Global economics, the dollar, and financial stability
What a strategist needs to know about industry trends
PART III: This is the third article in a three-part series on strategic issues affecting the global hydrocarbon industry - an analysis developed following an interview with 70 major industry executives. Parts I and II appeared in previous issues.
Convincing energy executives of the cen-trality and importance of global economic forces to their success shouldn't be difficult. The economic crisis in Asia and Russia is an unhappy reminder of the consequences of such turbulence on individual companies and the global economy.
For this reason, it is important that oil, chemical, and service related executives and strategists consider the medium term impact of evolving global economic forces, and particularly, the US position in the global economy. The US position appears central since it is the only remaining superpower, the only economic model that seems to work, and still the only truly global reserve currency in the world.
There are four issues related to global economics that require deep consideration by those developing strategic plans:
- US imports and exports and dollar strength
- Financial instability - will it get worse?
- Investment flow: US versus Europe and Japan.
The world is increasingly becoming a US dollar-based economy. The key question is whether this trend will continue into the medium and long-term future? Also, will the world economy become totally dollarized?
The answers to these questions are important, especially for equipment and service type companies serving the oil and chemical industries. The answers will help determine geographic placement of offices as well as commercial strategies. Depending on the answer, companies may or may not seek mergers, acquisitions, or strategic alliances. To a large degree, the oil industry is already completely dollarized since oil and gas transactions normally are paid out in US dollars.
Study evidence strongly points out that the global economy is rapidly becoming totally dollarized. Dollarization has been going on for some decades in the developing countries, and is now accelerating. Ordinary people in developing countries gave up on their local currencies and central banks and used dollars for purchases, and as a store of value.
During the 1980s debt crises in Latin America, most US dollars in circulation ended up there. The same is true for the former Eastern bloc countries of the Soviet empire during the 1990s. It is worth noting that in 1997, a year of relatively low inflation and currency stability in Russia, IMF statistics indicated that people exchanged $13 billion in rubles for dollars. Today, there is over $300 billion physically in circulation, with about 70% outside the US. Much of that currency volume is in the emerging nations.
First, developing nations
Is it likely that dollarization could pass from de-facto status to de-jure status in many of the developing countries? Growing evidence indicates the answer is yes. Consider, for example, that President Menem of Argentina recently proposed the idea of dollarization for his country. Furthermore, the idea is being strongly debated in countries such as El Salvador, Ecuador, and even Mexico.
The main argument against official dollarization is that every country needs a central bank to stabilize their economy. However, this is most likely a spurious criticism, since all 50 US states are dollarized and work quite well without a central bank. Furthermore, any argument regarding the need for a central bank for really big economies is negated by the fact that California's economy is larger than Brazil's, and the latter accounts for 45% of all Latin America's economic output.
The continuing wave of dollarization presents particularly interesting strategic problems for European and Asian engineering contractors and technical service companies who face American competitors.
The perceived strength or weakness of the US dollar is of critical importance to hydrocarbon-based companies and the industries that serve them. An expensive or inexpensive dollar can greatly impact the commercial prospects of firms such as Toyo, Snamprogetti, or even an equipment firm such as Thyssen.
The US's unique position as a reserve currency country and its thriving economy tend to bolster the dollars' strength. Conversely, the US position as the "buyer of last resort" in the weak global economy applies downward pressure on the American currency. This downward pressure occurs largely because of perceived trade deficit problems running into the tens of billions of dollars. Conventional wisdom suggests that US deficits will grow in the years to come, dampening the value of the dollar.
US imports and exports
If this bit of conventional wisdom is wrong, the US dollar in the future is likely to be a lot stronger than many strategists think. A stronger-than-expected dollar holds important consequences, particularly for technical service companies and engineering contractors. This suggests the US trade deficit does not exist or is minimal, and the dollar would be significantly stronger in the coming years. Consider the following:
- Exports under-counted: There is strong evidence that most countries undercount exports and are much more accurate with import counts. The reason is that there are usually tariffs to collect on imports. Therefore, governments set up the administrative machinery necessary to count carefully and collect the monies. There is no tariff duty to collect on exports, so there is no incentive.
- Exports don't equal imports: On a global basis imports should always equal exports. However, this is not the case. In 1995, for example, statistics show imports actually exceeded exports by a huge $ 98 billion. Thus, there are immense undercounts of exports particularly by the poorly organized US Customs department handling exports.
- Service exports: The accurate counting of US exports is exacerbated by the growing importance of services in the export mix. Service exports are much more difficult to count. In 1980, service exports accounted for 18% of US exports. In 1997, service exports in the US accounted for over 27% of exports.
Scholarly sources estimate that US exports are undercounted by about 10-12% of the total. The reality is that there is little or no trade deficit. Therefore, the US dollar will be considerably stronger than anticipated, impacting investment flows and the competitive position of US exporters.
Will financial instability get worse?
Today, financial stability is ubiquitous. Many thinkers believe that international institutions like the IMF (International Monetary Fund), the World Bank, and the G-7 (economic group of seven nations) properly used will calm or even quell international financial crises. With an international financial architecture in place, the argument goes, the groundwork is in place for financial stability.
The evidence and our judgment tells us differently. Oil, chemical, equipment, and contracting firms will face a far different world than many are assuming in their strategic planning - a world of greater turbulence and greater financial instability. Our reasoning is rooted in common sense and the laws of physics:
- Liquidity: In an increasingly wired world of personal computers, wealth moves cheaply from region to region with the click of a mouse. Brokerage fees in recent years have fallen more than 90%, and are still falling. Transaction costs and financial friction are decreasing. In physics terms, we are increasingly removing the viscosity from the financial system. Money that yesterday moved at the speed of molasses, now flows like water.
- Increasing financial momentum: More wealth than ever is moving faster through the global financial pipeline. Countries, through deregulation, privatization, and revamped laws, are opening up their systems. Again, in physics terms, as viscosity falls and momentum rises, fluid flow makes a transition from stable to unstable.
Consider a kitchen faucet. Water in the faucet transitions from laminar to turbulent when the tap is opened wide. The same is true with all fluids that flow through pipes, ducts, or over the wings of an airplane. Waves, oscillations, and shocks all multiply when more mass flows with less friction. Attempts to put financial circuit breakers in place to replace the disappearing financial friction are misguided attempts to stick a thumb in a breaking dam.
The new technology applied to the global financial system will increasingly destabilize regions, nations and specific companies. However, the increase in financial turbulence is not only disruptive, but also healthy. After all, most socialist countries in the past were financially stable but rotting at the core.
True turbulence is disruptive and wasteful of energy, but also a sign, like bankruptcy, of healthy dynamic capitalism. The new liquidity and momentum will keep global markets healthy and innovative. However, they also will place additional pressure on strategists to think thorough the implications on their own company's strategic actions.
US versus Europe, Japan
It is clear that the fastest growing markets for goods and services will be in the Asian theatre. Latin America should also generate high levels of growth for goods and services. However, where will most investor funds flow to in the near and medium term? In brief, which country's companies will most benefit from investor flow of funds - funds that can be used to build up dominate businesses?
The answer to these questions is the US. This will have strategic importance for Asian and European petroleum, chemical, technical service, and engineering contractors.
The flow of funds would allow American firms to dominate in the fast growth markets. The main reason is that the populations of Europe and Japan are aging rapidly and they are saddled with state pension schemes that are essentially bankrupt. Population levels will drop dramatically in coming years in Europe and Japan with an insufficient number of young people to support the costly social structure. Therefore, older people with money to invest from Europe and Japan will continue investing in the US, not their home countries. This will harm European and Japanese industry.
Another problem preventing European and Japanese industry from fully modernizing and restructuring is underdeveloped shareholder rights. In the US, pension funds are mostly in private hands and are subject to strong pressure for performance from investors. In Europe and Japan most pension funds are in the hands of government agencies and not subject to shareholder pressures. Consequently, performance results are generally below those in the US, with the result that Japanese and European investors continue to channel more of their investments into American funds.
Since the start of 1996, the total return (capital appreciation, plus reinvested dividends) of the Standard & Poor 500 index has exceeded the return of the Bloomberg European 500 by a whopping 16 percentage points. It is this state of affairs that will give the American-owned firms a strategic advantage and that strategists involved with the hydrocarbon industry must carefully consider.
Contrary to conventional wisdom, the pace of overall change washing over the hydrocarbon business is no worse and considerably better than that of many other industries. The rapid pace of change today is definitely manageable in our judgment, if top management can capably understand its' role and the tasks ahead.
Compared to the information industry, for example, oil and chemical industry price adaptations are actually quite modest. For example, in 1973, a megabyte of semiconductor memory was priced at $555,000. Today, the cost for the same megabyte of memory is less than $4.00. That kind of price fluctuation really does require extreme adaptation on the part of senior management. Successful top management at information technology firms are playing the role and completing the thinking tasks required.
The key to successfully dealing with the difficult changes impacting the oil, chemical, technical services, and engineering contractor industries is an effective top management team. The management team must identify, examine, and decide on a course of action regarding important issues, such as the growing role of intellectual capital. Too often, the top management team focuses on operating issues or activities of personal interest, leaving the real work of upper management undone. Consequently, too many oil, chemical, and contracting firms are floundering.
Every management unit in a company is based on performing a specific task (finance, marketing, manufacturing, for example). However, top management is different; its job is multi-dimensional. There is no single top management task, only top management tasks.
Top management's primary task, among many, is to set objectives and develop strategies that allow a company to make decisions today that will positively impact tomorrow's results. This requires that top management think through the consequences of the forces of change reshaping the industry. Only top management can perform this crucial role, since it alone sees a business in its entirety.
Or changing management
Why are top management teams in the hydrocarbon industry often not performing the roles and tasks of their station? One reason is that some top executives are more interested in functional operating activities. In essence, they continue to perform their former jobs. By way of illustration, this is what happens when an engineering contractor sales executive becomes president, and then spends all of his or her time visiting clients and reviewing sales data.
Another common reason why top management fails to complete all its tasks is that there is no top management team - only a top executive. Top management work is work for a team, not one man or woman. No one person has all of the skills, experiences, and temperaments needed to complete these tasks. A one-person top management is a continuous gamble and succession of crises.
Conventional wisdom today is to disparage corporate overhead, labeled as wasteful and useless. However, top management should be thought of like a brain in a human body, which requires about half of all the oxygen and energy in the body to function properly. In a sense, the human body is organized to nourish, stimulate, and provide energy to the brain. Similarly, a corporation needs a special organ to nourish and stimulate the top management team to get optimal results.
Most oil, chemical, technical service and contracting companies have staffs producing reams of data and information for management review. Unfortunately, the staff services within the typical hydrocarbon firm are set up to support operating management, not the needs of top management teams. Even the most advanced SAP and Oracle information systems provide insights that are most useful only to the financial and operating functions of a company. Too often, top management is starved for proper nourishment and stimulation.
The needs of the top management team are different than those of the operating executives. They are concerned with the whole business, not a part, and with the future, not just the present. Thus, their information and stimulation needs are quite different. Top management needs a special staff or cell that can supply the stimulating oxygen of thinking, knowledge, and good questions. A qualified staff that can help top management better understand and come to grips with the difficult issues presented here.
This type of top management organ is rare in the oil and chemical industries, and almost unknown in the contractor field. Nevertheless, its introduction in some firms will be critical to future survival. It is well to remember that no company or industry can be better than its top management permits. After all, the bottleneck is always at the head of the bottle.
Note: Transmar Consult, Inc. is a Houston-based consultancy.