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Energy Subsidies and the Global Economy

The government of Bolivia last week issued a decree revoking consumption subsidies on some petroleum products. The action sparked a wave of strikes by trade unions as well as civil groups. Prices of diesel in the country increased by 83% while those of low- and high-octane gasolines increased by 73% and 57% respectively. Following meetings with various union and civil society groups, Eva Morales, the country’s president reportedly reversed that enabling decree .

The International Energy Agency, IEA, in a recent report estimated the total fossil-fuel subsidy for the year 2009 at US$312 billion compared with US$57 billion for renewable energy. It also estimated that eliminating fossil fuel subsidies by the year 2020 would reduce carbon emissions by almost 6% while reducing energy demand by about 5% at that time.

Many countries – developed and developing – retain subsidies for various products in sectors such as energy and agriculture. According to the Energy Information Administration, EIA, for example, total fuel-specific energy subsidies in the United States for financial year 2007 was US$7.435 billion; and fossil-fuels accounted for most of that.  For many of these countries then, the issue of eliminating both production and consumption subsidies constitutes a political minefield. Lobbyists and interests groups wield formidable influence in developed countries while for developing countries, the prospects of a “Bolivia” response are daunting; in Pakistan, a vote of confidence in parliament looms large as an ally in a tenuous coalition bolted citing the 9% increase in gasoline price just a few days ago.

That said, there are in the main, three energy subsidy issues that impact the global economy:

First, international crude oil prices. Energy demand by developing countries has been on the increase; for many of the oil-exporting countries among them, the hike in demand has been boosted by significant levels of consumption subsidy, according to the Center for Global Energy Studies, CGES in London. The CGES reports that during the period 1998-2010, while global crude oil demand grew by 1.2% per year, the demand growth for members of the Organization of the Petroleum Exporting Countries, OPEC, was 3% per year. The import then is that the increasing domestic demand would place constraints on export quotas, a possible driver for higher international crude oil prices. The head of Saudi Arabia’s Saudi Aramco, last year warned that domestic energy demand could rise from 2009’s 3.4 million barrels per day of oil equivalent to 8.3 million barrels per day of oil equivalent by 2028, citing inefficiencies; oil and natural gas are used for generation of heavily-subsidized electricity in Saudi Arabia.

Many of these producer-nations have also embarked on very capital-intensive, medium-term national development programs which require crude oil prices of between US$59 and US$76 per barrel for break-even. It is therefore unlikely that they would be averse to higher, international crude oil prices.  One frightful aspect of resource-driven boom is that for unprepared countries, price-collapse is usually devastating.

Secondly, the issue of inadequate energy prices among many oil and gas producer-nations, has stifled capital investment and therefore supply. In resource provinces where natural gas is associated with oil, operators elect to flare the gas and exploit the oil rather than invest in gas infrastructure which would not provide adequate returns. For mostly natural gas provinces, investment is almost non-existent for the same reason. According to Oil and Gas Journal, Nigeria for example held 185 trillion cubic feet, Tcf, of natural gas as at January 2010, giving her the world’s eighth-largest natural gas reserves. The country, however flares a significant proportion of her natural gas production. The amount of natural gas flared in one year could easily meet some countries’ total energy needs for the same period. According to EIA, the country flared 532 billion cubic feet, Bcf, of natural gas in 2008. The country herself consumed only a total of 430 Bcf of natural gas (about 65% of which was used for electricity generation) in the same year. Of the country’s gross natural gas production in 2008, only about 50% was marketed.

The result is that in Nigeria, only about 47% of the people have access to electricity; those manufacturing companies that are still standing – many have fallen away – have had to invest in private power generation and that has increased operation costs by as much as 20% to 40%. However, the current president, Goodluck Jonathan, has instituted a complete overhaul of the country’s power sector with a new investor-friendly gas roadmap; but the country’s poorly regulated oil and gas sector has also led to an acutely  notorious lack of transparency as well as gas flare problems and oil spills more severe than the April 20, 2010 Gulf of Mexico disaster.

Finally, the sustainability of excessive energy subsidies. The steeply rising proportion of energy subsidies in national expenditure for highly subsidized economies has challenged their economic viability. In Iran, for example, inherent energy problems associated with high subsidies – until just December last year, gasoline prices were only ten cents a liter – have been accentuated by the recent series of asphyxiating economic sanctions spearheaded by the United States. According to TheNational, energy subsidies cost the country a third of her GDP. The degree of infrastructural decay is such that the country, which has the second-largest natural gas reserves is a net importer and the third-largest consumer behind United States and Russia despite having a smaller population. The situation with her crude oil is not much better. The lack of capital investment means that the country with one of the highest reserves could soon become a net importer. Even with the new US$0.40/liter price, the allowable monthly gasoline ration for each motorist would be meaningless in many countries.

Venezuela, with the world’s sixth-largest crude oil reserves is also an unenviable paradigm. A grossly mismanaged energy sector which has witnessed nationalization of assets and gasoline prices as low as US$0.07/liter has left little revenue for President Hugo Chávez to finance his ambitious 21st Century Socialism program. The result has been spates of food and power rationing and an inflation rate which the country’s own central bank put at 26.9% for 2010. The devaluation last week, of the country’s currency – one of several in the past and the second in the last twelve months – would probably add to her woes.

In Nigeria (the fifth-highest foreign supplier of crude oil to the U.S in 2009), the Petroleum Product Pricing Regulatory Agency, PPPRA, has reported that in the period between January 2006 and June 2010, about US$13 billion was expended to subsidize petroleum products. In comparison, provisions for total capital expenditure in the country’s 2011 budget amount to about US$6.4 billion. In that 2011 budget, recurrent expenditure takes about 59% of total outlay, boosted by politicians’ salaries and expenses. As reported, each Senator in the country’s legislature takes home about US$1.34 million per annum while a Representative takes home about US$848,000 per annum (not so sure how that stacks up with the U.S. Congress); and that in a country where about 7 in 10 people live on less than US$2 per day. The country’s central bank governor has at different fora inveighed against such massive fraud associated with her petroleum product subsidies and which make the exercise both meaningless and unsustainable. A Petroleum Industry Bill which was supposed to sanitize the country’s oil and gas sector has been languishing in the legislature; the Freedom of Information Bill, FOI, which is needed to enshrine transparency and good governance is also buried there in ten years of the chamber’s dust. One of the sponsors of that FOI bill has pointed out that the books of the country’s National Oil Company, are not subject to any legislative audit.

In countries such as India, China and even Pakistan, subsidy withdrawal processes have gained currency in bids to ease the rising burden on public purses.

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The Gulf of Mexico Oil Spill: Lessons in Due Process

The oil major BP is currently preparing for a “total kill” (an industry expression meaning a permanent plug) of the disaster-stricken Macondo oil well in the Gulf of Mexico. Attention is now shifting to determination of liabilities, an exercise for which legal gladiators have since been readying their swords and shields. Preliminary estimates of total liability to BP have been put at between US$30 billion and US$70 billion and its impact on the oil major as well as some niche industries may be severe.

Some industries as well as their regulatory bodies have seemingly failed to learn from previous disasters, a situation that has often compounded the severity of subsequent incidents. Recent accounts show the Macondo well disaster to have been “all too foreseeable”.

While many lessons from that Gulf of Mexico disaster abound, four, with regard to due process, stand out:

First, a weak, regulatory regime conduces inevitably to poor service delivery. Many industries have proved incapable of self-regulation and the recent global financial crises constitute a painful testament to that. According to U.S. Department of Interior documents, federal officials with oversight duties for Gulf of Mexico drilling, used illegal drugs, watched pornography at work and accepted gifts from oil companies (which they were supposed to supervise). The Mineral Management Service MMS, as it was then called, reportedly rubberstamped BP’s drilling plans and exempted the oil major from oil-spill response and prevention plans. One of the worst mine disasters in the United States during the last four decades resulted in the main, from weak regulatory oversight as did the current salmonella outbreak which has seen the recall of over 500 million eggs.

Presentations at a committee of the National Academies of Science currently studying the April 20 explosion at the Macondo well in the Gulf of Mexico, have indicated gaping regulatory and operational loopholes that need to be properly addressed by proper regulations if such accidents must be prevented in the future. However, much more important than such regulations, is the will to enforce them and to make regulatory officers accountable for their assessments (or lack thereof). Unenforced regulations or opaque regulatory processes are as good as no regulations and often breed a culture of graft.

Secondly, for operators, the gains from skimping on due processes are often ephemeral and do not justify the much larger, associated losses of the medium and longer term. The oil major BP, racked up quite a disproportionately (if not notoriously) large number of safety violations; and while a final report of findings on the Macondo well disaster is yet to be issued, there are clear indications that due processes were not employed in some critical operational functions. For example, as reported, certain critical integrity tests were omitted while the design of some crucial systems was woefully flawed;  even supervisors aboard the ill-fated rig were reportedly aware one year earlier, of its disabled alarm systems, a situation that could prove crucial in liability considerations. The potential liability of that disaster would certainly be unsavory to BP and investors who saw shares slide by as much as 45% at one point.

Third, many oil producing companies, especially at their top management levels need to upgrade their public communication skills. They quite often bear such cavalier attitudes (even if unintended) that are inimical to the very corporate brands they represent. The verbal gaffes of Tony Hayward – CEO of BP – in the aftermath of the Macondo well explosion, made him a proverbial “stench in the nostrils” of Americans, compounding the woes of the BP brand in their country; and when an incensed president Barack Obama joined the fray, the fate of Mr. Hayward was sealed.

At a U.S. congressional hearing on the Macondo well disaster, Tony Hayward, when grilled by impassioned lawmakers who were driven perhaps by public umbrage in an election year, was rather subdued and seemingly out of sorts. Oil executives are often more at ease among political claqueurs; but for a rather ill-advised congressman who apologized to BP for a US$20 billion “shakedown” (his interpretation of the company’s initial outlay to cover liabilities in the Macondo oil well disaster), the sudden volte-face was not unexpected.

Finally, the woeful lack of a proper, disaster or crises mitigation template was all too evident in that Gulf of Mexico incident; as it was in that of Hurricane Katrina and even arguably, in the last U.S. financial crises. The need for adequate contingency procedures is often lost in massive political dunghills, especially when interest groups hold substantial financial or other influence. For many industries, advances in operational technologies have over the years outpaced regulatory capabilities – or perhaps more appropriately, regulatory functions have been mindlessly relegated for ease of progress in operational processes. The result is that when such disasters occur, functionaries are hopelessly unprepared and this adds to the severity of the incident.

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Crude Oil Price Shocks and Market Fundamentals: An Update

The International Energy Agency, IEA, last year projected a crude oil price shock by the year 2012, just about two years away. The agency had argued that when the global economy began to rebound, crude oil demand would outstrip supply capability, the latter having been impacted by reduced capital expenditure (capex) associated with the global economic slump.
According to market reports, crude oil price reached US$80 per barrel in intraday trading on the last day of 2009, ending the year 78% up for the front-month contract on the New York market; that was more than twice the prices seen at the same period a year before. Price rallies saw some analysts adduce certain price markers, above which a surge would be triggered.

In a previous post on oil price shocks and market fundamentals, l argued, and for three reasons, that even in the unlikely event of a short-term oil price shock, such would be unlikely to show any market fundamental support. First reason was the somewhat, overstated figures for capex reduction as well as the increased viability of projects (due to reduced operational costs of mainly labor and materials) which arise from the economic slump; secondly, the increasing reserve additions; and finally, substitution and efficiency. Implicit in the reference above, to fundamentals, are the so-called “traditionals” or “physicals” such as inventories, demand and supply, as distinct from the “financials” such as currency values, bonds and equities.

Recent industry data do give credence to my arguments on all three scores:

1. Current data from IHS CERA and the U.S Department of Labor Statistics reportedly indicate that aggregate upstream capital costs  declined by 12% (year-on-year) in November 2009. The implication then is that even with reduced capital deployment (some recent reports put the capex decline at 15%), effective investment in the industry may at worst, be little changed while actual production may increase. The latter has been the case with Russia for example; the Natural Resources minister for that country, as reported by Platts, revealed that even with substantial capex reductions, reserves in 2009 grew by 5.3% over the previous year. Even the capital-intensive tar sands projects of Canada are set to benefit from such costs reduction. Capex values however, though currently lower than those for the period before the global economic  crises, have been increasing. According to Oil and Gas Financial Journal, capex in 2Q09 for the 20 largest U.S. publicly traded companies increased by more than 47.5%, nearly doubling the $28.1 billion spent in 1Q09.

2. Global crude oil production and reserves are also set to witness substantial additions (even in the short and medium terms). For example, Abdalla El-Badri, secretatry-general of the Organization of the Petroleum Exporting Countries, OPEC, as reported by Financial Times Energy Source has confirmed that “the current investment is going to be enough to satisfy demand and provide a cushion of spare capacity of 6 million barrels by 2013”. Rigzone reports that CEO of the Brazilian NOC, Petrobras says the company is on course to increase its reserves by 21 billion barrels from 2009 levels in just less than two years, increasing its production capacity in the process. In 2009, Russia’s addition to reserves exceeded  production by 25% and, though there are still political hurdles to be crossed, Iraq’s oil production is set to equal or exceed that of the long dominant Saudi Arabia in seven to ten years. Substantial capacity increases are also expected from the massive Atlantic provinces of Africa, where first production from Ghana’s 1.8 billion-barrel Jubilee fields for example, is expected later this year. According to Argus, non-OPEC supply grew by more than 500,000 barrels per day last year mainly from Russia and the Gulf of Mexico. It also expects 2010 oil demand to rise by 1.5 million barrels per day, bbls/d, after falling by 2 million bbls/d last year, adding that 2010 consumption is unlikely to exceed 2006 levels. These are in addition to large inventories. Interestingly, recent United States Geological  Survey, USGS, data have put Venezuela’s technically recoverable reserves in that country’s Orinoco oil    belt at a massive 513 billion barrels (about the world’s largest), out of about 1 trillion barrels. In truth,  though most industry operators know where Venezuela is, few if any, for the moment, would be rushing down there; but it could only take a regime change to spur fervent interest.

3. Finally, a steep rebound to robust, global economic activity, a major driver for energy demand, is not likely. The International Monetary Fund, IMF, for example, in its recent Global Financial Stability Report and World Economic Outlook press conference, expected global economic growth rates in 2010 and 2011 to be 4% and 4.3% respectively (another report has 2.7% for 2010). It also warned that recovery of the global economy remains rather sluggish and fragile (especially with fears of a ‘double dip’), and such is quite indicative especially when viewed in the light of the depths to which it slumped. Even when economic activity does fully rebound, oil demand in developed economies would most likely not return to pre-slump levels due mainly to substitution and increased efficiency. Driven principally by China and India, oil demand growth in emerging market countries is expected to outstrip that of developed economies; but product subsidies (many of which are now being repealed or reduced) in emerging economies often distort demand projection figures. According to the IMF’s Oliver Blanchard, China’s growth “is still partly based on very strong fiscal stimulus and credit easing” and some analysts have hinted at a scaling back  on fears  of economic overheating among others. It is also noteworthy that according to most evaluation accounts, China boasts the steepest growth rate in renewable energy development, matching her “aggressive” oil policies. The latter therefore may largely be interim and supplementary.

These factors largely do not admit a short-term (or even a medium-term) supply crunch, which has been projected as the driver for a short-term price shock. That said, prices may surge even with adequate supply. During the oil price surge of 2008 for example, prices spiralled higher while the market was well supplied. The causative factors were aptly described by Chris Cook, former Director of the International Petroleum Exchange (as quoted in an article on Oil-Price.net). He said “…the principal cause of the financial crises and of the volatility are one and the same – to wit, the ‘leverage’ or ‘gearing’ derived in the former case by deficit-based credit creation by banks, and in the latter case by both bank credit creation and forward/futures contracts”.

Subsequent price spikes were in spite of bloated (including massive floating or unconventional) inventories as well as very weak demand. The result was that in 2009, even with a doubling of crude oil prices (between Q1 and Q2), major IOCs posted as much as 76% decline in their Q2 earnings reports.
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Iraq’s Second Oil Licensing Round and the Rising Dominance of National Oil Companies

Iraq currently boasts the world’s third-largest proven reserves of conventional crude oil, behind Iran and Saudi Arabia. Figure 1 shows countries with the largest crude oil reserves. If Canada’s tar sands were factored in, then Iraq would be edged into fourth place. Oil and gas data for Iraq, however date back more than three decades, long before the technological improvements that have transformed the oil and gas industry. The implication then is that the figures for the country’s recoverable reserves are most likely, significantly higher than previously reckoned. This may have informed the bids entered by companies in the second Iraqi oil block auction, which was held last week.
The auction for ten oil service contracts (as distinct from outright concessions or production sharing contracts) was a testament of sorts, to the increasing dominance of National Oil Companies, NOCs in the global oil and gas sector. West Qurna Phase 2, the largest oilfield (about 12.9 billion barrels) offered by the Iraqi government at the licensing round was won by the Russian privately held company, Lukoil in association with Statoil, Norway’s state-controlled oil company. This was closely followed by the Majnoon (about 12.6 billion barrels) field won by Royal Dutch Shell (45%) in association with Petronas (30%), the Malaysian NOC. The Halfaya field (about 4.1 billion barrels) was won by a consortium led by the Chinese NOC, CNPC in association with Malaysia’s NOC, Petronas and the major, Total (the Iraqi government took up the balance). Petronas won the bid for the Garraf (about 863 million barrels) field in association with Japex. Sonangol, the Angolan NOC won bids for the Najmah (about 800 million barrels) and Qaiyarah (about 858 million barrels) fields. Even the smaller field Badra (about 109 million barrels), was won by a partnership of four NOCs.

In all, Petronas and Sonangol were involved in five successful bids. Only three European International Oil Companies, IOCs, were successful, while no U.S. IOC was successful. Angola, on the southwest coast of Africa recently joined the Organization of the Petroleum Exporting Countries, OPEC and has since ramped up her production. The country’s offshore fields are part of the massive Atlantic petroleum provinces of Africa. China’s NOC entered the most bids by any company and won two majority stakes while two Russian companies (the NOC Gazprom and the privately held Lukoil) were successful.

The auction provided for the Iraqi government to pay the companies a bid amount for each barrel of crude oil produced by the companies above current production levels. The comparatively low bid values entered by the companies were indicative of the keenness of the competition. For example, the winning bid by the Royal Dutch Shell and Petronas partnership (which pledged to raise production to 1.8 million barrels per day, bpd, from the current 46,000 bpd) for the Majnoon field was US$1.39 per barrel, well below a delighted Iraqi Oil Ministry’s expectation. That for the Halfaya field entered by the CNPC consortium was US$1.40 per barrel. The latter pledged to raise production from the current 3,000 bpd to 535,000 bpd.

In a previous post, l discussed the challenges facing International Oil Companies. Essentially, in addition to the increasing difficulty to profitable discovery and production of crude oil, they face increasing threats from NOCs. For example, the Chinese NOCs, bolstered by an intimidating financial war chest (often procured on more favorable terms than IOCs can), lower operating costs (in terms of labor and materials) and the leverage of state (which can confer the ability to operate even in the world’s high-risk zones, and that, without shareholders’ scrutiny) are increasingly unassailable. Other NOCs (and many of them with very large, state oil and gas reserves domiciled with them) are not too far behind.

Many of the IOCs such as Royal Dutch Shell, BP and ConocoPhilips have recently reduced staff strength and spun off assests in initial cost-cutting and restructuring measures. Synergies in partnerships (such as these) with NOCs also offer IOCs avenues for viability in the face of fierce competition. A partnership between BP and the Chinese NOC, CNPC for example, for the development of the Rumaila field (Iraq’s largest, with about 17 billion barrels), was the only successful bid in Iraq’s first licensing round which held in June. Mergers and acquisitions (such as the recent acquisition by ExxonMobil, of XTO Energy) may be next. The said recent acquisition may provoke a series of M&A activity involving major IOCs and shale gas companies. The not-too-good news is that questions remain about the viability of shale gas though technological advances may just do the trick. In a related development, Royal Dutch Shell reportedly reached agreement with the Republic of South Africa to carryout a preliminary study on a prospective hydrocarbon field in the Karoo Basin, which will grant the company exclusive exploration rights to the field, believed to be a natural gas field.

Current natural gas inventories in the U.S. are still high, while the price regimes are not at their best. With high levels of financial exposure by some of the shale gas companies, ExxonMobil, with a much larger financial war chest and reputable research and development facilities, may be better placed (than these smaller shale gas companies) to develop the shale gas technology and perhaps extend to foreign shale formations.

Iraq’s second, postwar, oil licensing round was widely believed to be successful. Many oil companies keenly vied for one of the world’s largest, largely unexploited, easily accessible and cheaply exploitable crude oil reserves remaining. The process is expected to boost the country’s production capacity to more than 11 million bpd from the current 2.4 million bpd within ten years; and this could top the dominant Saudi Arabia. Since Iraq is also an OPEC member, what adjustment this would necessitate among OPEC members’ production, remains to be seen. Such substantial addition to global production may also significantly moderate prices subject of course to geopolitical considerations.

That said, it is “not yet Uhuru” for Iraq’s oil and gas sector. For example, these contracts still have to be ratified, and that, probably after next year’s elections. All parties to the auction remain cautiously optimistic that a new regime would respect the contracts and not nullify them.

In addition, several hotly disputed fields such as those in the Kurdish areas remain flash points, while fields such as the massive (eight-billion barrel) East Baghdad situated in politically unstable and terrorism-prone areas were largely avoided.

Even where bids have been successfully held, the sheer size of production, distribution, finishing and exportation infrastructure remains a challenge; but these are of less concern than political instability.
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