Given climate change and the transition toward cleaner energy sources are constantly in the headlines, lenders and institutional investors are increasingly interested in S&P Global Ratings view of Gulf banks' exposure to energy transition risk, and how we factor it into our ratings.

In this report, we look at Gulf Cooperation Council (GCC) banks' exposure to sectors directly affected by this risk, including oil and gas, mining and quarrying, manufacturing, and some power generation and public-sector lending. Our findings show that exposure to these sectors accounted for about 12% of GCC banks' lending (14% of rated GCC banks) at Dec. 31, 2018. Saudi Arabian and Qatari banks have the highest concentrations, at about 15% of lending at Dec. 31, 2018, linked to the extensive oil and gas production in these countries. United Arab Emirates (UAE) and Kuwaiti banks have the lowest concentration, at about 10% on the same date, which is explained by the higher diversification of the UAE economy and significant retail and real estate exposure in Kuwait. In our view, the effect of energy transition on oil and gas prices and investor appetite will be an important factor for the long-term creditworthiness of GCC banks. If oil and gas prices or investor appetite were to decline significantly, GCC banks could be affected through the potential deteriorating creditworthiness of their exposures to these sectors and the overall bearing on their economies. This is due to a lack of diversification and, for some systems, the lower availability of external funding sources.

How Can The Energy Transition Affect GCC Banks' Creditworthiness?

Banks' exposure to energy transition in the GCC can take several forms. In this study, we have limited ourselves to two that we consider relevant to GCC banks' creditworthiness. These are:

Credit risk

This risk can be direct, through banks' exposure to companies depending on oil/gas price performance, and indirect, through the overall effect on the economy and government financials given GCC countries' high reliance on hydrocarbons.

Lower investor appetite

This risk could take the form of a change in customer or investor behavior. Higher awareness of carbon transition could mean deposits or lending are shifted to another bank or region deemed more alert to such risk. This is particularly relevant for banking systems with high dependence on external funding, such as Qatar.

The GCC's Most Exposed Sectors To The Energy Transition

Given the structure of GCC economies, we focused on banks' exposure to oil and gas, mining and quarrying, manufacturing, and a portion of power generation and direct lending to the government. We chose these sectors due to their direct or indirect vulnerability to transition risk. When compiling the data, we used assumptions due to the lack of granularity of banks' disclosures. Our assumptions were informed by our analytical views on the banks that we rate in the region. For example, large oil companies in the GCC tend to be government-related and banks typically do not publicly disclose the breakdown of their government exposures by sector. We therefore took some assumptions based on large rated banks' exposure, including that 30%-40% of government exposure is to companies in sectors subject to energy transition risk. This approach likely gives a good view of the direct exposure to these sectors but ignores the indirect risks. The oil and gas sector is vital for GCC countries. Other sectors tend to correlate with its performance either directly through the supply chain or indirectly through government spending or consumer sentiment and spending. For example, when oil prices declined in 2014, real estate prices dropped materially.

How The Transition Affects Oil And Gas Prices Will Determine Its Bearing On GCC Banks

In charts 1 and 2 we summarize overall and rated banks' exposure to the identified sectors. This shows that, on average, 12% of banks' lending portfolios were concentrated on these sectors at Dec. 31, 2018.

Chart 1

As stated, Saudi and Qatari banks have the highest exposure to these sectors given that their countries are among the largest producers of oil and gas. UAE and Kuwaiti banks have the lowest exposures due to higher economic diversification and stronger exposure to the real estate and retail sectors respectively. We note that this exposure has remained stable over the past three years.

Chart 2

We also see a slight variation in individual rated banks disclosures and sector-level disclosures. This is because we typically rate the largest banks in these countries, which often have significant corporate and government/government-related lending activities. Since we expect stable oil prices in the next 12-24 months, we do not forecast this exposure will have any effect on GCC banks' creditworthiness in the same period. However, the effect of energy transition on oil and gas prices will be an important factor in the long term. If oil and gas prices were to drop significantly, GCC banks could be affected through the potential deterioration of the creditworthiness of their exposure to the identified sectors and the effect on their economies given the still-significant footprint of hydrocarbons. We believe that these processes are poised to accelerate but will take time to materialize, which gives countries some leeway to push their economic diversification agenda more aggressively.

We note that if transition results in lower investor appetite for instruments issued by GCC banks, Qatari banks' liquidity might be affected given their significant reliance on external funding (see chart 3).

Chart 3

Previous Rating Actions Are Partially A Consequence Of Concentration On A Single Sector

S&P Global Ratings has taken several negative rating actions on GCC banks over the past five years due to significant changes in their operating environment following the sharp decline in oil prices from 2014. This affected strategic sectors such as real estate and weighed on the creditworthiness of some GCC sovereigns, indirectly pressuring bank ratings through governments' reduced capacity to provide extraordinary support if needed. We expect oil prices will remain relatively stable in the next 12-24 months. However, the effect of the energy transition on oil and gas prices will be an important factor for GCC banks' long-term creditworthiness.

We also currently reflect concentration risk in our GCC bank ratings at the:

Sector level

For example, in our economic risk assessment for Qatar we take into account the volatility of wealth levels resulting from the high contribution of hydrocarbons.

Bank-specific level:

This is generally a negative factor in GCC banks' risk profiles. The top-20 loans typically account for 20%-30% of total exposures for regional rated banks. Within the top-20 exposures, we regularly see exposure to national champions, including national oil or petrochemical companies. Although the long term effect of energy transition on these companies' creditworthiness remains uncertain, they seem well positioned compared with their industry peers in terms of investment needs and average production costs. .