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Updated on July 21, 2001

The KSE-100 Index dropped by 52 points to close at 1260 on Friday, July 20 versus previous weeks' close at 1312 on July 13. Between June 15 to July 18, the Index had already lost 100 points YTD, the Pakistani market is down 16%, making it one of the worst performing markets in Asia so far in 2001, along with India and Hong Kong.

Unlike Hong Kong where fears about the dollar-peg and macro-level impact of Argentinean financial crisis have hit sentiments, the fall of markets in the Sub-Continent has been due not only to foreign selling pressure but also homegrown issues. The commencement of T+5 and T+3 rolling settlement systems in India and Pakistan respectively, has massively hit volumes (i.e. speculative activity) in both countries. In India the UTI crises in the largest US-64 mutual fund has compounded negative investor sentiment. In the case of Pakistan, the sheer lack of depth in the stock market and unregulated badla financing in the past few months appear to be the main cause of current woes. The last 150 points of the prolonged decline in the KSE-100 since 1Q01 can be chronicled and analyzed as follows:

•1Q01= Morgan Stanley Pakistan Fund sells out a part of liquidation of its Pakistan Fund Investment Portfolio amount is approximately US$35-40mn or about PkR2.3bn.
•1Q01= Domestic financial institutions and brokerages raise the quantum of badla financing. Badla volumes begin climbing back to Rs.5bn levels. At the same time, the SECP disallows blank selling and puts further restrictions on short sales.
•2Q01= Foreign selling continues as MSCIís free float index halves Pakistan's already tiny weight in its universe. Generalist global investors and remaining index funds sell out of Pakistan stocks.
•2Q01= Domestic financial institutions, seeing the continual selling step away from the BUY side and instead begin to get even more aggressively involved in the badla business, which gives them a clear spread of 4-6% on their cost of bulk funds. This allows weak-holders to continue building position and foreigners to continue exiting at higher levels. Contrarian investors who used to take a bearish stand and push market down sharply are unable to do so thus creating artificial sense of security for badla financed weak-holders.
•3Q01= T+3 commences, foreign selling continues in bouts and financial institutions now begin to get nervous about weak-holders' ability to hold on to their shares. Regulators push some large players to reduce long-positions. Prudential Bank crisis erupts and several heavy speculative brokerage houses come under NAB investigation. Weak holders now panic and brokerage houses force several large ones to liquidate positions.
•3Q01= Unrealistically optimistic expectations about the Agra Summit remain unfulfilled and market sentiment turns very negative. Despite the market moving to a lower zone of neutral territory, players simply dump their trading holdings. The market falls around 150 points over a 5-week period ending on Friday, July 20, 2001.

Now had the financial institutions and brokerage houses not jumped onto the bandwagon of badla financing so aggressively in 1Q01, and instead gone into the stocks themselves, the huge excess of scrip liquidity would not have built up in the first place.

Which brings us to the next part:

What next?

There are several questions to be addressed regarding future outlook of the market.

1. Will the foreign selling continue and if so, how much and for how long?
2. Will the recent sell-off significantly reduce badla financing so that genuine investors can slowly begin accumulation?
3. Are market fundamentals in term of corporate earnings outlook and stock valuations now sufficiently attractive for longer-term investors to even look seriously at Pakistani equities at this point in time?
4. Will the T+3 system in itself come under scrutiny as far as exchanges are concerned, given the sharp reduction in trading volumes and thus concurrent fall in brokerage commission income?
5. Will the change in tax rules on dividends lead to a significant fall in payments by the corporate sector and thus permanently damage domestic investors' interest in locally listed stocks? This begs a more fundamental question: Do dividends (dividend policies) matter?
6. What should investors do going forward from here, in the light of the issues raised above?

Sector Review

Oil Marketing Companies- FY01 Earnings Preview

The FY01 results season for OMC's will soon be upon us. Thus while the overall market continues to be under pressure due to various technical and regulatory (T+3) reasons, it may be a good time to assess how the OMC sector has performed in FY01 and what is the likely outlook for FY02 earnings.

Before we start discussing the financial results of the OMC sector, we might want to take a look at some important drivers of growth for the sector. The OMC sector growth is dependent upon two main drivers, as follows:

1. Consumer Prices: The GoP has recently allowed the OMCs to set end consumer prices with but the gross margins still fixed. The end-prices (consumer) are officially set by Oil Companies Advisory Committee (OCAC), but with government maintaining indirect control via indicating max limits, except for lubricants. Thus while prices are likely to follow international petroleum price trends, there would be lags and not necessarily a close correlation at all times.
2. Volume: Change in volume sales by a company (PSO, SHELL, CALTEX) flows directly to the bottom line thus enhancing the return to its shareholders. The volume of sales is in turn dependent on the demand for POL products. The demand for the POL products is directly driven by the economic activity. A slow down in economic activity results in declining sales volumes for the OMCs and vice versa. The major demand generating sectors for the POL products in Pakistan are Power and Cement (FO), Transport (HSD) and Industrial Lubricants consumers.

a) Power sector in Pakistan has always been the major consumer of furnace oil (FO) with 75.6% of total volumes sold in the market in 2000 alone. The main supplier, PSO, controls over 90% of the market share in FO due to its large infrastructure and storage capacities. Due to the rise in international oil prices, the cost to import oil has also risen considerably. In 2000 alone, the total imports stood at US$10bn with cost of petroleum imports at US$3.0bn or 30% of the total. This prompted the GoP to look at alternative source of energy — natural gas and coal. In our opinion, the shift from oil to natural gas by power sector companies would seriously hamper the sales of PSO, going forward. On the other hand Shell, which has a much smaller share of the FO market, is relatively more insulated to this change in FO demand.

The cement sector, which consumes around 1.6mn tonnes of FO, has also been asked by the GoP to shift its focus from FO to coal for heating the kiln. We believe these moves would have a negative impact on long-term demand for FO — and the implication is that PSO might be hurt more than Shell and Caltex.

b) The transport sector of course is a major demand driver of the OMCs. Demand by the transport sector for High Speed Diesel (HSD) is linked closely to the agricultural activity in the country. Transport sector's demand for HSD stood at 94.47% of total consumed in 2000. PSO controls over 60% of the market share in HSD where as the rest lies with Shell and Caltex (not listed). Here, we believe that PSO, with its larger market share and storage capacities, has an advantage over its competitors. As against power and cement sectors, the transport sector led demand for HSD could prove to be the main driver of sales growth for the OMCs.

c) The OMCs focus aggressively on Industrial consumers of Lubricants for increase in their net profits. Growth in demand of Industrial lubricants occurs mainly on the back of higher economic activity. With no controls by the government on end consumer prices, the companies compete aggressively in increasing their market share. Shell, we believe, has an advantage over PSO with its international expertise whereas PSO has been struggling lately to keep its existing market share, as competition from new sources (BP-Amoco, PARCO) has also started.







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