Oil and Gas Investment: Three Noteworthy Issues

The European sovereign debt and currency crises as well as a very sluggish global economy led many analysts last year to project lower crude oil prices for the year 2012. However, in a seemingly counter-intuitive measure, oil and gas companies substantially increased capital expenditure (capex) provisions for the year (See Figure 1 below).

With increasing geopolitical tensions — especially in the critical Middle East region — and concerns over a precarious global economy, investment prospects in the oil and gas sector have come under greater scrutiny. Three issues then, are noteworthy:

Oil Price levels

High oil prices most often conduce to higher returns for operating companies (and good news for investors). Even when these companies have recorded production declines (as has sometimes been the case with some of the majors), high oil prices have boosted profits.

 Oil prices have been on the increase. The price for the global benchmark, Brent for example, has risen by about 15% since the beginning of the year, and just a few days ago reached its highest level since 2008. The increases have been in spite of weak global demand. According to the International Energy Agency (IEA) for example, 4Q 2011 demand fell by 530,000 and 690,000 barrels per day (bbl/d) year-on-year for North America and Europe respectively, in a net global (albeit slight) decline. In the United States, total petroleum product demand measured on a four-week-average basis fell by 6.7% to 18.054 million bbl/d year-on-year the week ending 17 February 2012, the Energy Information Administration (EIA) reports. That value was the lowest since April 1997.

Gasoline prices show fairly high correlation with crude oil prices. In the U.S. for example, even with falling gasoline demand, pump prices have been on the increase (See Figure 2) and will probably remain high for as long as global crude oil supply issues remain. Crude oil prices are internationally set; and so except for an improbable price enforcement by the U.S. government over domestic producers, the idea that increased U.S. domestic oil production will lead to lower domestic petroleum product prices is misplaced.

Global oil prices are unlikely to fall substantially for some time to come even with demand growth among OECD countries projected to be largely flat through 2030. Of course there would be the usual spikes and dips but issues such as a potential Israel-Iran flash point, capex delays in the MENA region (which according to the IEA would account for 90% of the world’s marginal production increase through 2035) as well as countervailing demand growth among emerging markets (particularly the Asia-Pacific Region, see Figure 3 below) would most probably sustain prices. In addition, production among non-members of the Organization of the Petroleum Exporting Countries, OPEC, has often fallen short of forecasts, Iran’s output has been severely curtailed by sanctions, Japan is ramping up imports to replace offline nuclear power capacity and OPEC’s spare production capacity looks set to be critically tested.

Mergers and Acquisitions

When share prices are depressed in equally depressed, cost-of-money regimes, windows inevitably open up for Mergers and Acquisitions (M&A). Last year, Canada’s “unconventionals” for example — relentlessly buffeted by environmental groups and weighed down by low valuations even when largely profitable — looked particularly amenable. Another round of acquisitions since gas-seeking U.S. players took advantage of low Canadian dollar rates about a decade ago, loomed large. Bigger operators such as Encana and Talisman have large natural gas (and oil, in the case of Talisman) assets as well as better financial standing to make them attractive. Mitsubishi Corporation recently acquired a 40% interest in Encana’s Cutbank Ridge Partnership. That however was not a replacement for PetroChina which last year pulled out of a $5.4 billion deal for a 50% interest in Encana’s Montney shale play due to a disagreement on terms.

As the oil and gas majors continue decoupling of Refining and Marketing (R&M) assets, niche-focused independent operators in the U.S. look set to dominate that subsector. These independents have often proved more efficient in their respective niches than the majors. For example, independent Exploration and Production (E&P) as well as R&M companies reported much higher share price gains year-on-year in 2010 than the majors.

Outside North America, deep offshore assets are set to witness a lot of activity, continuing from last year. In Northwest Europe for example, where drilling operations declined 12% in 2011 according to Argus, there were 118 deals as more prone companies sought relief from financial risk.

Natural Gas Production Levels

Technological advances such as hydraulic fracturing and horizontal drilling have opened up access to very large volumes of natural gas in the United States and increasingly in other parts of the world. However, the massive supply overhang and the consequent depression of prices have led to consolidation and refocusing in the industry. Smaller, financially prone producers have been taken over by bigger corporations and liquid-rich plays have become more attractive. Producers are also turning to Liquefied Natural Gas (LNG) production; but such is the rate of capacity expansion, that a global glut may develop by the year 2018, just six years on, according to a PennEnergy report; for the U.S. that would mean another wave of depressed natural gas prices and possibly, further restructuring in the industry.

Beyond the medium term however, natural gas prices would probably rebound with increasing demand (especially for power generation) and prospects of supply constraints. The latest estimate of U.S. recoverable shale gas reserves made by the country’s Department of Energy saw a 42% decline over previous-year levels.

 

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5 Responses to “Oil and Gas Investment: Three Noteworthy Issues”

  • U.S. refiners are experiencing a crack spread imbalance: the current rate of gasoline price increases do not cover the rate of oil price hikes. I agree that oil prices will not drop significantly over the next few years; matter of fact there is even the possibility of $150-200 per barrel levels. The implication is that there could be even greater divestment and consolidation in U.S. R&M.

  • $4 per gallon gasoline + high oil prices + election year = muck politics. Sometimes l wonder if or how those GOP candidates made it through college.

  • The current high oil prices are not as a result of a supply crunch and that’s a big relief.

  • Good assessment, Dennis. I believe natgas prices in the United States will remain low for quite a few years. The rise in oil prices in spite of weak demand shows an upside for global economic recovery.

  • LSES:

    Well, as long as there is no actual supply crunch, I think the economy should be able to bounce back!

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