to the class of securities or financial instruments for which such analyst is responsible.BofA Merrill Lynch Global Credit Research analysts regularly interact with sales and trading desk personnel in connection with their research, including to ascertain pricing and liquidity in thefixed income markets.Other Important DisclosuresPrices are indicative and for information purposes only. Except as otherwise stated in the report, for the purpose of any recommendation in relation to: (i) an equity security, the pricereferenced is the publicly traded price of the security as of close of business on the day prior to the date of the report or, if the report is published during intraday trading, the price referenced isindicative of the traded price as of the date and time of the report; or (ii) a debt security (including equity preferred and CDS), prices are indicative as of the date and time of the report and arefrom various sources including Bank of America Merrill Lynch trading desks.The date and time of completion of the production of any recommendation in this report shall be the date and time of dissemination of this report as recorded electronically on the platform inwhich the report was accessed.This report may refer to fixed income securities that may not be offered or sold in one or more states or jurisdictions. Readers of this report are advised that any discussion, recommendation orother mention of such securities is not a solicitation or offer to transact in such securities. Investors should contact their BofA Merrill Lynch representative or Merrill Lynch Financial GlobalWealth Management financial advisor for information relating to fixed income securitiesRule 144A securities may be offered or sold only to persons in the U.S. who are Qualified Institutional Buyers within the meaning of Rule 144A under the Securities Act of 1933, as amended.SECURITIES DISCUSSED HEREIN MAY BE RATED BELOW INVESTMENT GRADE AND SHOULD THEREFORE ONLY BE CONSIDERED FOR INCLUSION IN ACCOUNTS QUALIFIED FOR SPECULATIVEINVESTMENT.Recipients who are not institutional investors or market professionals should seek the advice of their independent financial advisor before considering information in this report in connectionwith any investment decision, or for a necessary explanation of its contents.The securities discussed in this report may be traded over-the-counter. Retail sales and/or distribution of this report may be made only in states where these securities are exempt fromregistration or have been qualified for sale.This report, and the securities discussed herein, may not be eligible for distribution or sale in all countries or to certain categories of investors.Individuals identified as economists do not function as research analysts under U.S. law and reports prepared by them are not research reports under applicable U.S. rules and regulations.Macroeconomic analysis is considered investment research for purposes of distribution in the U.K. under the rules of the Financial Services Authority.BofA Merrill Lynch Global Research policies relating to conflicts of interest are described at http://go.bofa.com/coi."BofA Merrill Lynch" includes Merrill Lynch, Pierce, Fenner & Smith Incorporated ("MLPF&S") and its affiliates. Investors should contact their BofA Merrill Lynch representative orMerrill Lynch Global Wealth Management financial advisor if they have questions concerning this report. "BofA Merrill Lynch" and "Merrill Lynch" are each global brands for BofAMerrill Lynch Global Research.Information relating to Non-US affiliates of BofA Merrill Lynch and Distribution of Affiliate Research Reports:MLPF&S distributes, or may in the future distribute, research reports of the following non-US affiliates in the US (short name: legal name, regulator): Merrill Lynch (South Africa): Merrill LynchSouth Africa (Pty) Ltd., regulated by The Financial Service Board; MLI (UK): Merrill Lynch International, regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority(PRA); Merrill Lynch (Australia): Merrill Lynch Equities (Australia) Limited, regulated by the Australian Securities and Investments Commission; Merrill Lynch (Hong Kong): Merrill Lynch (AsiaPacific) Limited, regulated by the Hong Kong Securities and Futures Commission (HKSFC) and the Hong Kong Monetary Authority (HKMA); Merrill Lynch (Singapore): Merrill Lynch (Singapore)Pte Ltd, regulated by the Monetary Authority of Singapore (MAS); Merrill Lynch (Canada): Merrill Lynch Canada Inc, regulated by the Investment Industry Regulatory Organization of Canada;Merrill Lynch (Mexico): Merrill Lynch Mexico, SA de CV, Casa de Bolsa, regulated by the Comisión Nacional Bancaria y de Valores; Merrill Lynch (Argentina): Merrill Lynch Argentina SA, regulatedby Comisión Nacional de Valores; Merrill Lynch (Japan): Merrill Lynch Japan Securities Co., Ltd., regulated by the Financial Services Agency; Merrill Lynch (Seoul): Merrill Lynch InternationalIncorporated (Seoul Branch) regulated by the Financial Supervisory Service; Merrill Lynch (Taiwan): Merrill Lynch Securities (Taiwan) Ltd., regulated by the Securities and Futures Bureau; DSPMerrill Lynch (India): DSP Merrill Lynch Limited, regulated by the Securities and Exchange Board of India; PT Merrill Lynch (Indonesia): PT Merrill Lynch Indonesia, regulated by Otoritas JasaKeuangan (OJK); Merrill Lynch (Israel): Merrill Lynch Israel Limited, regulated by Israel Securities Authority; Merrill Lynch (Russia): OOO Merrill Lynch Securities, Moscow, regulated by the CentralBank of the Russian Federation; Merrill Lynch (Turkey I.B.): Merrill Lynch Yatirim Bank A.S., regulated by the Capital Markets Board of Turkey; Merrill Lynch (Turkey Broker): Merrill Lynch MenkulDeğerler A.Ş., regulated by the Capital Markets Board of Turkey; Merrill Lynch (DIFC): Merrill Lynch International (DIFC Branch), regulated by the Dubai Financial Services Authority (DFSA); MerrillLynch (Spain): Merrill Lynch Capital Markets Espana, S.A.S.V., regulated by Comisión Nacional del Mercado De Valores; Merrill Lynch (Brazil): Bank of America Merrill Lynch Banco Multiplo S.A.,regulated by Comissão de Valores Mobiliários; Merrill Lynch KSA Company, Merrill Lynch Kingdom of Saudi Arabia Company, regulated by the Capital Market Authority.GEMs Paper #26 | 30 June 2016 83This information: has been approved for publication and is distributed in the United Kingdom (UK) to professional clients and eligible counterparties (as each is defined in the rules of the FCAand the PRA) by MLI (UK) and Bank of America Merrill Lynch International Limited, which are authorized by the PRA and regulated by the FCA and the PRA, and is distributed in the UK to retailclients (as defined in the rules of the FCA and the PRA) by Merrill Lynch International Bank Limited, London Branch, which is authorized by the Central Bank of Ireland and subject to limitedregulation by the FCA and PRA - details about the extent of our regulation by the FCA and PRA are available from us on request; has been considered and distributed in Japan by Merrill Lynch(Japan), a registered securities dealer under the Financial Instruments and Exchange Act in Japan; is distributed in Hong Kong by Merrill Lynch (Hong Kong), which is regulated by HKSFC andHKMA; is issued and distributed in Taiwan by Merrill Lynch (Taiwan); is issued and distributed in India by DSP Merrill Lynch (India); and is issued and distributed in Singapore to institutionalinvestors and/or accredited investors (each as defined under the Financial Advisers Regulations) by Merrill Lynch International Bank Limited (Merchant Bank) (MLIBLMB) and Merrill Lynch(Singapore) (Company Registration Nos F 06872E and 198602883D respectively). MLIBLMB and Merrill Lynch (Singapore) are regulated by MAS. Bank of America N.A., Australian Branch (ARBN064 874 531), AFS License 412901 (BANA Australia) and Merrill Lynch Equities (Australia) Limited (ABN 65 006 276 795), AFS License 235132 (MLEA) distribute this report in Australia only to'Wholesale' clients as defined by s.761G of the Corporations Act 2001. With the exception of BANA Australia, neither MLEA nor any of its affiliates involved in preparing this research report is anAuthorised Deposit-Taking Institution under the Banking Act 1959 nor regulated by the Australian Prudential Regulation Authority. No approval is required for publication or distribution of thisreport in Brazil and its local distribution is by Merrill Lynch (Brazil) in accordance with applicable regulations. Merrill Lynch (DIFC) is authorized and regulated by the DFSA. Research reportsprepared and issued by Merrill Lynch (DIFC) are done so in accordance with the requirements of the DFSA conduct of business rules. Bank of America Merrill Lynch International Limited,Frankfurt Branch (BAMLI Frankfurt) distributes this report in Germany and is regulated by BaFin.This research report has been prepared and issued by MLPF&S and/or one or more of its non-US affiliates. MLPF&S is the distributor of this research report in the US and accepts fullresponsibility for research reports of its non-US affiliates distributed to MLPF&S clients in the US. Any US person receiving this research report and wishing to effect any transaction in anysecurity discussed in the report should do so through MLPF&S and not such foreign affiliates. Hong Kong recipients of this research report should contact Merrill Lynch (Asia Pacific) Limited inrespect of any matters relating to dealing in securities or provision of specific advice on securities. Singapore recipients of this research report should contact Merrill Lynch International BankLimited (Merchant Bank) and/or Merrill Lynch (Singapore) Pte Ltd in respect of any matters arising from, or in connection with, this research report.General Investment Related Disclosures:Taiwan Readers: Neither the information nor any opinion expressed herein constitutes an offer or a solicitation of an offer to transact in any securities or other financial instrument. No part ofthis report may be used or reproduced or quoted in any manner whatsoever in Taiwan by the press or any other person without the express written consent of BofA Merrill Lynch.This research report provides general information only. Neither the information nor any opinion expressed constitutes an offer or an invitation to make an offer, to buy or sell any securities orother financial instrument or any derivative related to such securities or instruments (e.g., options, futures, warrants, and contracts for differences). This report is not intended to providepersonal investment advice and it does not take into account the specific investment objectives, financial situation and the particular needs of any specific person. Investors should seekfinancial advice regarding the appropriateness of investing in financial instruments and implementing investment strategies discussed or recommended in this report and should understandthat statements regarding future prospects may not be realized. Any decision to purchase or subscribe for securities in any offering must be based solely on existing public information on suchsecurity or the information in the prospectus or other offering document issued in connection with such offering, and not on this report.Securities and other financial instruments discussed in this report, or recommended, offered or sold by Merrill Lynch, are not insured by the Federal Deposit Insurance Corporation and are notdeposits or other obligations of any insured depository institution (including, Bank of America, N.A.). Investments in general and, derivatives, in particular, involve numerous risks, including,among others, market risk, counterparty default risk and liquidity risk. No security, financial instrument or derivative is suitable for all investors. In some cases, securities and other financialinstruments may be difficult to value or sell and reliable information about the value or risks related to the security or financial instrument may be difficult to obtain. Investors should note thatincome from such securities and other financial instruments, if any, may fluctuate and that price or value of such securities and instruments may rise or fall and, in some cases, investors maylose their entire principal investment. Past performance is not necessarily a guide to future performance. Levels and basis for taxation may change.Futures and options are not appropriate for all investors. Such financial instruments may expire worthless. Before investing in futures or options, clients must receive the appropriate riskdisclosure documents. Investment strategies explained in this report may not be appropriate at all times. Costs of such strategies do not include commission or margin expenses.BofA Merrill Lynch is aware that the implementation of the ideas expressed in this report may depend upon an investor's ability to "short" securities or other financial instruments and that suchaction may be limited by regulations prohibiting or restricting "shortselling" in many jurisdictions. Investors are urged to seek advice regarding the applicability of such regulations prior toexecuting any short idea contained in this report.This report may contain a trading idea or recommendation which highlights a specific identified near-term catalyst or event impacting a security, issuer, industry sector or the market generallythat presents a transaction opportunity, but does not have any impact on the analyst’s particular “Overweight” or “Underweight” rating (which is based on a three month trade horizon). Tradingideas and recommendations may differ directionally from the analyst’s rating on a security or issuer because they reflect the impact of a near-term catalyst or event.Certain investment strategies and financial instruments discussed herein may only be appropriate for consideration in accounts qualified for high risk investment.Foreign currency rates of exchange may adversely affect the value, price or income of any security or financial instrument mentioned in this report. Investors in such securities and instrumentseffectively assume currency risk.UK Readers: The protections provided by the U.K. regulatory regime, including the Financial Services Scheme, do not apply in general to business coordinated by BofA Merrill Lynch entitieslocated outside of the United Kingdom. BofA Merrill Lynch Global Research policies relating to conflicts of interest are described at http://go.bofa.com/coi.MLPF&S or one of its affiliates is a regular issuer of traded financial instruments linked to securities that may have been recommended in this report. MLPF&S or one of its affiliates may, at anytime, hold a trading position (long or short) in the securities and financial instruments discussed in this report.BofA Merrill Lynch, through business units other than BofA Merrill Lynch Global Research, may have issued and may in the future issue trading ideas or recommendations that are inconsistentwith, and reach different conclusions from, the information presented in this report. Such ideas or recommendations reflect the different time frames, assumptions, views and analyticalmethods of the persons who prepared them, and BofA Merrill Lynch is under no obligation to ensure that such other trading ideas or recommendations are brought to the attention of anyrecipient of this report.In the event that the recipient received this report pursuant to a contract between the recipient and MLPF&S for the provision of research services for a separate fee, and in connectiontherewith MLPF&S may be deemed to be acting as an investment adviser, such status relates, if at all, solely to the person with whom MLPF&S has contracted directly and does not extendbeyond the delivery of this report (unless otherwise agreed specifically in writing by MLPF&S). MLPF&S is and continues to act solely as a broker-dealer in connection with the execution of anytransactions, including transactions in any securities mentioned in this report.Copyright and General Information regarding Research Reports:Copyright 2016 Bank of America Corporation. All rights reserved. This research report is prepared for the use of BofA Merrill Lynch clients and may not be redistributed, retransmitted ordisclosed, in whole or in part, or in any form or manner, without the express written consent of BofA Merrill Lynch. BofA Merrill Lynch research reports are distributed simultaneously to internaland client websites and other portals by BofA Merrill Lynch and are not publicly-available materials. Any unauthorized use or disclosure is prohibited. Receipt and review of this research reportconstitutes your agreement not to redistribute, retransmit, or disclose to others the contents, opinions, conclusion, or information contained in this report (including any investmentrecommendations, estimates or price targets) without first obtaining expressed permission from an authorized officer of BofA Merrill Lynch.Materials prepared by BofA Merrill Lynch Global Research personnel are based on public information. Facts and views presented in this material have not been reviewed by, and may not reflectinformation known to, professionals in other business areas of BofA Merrill Lynch, including investment banking personnel. BofA Merrill Lynch has established information barriers betweenBofA Merrill Lynch Global Research and certain business groups. As a result, BofA Merrill Lynch does not disclose certain client relationships with, or compensation received from, such issuers inresearch reports. To the extent this report discusses any legal proceeding or issues, it has not been prepared as nor is it intended to express any legal conclusion, opinion or advice. Investorsshould consult their own legal advisers as to issues of law relating to the subject matter of this report. BofA Merrill Lynch Global Research personnel’s knowledge of legal proceedings in whichany BofA Merrill Lynch entity and/or its directors, officers and employees may be plaintiffs, defendants, co-defendants or co-plaintiffs with or involving issuers mentioned in this report is basedon public information. Facts and views presented in this material that relate to any such proceedings have not been reviewed by, discussed with, and may not reflect information known to,professionals in other business areas of BofA Merrill Lynch in connection with the legal proceedings or matters relevant to such proceedings.Any information relating to the tax status of financial instruments discussed herein is not intended to provide tax advice or to be used by anyone to provide tax advice. Investors are urged toseek tax advice based on their particular circumstances from an independent tax professional.The information herein (other than disclosure information relating to BofA Merrill Lynch and its affiliates) was obtained from various sources and we do not guarantee its accuracy. This reportmay contain links to third-party websites. BofA Merrill Lynch is not responsible for the content of any third-party website or any linked content contained in a third-party website. Contentcontained on such third-party websites is not part of this report and is not incorporated by reference into this report. The inclusion of a link in this report does not imply any endorsement by or84 GEMs Paper #26 | 30 June 2016any affiliation with BofA Merrill Lynch. Access to any third-party website is at your own risk, and you should always review the terms and privacy policies at third-party websites beforesubmitting any personal information to them. BofA Merrill Lynch is not responsible for such terms and privacy policies and expressly disclaims any liability for them.All opinions, projections and estimates constitute the judgment of the author as of the date of the report and are subject to change without notice. Prices also are subject to change withoutnotice. BofA Merrill Lynch is under no obligation to update this report and BofA Merrill Lynch's ability to publish research on the subject issuer(s) in the future is subject to applicable quietperiods. You should therefore assume that BofA Merrill Lynch will not update any fact, circumstance or opinion contained in this report.Certain outstanding reports may contain discussions and/or investment opinions relating to securities, financial instruments and/or issuers that are no longer current. Always refer to the mostrecent research report relating to an issuer prior to making an investment decision.In some cases, an issuer may be classified as Restricted or may be Under Review or Extended Review. In each case, investors should consider any investment opinion relating to such issuer (orits security and/or financial instruments) to be suspended or withdrawn and should not rely on the analyses and investment opinion(s) pertaining to such issuer (or its securities and/orfinancial instruments) nor should the analyses or opinion(s) be considered a solicitation of any kind. Sales persons and financial advisors affiliated with MLPF&S or any of its affiliates may notsolicit purchases of securities or financial instruments that are Restricted or Under Review and may only solicit securities under Extended Review in accordance with firm policies.Neither BofA Merrill Lynch nor any officer or employee of BofA Merrill Lynch accepts any liability whatsoever for any direct, indirect or consequential damages or losses arising from any use ofthis report or its contents.GEMs Paper #26 | 30 June 2016 85Research AnalystsEconomicsJean-Michel SalibaMENA EconomistMLI (UK)+44 20 7995 8568jean-michel.saliba@baml.comMENA & FM equityHootan Yazhari, CFA >>Research AnalystMerrill Lynch (DIFC)+971 4 4258218hootan.yazhari@baml.comHealthcareJamie Clark, CFA >>Research AnalystMLI (UK)+44 20 7995 1300jamie.clark@baml.comChemicals & MiningFaisal AlAzmeh, CFA >>Research AnalystMerrill Lynch KSA Company+966 11 299 3741faisal.alazmeh@baml.comReal Estate & ConsumerAbdelrali El Jattari >>Research AnalystMerrill Lynch (DIFC)+971 4 4258231abdelrali.eljattari@baml.comCredit ResearchAli DhaloomalResearch AnalystMLI (UK)+44 20 7996 9107ali.dhaloomal@baml.comCommoditiesFrancisco BlanchCommodity & Deriv StrategistMLPF&S+1 646 855 6212francisco.blanch@baml.comPeter HellesCommodity StrategistMLI (UK)+44 20 7996 8154peter.helles@baml.comAerospace, Defence & Satellite ServicesCeline Fornaro >>Research AnalystMLI (UK)+44 20 7996 5515celine.fornaro@baml.comBenjamin Heelan >>Research AnalystMLI (UK)+44 20 7996 5723benjamin.heelan@baml.comEnergyAnton Fedotov >>Research AnalystMerrill Lynch (Russia)+7 495 662 6079anton.a.fedotov@baml.comTrading ideas and investment strategies discussed herein may give rise to significant risk and are not suitable for allinvestors. Investors should have experience in FX markets and the financial resources to absorb any losses arising fromapplying these ideas or strategies.>> Employed by a non-US affiliate of MLPF&S and is not registered/qualified as a research analyst under the FINRA rules.Refer to "Other Important Disclosures" for information on certain BofA Merrill Lynch entities that take responsibility forthis report in particular jurisdictions.86 GEMs Paper #26 | 30 June 2016