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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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Global Crude Oil Prices: Four Defining Issues

Global crude oil demand has declined over the past few months, due principally to sluggish economic activity, particularly in the United States and Europe but also to higher crude oil prices. For example, MasterCard in its Spending Pulse, reported about a fortnight ago that U.S. retail gasoline demand declined significantly over year-ago levels while crude oil prices rose by more than 30% over the same period.

While some investors are still bullish on oil stocks, a good many are thinking otherwise. Four issues will most likely define the future of crude oil prices:

The Global Economy

Global stocks last week, ended their worst quarter since the 2008 financial meltdown. According to Financial Post, the MSCI All Country World Index, had by Thursday last week lost about US$4.7 trillion in market capitalization; and for the Wiltshire 5000 index — the broadest measure of U.S. stocks — that loss was US$2.2 trillion.

The International Monetary Fund last week warned that the global economy was at risk of a double-dip recession. The United States Federal Reserve Bank also warned that the country’s economic growth was disturbingly sluggish. In the event of a protracted second dip, the impact on the already-troubled European and U.S. economies could be devastating and would most likely spur a global knock-on effect. The result would most likely be a slump in crude oil demand, putting downward pressures on the commodity’s prices.

Many analysts had proffered that the decline in oil demand among OECD countries would be offset by an increase among the emerging markets, particularly China; and that was supposed to bolster crude oil prices. That, however has not been the case. Though total OECD petroleum consumption declined in the first half of 2011 compared with the previous year, that for non-OECD recorded only a lower growth rate (Table 1).

Indeed, China’s implied oil demand (domestic refining throughput plus net import) fell to a ten-month daily average low in August, Platts reports. While the country’s consumption of oil products has grown over the last few months, the growth rate has declined significantly. In July for example, it recorded four consecutive months of decline in crude oil imports, according to the Center for Global Energy Studies, CGES. And the prospects for a rapid rebound are somewhat precarious: the sluggish global economic activity may impact the country’s export-oriented manufacturing capacity as may domestic debt and inflationary pressures which, for some time have been of concern to the country’s leadership. In what may also be of concern not only to China but the global economy, China’s manufacturing sector shrank for the third consecutive month.

Risk Premiums and Speculative Activity

The prices for crude oil, as those for commodities in general, should in theory be defined by market fundamentals; but that has often not been the case. For example, in 2008, global crude oil prices spiraled higher to a record US$145 (approx) per barrel even while the market was well-supplied. The spike was attributed to massive influx of speculative investment capital which fled the troubled housing and other markets. Again, as much as US$20 per barrel in risk premiums associated with the MENA region unrest, was probably added to Brent prices earlier in the year. Current Brent and WTI price levels may reflect some risk premiums.

The last may not have been heard about these regional crises and the current object of scrutiny is Saudi Arabia. The kingdom holds the world’s largest oil reserves, exports the largest volume of the commodity and boasts the largest spare production capacity. Any disruption — perceived or real — in the country’s production would most probably propel global crude oil prices to record highs.

Perhaps mindful of developments in MENA countries such as Tunisia, Egypt, Libya, Bahrain and Syria, Saudi Arabia’s monarchy is set to spend more than US$43 billion on palliative projects. Only last week, the king announced that for the first time, women would be allowed to run for public offices.

It is clear that socio-political changes will come to Saudi Arabia. What is not too clear however, is what manner those changes will assume; and that will most likely determine the trajectory of global oil prices in the short to medium term.

Demand Destruction

The United States alone currently accounts for just under a quarter of the global crude oil consumption, and as such its oil demand profiles are always of interest to analysts. One particular aspect of that profile stands out: while the country’s GDP has rebounded to pre-recession levels, its oil consumption is still about 1 million barrels per day below those levels; and it is unclear if that demand shortfall will be recovered. In the event that it is not, and if the trend is sustained and extended to other — particularly OECD — countries, then global oil prices will most likely see downward pressures.

Capital Expenditure

Capital expenditure (capex) in the oil and gas sector is necessary for sustaining oil and gas output. For most oilfields, there is usually an average of 5 to 8 years from development to beneficiation and when there is a break in developmental funding, that beneficiation is often delayed.

The International Energy Agency (IEA) and the oil super major, Shell, a few days ago projected a steep rebound in global crude oil prices. They held that low capex regimes occasioned by low crude oil prices would cripple reserves additions which would in turn lead to a supply crunch as demand spikes with a rebounding global economy.

In 2009, IEA rather ceremoniously projected — and for the same reasons — an oil price shock within three years, to wit in 2012 (next year). In my analysis at that time, l maintained that even if an oil price shock were to take place in 2012, it would most likely show no market fundamental support. There is currently no indication of any such support for an oil price shock next year nor is there likely to be.

To be sure, a very deep economic recession — and many analysts are currently projecting such — could bring global oil prices to capex-crippling lows. That said, Brazil’s ultra-deep, pre-salt production has a breakeven price of about US$40 per barrel while for Canada’s oil sands, that value is about US$60 per barrel. Even the massive resources of Venezuela’s Orinoco belt have breakeven values of about US$55 per barrel. With Brent prices currently about US$100 per barrel, project economists around the world are probably sleeping easy.

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Three Reasons Why Crude Oil Prices Will Stay High

Global crude oil prices have risen significantly since the beginning of the year, largely driven by the unrest in the Middle East and North Africa (MENA) region. Brent prices for example, rose by more than 21% between the beginning of the year and the end of March; but with the seeming adaptation by markets to the risks associated with the unrest, as well as the recent advice issued by Goldman Sachs to its clients to sell their investments in oil, investment decisions have focused on a possible crude oil price collapse and its implication for oil stocks.

Fundamentals

The MENA unrest has undoubtedly added to recent global crude oil prices but it is worth noting that the latter were already on an upward trend since 2009 (See Figure 1 below), bolstered largely by strong emerging market demand in a rebounding (even if sluggish) global economy.

However, recent spikes such as the thirty-month highs seen about a fortnight ago may reflect more of a risk premium than any fundamental tightening since there were, and currently are no near-term shortfalls in supply projections. About the same period for example, Energy Intelligence reported that global crude oil production exceeded demand by about 500,000 barrels per day, bpd; and last week, the Saudi Oil Minister revealed that the country’s crude oil production for the month of March fell by 833,000 bpd from February’s production levels due to lower demand.  Though the International Energy Agency, IEA, in its latest report held that growth in global oil consumption for 1Q’11 dropped to 2.6% from the 4.1% recorded in 4Q’10, that may be set to change; the second quarter typically sees an uptick in crude oil demand even as refineries return from maintenance.

Outlook

That said, high crude oil prices boosted energy stocks during the first quarter of the year. The Energy sector at S&P for example, showed better than threefold return over the market average (See Figure 2 below).

Though there may be dips or corrections, crude oil prices would probably remain high and for three reasons:

First, emerging market demand has been a strong driver for oil prices in recent years and even when the economies of China and India declined in 2008 for example, their total petroleum consumption increased. Oil demand in many of the emerging economies is driven in the main, by subsidies, which, given their rather low socio-political flashpoints may not be removed anytime soon; and that raises fears of inflation. China, in an attempt to curb inflation recently increased banks’ reserve ratios by 50 basis points to 20.5% but only allowed domestic fuel prices to rise by a smaller rate (5%) than the rate of increase (14%) for its reference crude oil basket. These may not translate to any significant reduction in the country’s oil consumption though the longer-term sustainability of these subsidies remains to be determined.

In spite of rising oil prices, the Asian Development Bank expects a growth in the region’s economy, of 7.8% and 7.7% for 2011 and 2012 respectively. According to Financial Times, while European crude oil demand for February was largely flat, that for Asia was up 5.9% (China’s up 9.6%) and that for the U.S. up 2.9% (possibly rising higher in the summer or driving months).

Secondly, despite pockets of problem zones, the global economy is seemingly set for growth, and with it crude oil demand, even if in the medium-term. The International Monetary Fund, IMF, in a recent report for example, expected global economic growth for 2011 to be 4.4%. In addition, the Organization for Economic Co-operation and Development estimated the annualized 1H’11 growth rate for its G7 member-countries (exclusive of Japan) to be 3%. However, a major oil price shock, especially if sustained, would most probably end all such growth prospects. Current crude oil price levels inevitably draw comparisons with the record values of 2008. Energy Information Administration (EIA) data show that in 2008, average prices for Brent and West Texas Intermediate (WTI) crude oil grades were US$96.94 per barrel and US$99.64 per barrel respectively; for 1Q’11, the values were US$104.96 for Brent and US$93.54 for WTI.

Finally, quite a few members of the group, Organization of the Petroleum Exporting Countries, OPEC, have embarked on various elaborate short- to medium-term projects which require certain oil price levels to break even. Estimates for these levels range from US$79 per barrel to US$92 per barrel and would be significant factors in setting target crude oil prices. This is compounded by the group’s rising domestic oil consumption profiles which, if sustained, would amount to between 35% and 40% of its total production in a little more than a decade. The consequent reduction in available export volumes would further tighten global supply, putting upward pressures on prices.

 

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