BP breathes a sigh; but end of legal woes not nigh!

It has been a crudely British fortnight in terms of Black Gold related news, none more so than BP’s announcement – on March 3 – that it has reached a settlement of US$7.8 billion with the Plaintiffs' Steering Committee (PSC) for civil charges related to the 201 Macondo oil spill in the Gulf of Mexico.

The settlement amount is at the upper end of market conjecture and certainly well above conservative estimates. However, it does not mean that the US government is going to in any way, shape or form, let up on BP – especially in an election year. Everyone knows that, especially BP. However for a second time, the trial case brought against it will have to be delayed as the US Judge in the case – Carl Barbier – noted the settlement would lead to a “realignment of the parties in this litigation and require substantial changes to the current Phase I trial plan, and in order to allow the parties to reassess their respective positions.”

The US government maintains that the US$7.8 billion deal does not address "significant damages" to the environment but PSC-BP agreement is expected to benefit regional 100,000 fishermen, local residents and clean-up workers who suffered following the spill.

BP says it expects the money to come from a US$20 billion compensation fund it had previously set aside and the response of the wider market and ratings agencies to the settlement has been positive. While reaffirming BP’s long term Issuer Default Rating (IDR) at ‘A’, Fitch Ratings notes that BP has adequate financial resources to meet its remaining oil spill related obligations currently estimated by the agency at US$20 billion between 2012 and 2014.

This figure includes the remainder of BP's provisioned costs of US$10.6 billion and approximately US$10 billion of Fitch assumed additional litigation related payments, excluding potential fines for gross negligence. As of end-December 2011, BP had adequate financial resources to meet this obligation with US$14.1 billion of ‘on balance sheet’ cash and US$6.9 billion of undrawn committed stand-by and revolving credit lines. Additionally, the company plans to dispose of assets for about US$18 billion by end-2013 within its US$38 billion asset disposal programme.

Fitch Ratings estimates BP's total Gulf of Mexico spill related payments, net of partner recoveries, will range between US$45 billion and US$50 billion assuming BP was not grossly negligent. BP's cash outflow related to the Gulf of Mexico oil spill amounted to US$26.6 billion by end-2011, net of partner recoveries.

S&P also views the settlement as “somewhat supportive” for its ‘A/A-1/Stable’ ratings on BP and consistent with the agency’s base-case assumptions. “This is because the settlement addresses some material litigation and payment uncertainties, and because we understand that the plaintiffs cannot pursue further punitive damages against BP as a condition of the settlement,” it says.

BP has not admitted liability and still faces other legal claims at State and Federal level. Nonetheless, while the settlement is credit supportive, market commentators in City feel the uncertainty related to the total oil spill liability is not ending any time soon. The Oilholic feels an investigation by US Department of Justice against BP into the oil spill incident encompassing possible violations of US civil or criminal laws could be a potential banana skin as no love has been lost between the two. With several cases still ongoing, a settlement with PSC was a first of many legal hurdles for BP; albeit an important one.

Away from the legal wrangles of “British Petroleum” as US politicians love to call it, Brits themselves had to contend with a record high price of petrol at the pump this week – an average gas station forecourt quote of 137.3 pence per litre on March 5, according to the UK Department of Energy and Climate Change (DECC). The previous record of 137.05p was set on May 9, 2011. However, private research by Experian Catalist says the high is a little “higher” at 137.44p per litre.

And if you thought, the Oilholic’s diesel-powered readership was faring any better, the diesel price is hit a record high of 144.7p per litre, up 0.8p from the previous UK record, which was set the week before! As if that wasn’t enough – the country’s (Markit/CIPS) Purchasing Managers' Index (PMI) for manufacturing slipped to 51.2 in February, down from 52 in January with analysts blaming the high cost oil for manufacturers which rose at the fastest rate in 19 years. It presents another serious quandary for UK Chancellor George Osborne who’s due to table his government’s Union budget on March 21st.

From the price of the refined stuff at British gas station forecourts to the price of a barrel of the crude stuff on the futures market – which saw Brent resisting the US$125 level and WTI resisting the US$106 level for the forward month contract. Myrto Sokou, analyst at Sucden Financial, reckons stronger US economic data brought back risk appetite and improved sentiment this week.

Greece is going to be a main focus for the market with hopes of a positive result on its debt bailout, Sokou adds, but amid renewed rumours whether it would be better for the country to leave the Euro. Cautious optimism is ‘crudely’ warranted indeed.

Elsewhere, the Indian government's attempt divest a 5% stake in one of its NOCs – the Oil and Natural Gas Corporation (ONGC) – via public share offering fell marginally short of expectations last week. Despite tall claims of oversubscription, only 98% of the shares on sale were subscribed. With high hopes of raising something in the region of US$2.5 billion, the government had offered 428 million shares at a price of INR290 per share (approximately US$5.85 and 2% higher than ONGC average share price for February).

However, the Oilholic thinks that even for a company which admittedly has a massive role in a burgeoning domestic market, the price offer was strange at best and overpriced at worst. This probably put off many of the country’s average middle tier investors, especially as many used February’s price as a reference point. Who can blame them and perhaps the Indian government is wiser for the experience too. That’s all for the moment folks. Keep reading, keep it ‘crude’!

© Gaurav Sharma 2012. Photo: Aerial of the Helix Q4000 taken shortly before "Static Kill" procedure began at Macondo (MC 252) site in Gulf of Mexico, August 3, 2010 © BP Plc.

Mr. Gabrielli, an IEA revision & the Kuwaiti situation

This Monday, the crude world bid farewell to Petrobras’ inimitable CEO José Sergio Gabrielli de Azevedo who stepped down from his position having been at the Brazilian major's helm since July 2005. Over his tenure, Petrobras took great strides towards ultradeepwater offshore exploration and made several overseas forays. Rumours had been lurking around since January that Gabrielli was in the twilight of his career at Petrobras following differences with Brazilian President Dilma Rouseff – but both the government and the company strenuously denied it.

The reins of Petrobras have now passed on to Maria das Graças Silva Foster (pictured left) a corporate veteran who has worked at Petrobras for 31 years. In addition to occupying various executive level positions in the company, Foster has been CEO of Petroquisa - Petrobras Química, and CEO and CFO of Petrobras Distribuidora. In her career, she was also Secretary of Oil, Natural Gas and Renewable Fuels at the Brazilian Ministry of Mines and Energy from January 2003 to September 2005.

Earlier, Petrobras approved the contract for 21 offline rigs with Sete Brasil, at an average daily rate of US$530,000 and the contract for 5 dual activity rigs with Ocean Rig, at the average day rate of US$548,000, both for a 15-year term. All units, which have local content requirements ranging from 55% to 65%, are to be delivered within 48 to 90 months, according to the schedules established in the contracts.

The project includes the construction of new shipyards in the country and the use of existing infrastructure. Petrobras expects to reduce the average daily rates to US$500,000 for the Sete Brasil contract and to US$535,000 for the Ocean Rig contract. These amounts may suffer further reductions if the parties detect and agree to mechanisms that reduce operating costs.

With these contracts, the plan to contract 28 drilling rigs to be built in Brazil to meet the demands of the long-term drilling program, primarily for use in pre-salt wells has been completed. Based on the conditions submitted by the companies and on the current demand for the development of future projects, Petrobras, in its own words, "chose to take advantage of the negotiated conditions and contract five additional which were not originally planned."

All this is fine and dandy, but since the timelines of construction and delivery are so lengthy, a hike in construction costs is likely – more so because some yards where the rigs are expected to be built, haven’t yet been built themselves. But the Oilholics loathes being too sceptical about what is a reasonably positive agreement.

Meanwhile, the IEA has cut its oil demand forecast again! In an announcement last week, the agency said a weak global economy had prompted its sixth successive monthly revision to forecasts by 250,000 barrels per day (bpd) to 800,000 barrels for 2012. Before the IEA, the US EIA actually made an upward revision of 50,000 barrels to 1.32 million bpd while OPEC cut its forecast by 120,000 bpd to 940,000. All three forecasters are looking towards non-OECD jurisdictions for demand growth.

Elsewhere, the Oilholic would like to highlight two very interesting corporate client notes. In one issued on February 7th, Fitch Ratings observed that following the recent parliamentary elections in Kuwait, marked frictions between an elected Parliament and the appointed government will continue to weigh on the reform agenda and hamper political effectiveness.

The agency feels that difficulties in reaching agreement at the political level will continue to affect economic reforms, including the implementation of a four-year development plan (worth 80% of GDP over 2010-11 and 2013-14), which aims at boosting the country's infrastructure and diversifying the economy away from oil.

Nonetheless, Fitch rates Kuwait as 'AA' with a Stable Outlook. As relatively high oil prices are being forecast, Fitch’s own being at US$100/barrel for 2012, Kuwait’s earnings should continue to ensure double digit current account and fiscal surpluses which lend support to the rating.

Moving on to the second note, on the expected impact of US' QE3 on the commodity market circulated on February 10th, Société Générale analysts Michael Haigh and Jesper Dannesboe opine that an increase of expected inflation during QE3 Stateside coupled with the impact of the EU embargo on Iran could result in the DJ-UBS commodity index rising 20% and Brent prices rising to US$130/barrel.

“Sep12 Brent call spread with strikes at US$117 (long) and US$130 (short). The current net up-front cost: about US$4.6/barrel. This results in a maximum net profit of US$8.4/barrel. If one also sells a Sep12 US$100/barrel put, the overall structure would have zero upfront cost and the maximum net profit would be US$13.7/barrel. We consider a price drop below US$100 to be very unlikely,” they wrote and the Oilholic quotes. That’s all for the moment folks! Keep reading, keep it 'crude'!

© Gaurav Sharma 2012. Photo: Petrobras CEO Maria das Graças Silva Foster © Petrobras Press Office.

EU’s Iran ban, upcoming Indian adventure & Cairn

Earlier on Monday and in line with market expectations, the European Union agreed to impose an embargo on the import of Iranian crude oil. The EU, which accounts for 20% of Iran’s crude exports, now prohibits the import, purchase and transport of Iranian crude oil and petroleum products as well as related finance and insurance. All existing contracts will have to be phased out by July 1st, 2012.

In response, Iran declared the ban as "unfair" and "doomed to fail", said it will not force it to change course on its controversial nuclear programme and renewed threats to blockade the Strait of Hormuz. Going into further details, EU Investment in as well as the export of key equipment and technology for Iran's petrochemical sector is also banned.

A strongly worded joint statement by British Prime Minister David Cameron, French President Nicolas Sarkozy and German Chancellor Angela Merkel says, “Until Iran comes to the table, we will be united behind strong measures to undermine the regime’s ability to fund its nuclear programme, and to demonstrate the cost of a path that threatens the peace and security of us all.”

That’s all fine and yes it will hurt Iran but unless major Asian importing nations such as China, India and Japan decide to ban Iranian imports as well, EU’s ban would not have the desired impact. Of these, China alone imports as much Iranian oil as the EU, Japan accounts for 17% of the country’s exports, followed by India (16%) and South Korea (9%).

So until the major Asian economies join in the embargo, both EU and Iran will end up hurting themselves. As a Sucden Financial note concludes, “Unless a deal can be agreed unilaterally, it is likely that the weak European economies could suffer from firmer crude prices whilst relatively robust Asian economies might benefit from preferential crude trade agreements.”

China is unwilling to follow suit while it is thought that Japan and South Korea are seeking supply assurances from other sources before reacting. India’s response had been lukewarm in the run-up the EU’s decision. Now that the decision has been made, it will be interesting to note how the Indian government responds. The Oilholic is heading to India this week (and for better parts of the next) and will try to sniff out the public and government mood.

Meanwhile, Fitch Ratings has said the EU embargo will increase geopolitical risk in the Middle East region supporting high oil prices. The agency considers blocking the Strait of Hormuz - the world's most important oil chokepoint - to be a low-probability scenario and believes any obstruction to trade routes would have a short duration if it did actually transpire.

Arkadiusz Wicik, Director in Fitch's European Energy, Utilities and Regulation team and an old contact of the Oilholic’s, feels that the EU ban on Iranian oil is largely credit neutral for EU integrated oil and gas companies. "The cash flow impact of the ban may be negative for refining operations, but should be positive or neutral for upstream operations," he says.

The most likely scenario is that the EU embargo will result in higher oil prices. However, prices may not necessarily increase markedly from current levels as some of the risks related to the EU ban on Iranian oil appear factored in already.

A new Fitch report further notes the ban is likely to have a moderately negative impact on EU refiners as high oil prices may further erode demand for refined products in Europe. This would worsen the already weak supply-demand balance in European refining. The embargo may also change oil price spreads in Europe as Iranian crude imports would likely be replaced with alternative crude, which may be priced at a lower discount to Brent than Iranian crude oil.

EU refiners' security of oil supply is unlikely to be substantially affected by an Iran ban. There are alternative suppliers, such as Saudi Arabia (which has said it is able and willing to increase oil production to meet additional demand), Russia and Iraq. Libyan oil production is also recovering. Iranian oil accounted for just 5.7% of total oil imports to the EU in 2010, and 4.4% in Q111. Furthermore, the sanctions will be implemented gradually by July 1st, 2012, which should give companies that use Iranian crude oil time to find alternative suppliers, the report notes.

Southern European countries - Italy, Spain and Greece - are the largest importers of Iranian crude oil in the EU. A rise in oil prices could be further bad news for these countries, which already face a weak economic outlook in 2012.

“The impact of the new US sanctions signed into law late last year against Iran is difficult to predict at this stage. It is not certain whether Asian countries, which are by far the largest importers of Iranian crude, accounting for about 70% of total Iranian oil imports, will substantially reduce supplies from Iran in 2012 and replace them with other OPEC sources as a result of the new US sanctions,” the Fitch report notes further.

The agency’s report does make one very important observation – one that has been doing the rounds in the City ever since news of the ban first emerged – that’s if Asian reduction is substantial, in combination with the EU ban, it could considerably lower OPEC's spare production capacity. In such a scenario, the global oil market would have less flexibility in the event of large unexpected supply interruptions elsewhere, potentially sending oil prices much higher than current levels.

Moving away from the Iranian situation, Cairn Energy has sold a 30% stake in one of its Greenland exploration licences to Norway’s Statoil. The UK independent upstart spent nearly £400 million in exploration costs last year with little to show for it as no commercially exploitable oil or gas discovery was recorded. While the percentage of the stake has been revealed, neither Cairn nor Statoil are saying how much was paid for the stake. Nonetheless, whatever the amount, it would help Cairn mitigate exploration costs and risks as it appears to be in Greenland for the long haul.

Elsewhere, there is positive and negative news on refineries front. Starting with the bad news, shares in Petroplus – Europe’s largest independent refiner – were suspended from trading on the Swiss SIX stock exchange on Monday at the company’s request. As fears rise about Petroplus defaulting on its debt following an S&P downgrade last month and yet another one on January 17th, looks like the refiner is in a fight for its commercial life.

Lenders suspended nearly US$1 billion in credit lines last month which prevented Petroplus from sourcing crude oil for its five refineries. However, it had still managed to keep refineries at Coryton (Essex, UK) and Ingolstadt (Germany) running at reduced capacity. Late on Monday, Bloomberg reported that delivery lorries did not leave the Coryton facility and concerns are rising for the facility’s 1000-odd workforce. PwC, which has been appointed as the administrator of Petroplus' UK business, said on Tuesday that it aims to continue to operate the Coryton facility without disruption. The Oilholic hopes for the best but fears the worst.

Switching to the positive news in the refineries business, China National Petroleum Corp, Qatar Petroleum and Royal Dutch Shell agreed plans on January 20th for a US$12.6 billion refinery and petrochemical complex in eastern China. Quite clearly, hounded by overcapacity and poor margins in Europe, the future of the refineries business increasingly lies in the Far East on the basis of consumption patterns. That’s all for the moment folks. Keep reading, keep it ‘crude’!

© Gaurav Sharma 2012. Photo: Oil tanker © Michael S. Quinton / National Geographic.

Economic malaise & ratings agencies' crude talk

Not the time to say the Oilholic told you so – but the bears never left Crude town. They were merely taking a breather after mauling the oil futures market in the first week of August. It is a no brainer that existing conditions, i.e. fears of recessionary trends in the US, a slowdown in China and Eurozone’s debt fears, are spooking sentiment (again!).

At 14:30 GMT on Monday, ICE Brent crude forward month futures contract was down 1.5% or US$1.63 in intraday trading at US$110.70. Concurrently, WTI futures contract, weighed down more by a perceived American economic malaise, was down 2.8% or US$2.58 trading at US$84.27. Feedback from the city suggests reports of sluggish Chinese service sector growth are as much of a concern as a quarter or two of negativity in the US.

In fact, analysts at Commerzbank believe were it not for market sentiment factoring in possible measures by the US Federal Reserve to stimulate the economy, the WTI could have dipped even further. Additionally, the Libyan instability premium is fast on the verge of being factored out too even though its supply dynamic is far from returning to normalcy.

Société Générale analyst Jesper Dannesboe believes that Brent prices are exposed to a sharp drop down to US$100, or lower, before year-end as oil demand weakens and the market starts pricing in weak 2012 economic and oil demand growth.

“The recent sharp drop in leading indicators in Europe and the US suggest that demand destruction is likely to escalate, thereby resulting in significant drop in global oil demand growth. It is worth remembering that while Chinese demand growth is likely to remain solid, China still only account for about 11-12% of global oil consumption in absolute terms. In other words, the demand outlook in US and Europe remains a key driver of oil consumption, and therefore oil prices,” he wrote in a recent investment note.

All indications are that Société Générale’s Global head of oil research Mike Wittner will review his oil price forecast and will be publishing new lower oil demand and oil price forecast in the investment bank’s Commodity Review slated for publication on Sept 12. However, it is also worth moving away from pricing analysis to discuss what the perceived malaise means for the energy business; both Fitch Ratings and Moody’s have been at it.

In a report published on August 30, Fitch calculates that average oil and gas sector revenue growth will be 6%-7% in 2012, but considers that there is a 20% chance that sector revenue growth may actually be less than zero next year due to slower developed market macroeconomic growth that may also adversely impact oil prices. (Click image to enlarge). Jeffrey Woodruff, London-based Senior Director in Fitch's Energy and Utilities Team, notes, “A US real-GDP growth rate of around 1.8% and an average Brent oil price of US$90 per barrel in 2012 would likely make it a 50/50 chance as to whether or not average oil and gas sector revenue grows or contracts next year."

Fitch believes sector revenue growth in 2011 will average around 20% but is likely to slow to a low double-digit or even high single-digit growth rate thereafter. EBITDA growth tends to broadly follow the trend in revenue growth, but with more volatility. If sector average revenue growth slows to zero in 2012, sector average EBITDA growth is likely to be negative. The cash flow impact from such an event is likely to be modest for investment grade names, but would be more severe for companies with low speculative grade ratings that are more exposed to earnings volatility.

A slowing global economy and particularly weak US economic growth could negatively impact demand for oil for the remainder of 2011 and potentially into 2012. Fitch anticipates the overall rating impact of a slowdown in average sector revenue growth in 2012 will be minimal for investment grade names. However, for non-investment grade companies, it would be an entirely different matter. Fitch believes they would be more affected and the agency could revise rating Outlooks to Negative.

In a report also published on the same day by Moody’s, specifically on downstream, the agency notes that refining and marketing (R&M) sector has reached a peak in its business cycle, with limited prospects for improving from current levels over the next 12-18 months as capacity overtakes demand.

As result, the agency changed its outlook on the R&M sector to stable from positive, because of the considerable risk generated by upcoming capacity additions worldwide. The stable outlook means Moody's expects business conditions in the R&M sector neither to improve nor deteriorate significantly over the next 12-18 months. It last changed the R&M sector's outlook, to positive from stable, on March 31 this year.

Gretchen French, Moody's Vice President and Senior Analyst, expects global demand for gasoline and distillate to grow modestly through 2012, based on the agency’s central scenario of a sluggish global recovery. "However, a capacity glut could suppress margins across the R&M sector as early as 2012 if demand or capacity rationalisation fails to offset anticipated supply increases," she adds.

After all, nearly 2.4 million barrels per day (bpd) of new capacity is scheduled to come online worldwide in 2012. Currently, estimated global demand is only 1.6 million bpd in 2012. Moody’s reckons these concerns, coupled with elevated prices, continued high unemployment in the OECD, softer US or Eurozone economies, and inflation-stemming efforts in China could all dampen demand for refined products. Blimey! Did we leave anything out? The Oilholic bets the bears didn’t either.

On a related note, the latest Iraqi oil exports figures, released by country’s Oil Ministry, make for interesting reading. Data for July suggests total exports came in at 67.2 billion barrels down marginally from 68.2 billion in June. However, as oil prices rose over the corresponding period, revenue actually rose 2% netting the government US$7.31 billion with output currently pegged at around 2.17 bpd.

The total revenue to end-July came in at US$48.6 billion which does suggest that the country is on track to meet its revenue target of US$82.5 billion as stated in its February 2011 budget statement. However, given what is going on in the market at the moment, future crude price could be a concern. It seems the Iraqi budget is predicated at a price of US$76.50 a barrel. So there is nothing to worry about for them, for now!

Finally, here is an interesting CNBC segment on the town of Williston (North Dakota, USA) brought to the Oilholic’s attention, by a colleague who is from around those parts. He calls it Boomtown USA and it may not be that far from the truth!

© Gaurav Sharma 2011. Photo: Oil Refinery - Quebec, Canada © Michael Melford / National Geographic. Graph: Oil & Gas Sector average revenue growth rate © Fitch Ratings, London 2011.

IEA, OPEC & a few more bits on BP

It has been a month of quite a few interesting reports and comments, but first and as usual - a word on pricing. Both Brent crude oil and WTI futures have partially retreated from the highs seen last month, especially in case of the latter. That’s despite the Libyan situation showing no signs of a resolution and its oil minister Shukri Ghanem either having defected or running a secret mission for Col. Gaddafi depending on which news source you rely on! (Graph 1: Historical average annual oil prices. Click on graph to enlarge.)

Either way, the 159th OPEC meeting in Vienna which the Oilholic will be attending in a few weeks promises to be an interesting one; we’re not just talking production quotas here. Iranian President Mahmoud Ahmadinejad is also expected to be in Austrian capital – so it should be fun. The market undoubtedly still craves and will continue to crave the quality of crude that Libya exports but other factors are now at play; despite whatever Gaddafi may or may not be playing at.

Contextualising the Libyan situation, Société Générale CIB analyst Jesper Dannesboe notes that Cushing (Oklahoma), the physical delivery point for WTI crude oil, has recently been oversupplied resulting in contango at the very front end of the WTI forward curve.

“This situation is likely to persist until at least mid-2012 as higher supply to Cushing from Canadian oil sands and from North Dakota should result in high Cushing stocks as new pipelines from Cushing to the coast will not be ready until late 2012 at the earliest. This makes it attractive to put on WTI time spreads further out the forward curve at backwardation as they should over time roll into contango,” he wrote in a note to clients.

Dannesboe also observes that while the entire Brent crude oil forward price curve is currently in backwardation (i.e. near-dated prices higher than further-dated prices) out to about 2017, the front-end of the WTI crude oil forward price curve has remained in contango.

The Brent forward curve flipped from contango to backwardation in late February as a result of the unrest in the Middle East & North Africa (MENA). However, contango at the front-end of the WTI forward curve has persisted because WTI's physical delivery point, Cushing (US midcontinent), has remained oversupplied despite a generally tight global market for sweet crude as a result of the loss of Libyan exports, he concludes.

Meanwhile, ahead of the OPEC meeting, the International Energy Agency (IEA) called for “action” from oil producers that will help avoid the negative global economic consequences which a further sharp market tightening could cause. Its governing board meeting last Thursday expressed “serious concern” that there are growing signs the rise in oil prices since September is affecting the economic recovery. As ever, the IEA said it stood ready to work with producers as well as non-member consumers.

The Oilholic also recently had the pleasure of reading a Fitch Ratings report, authored earlier this month in wake of the Libyan situation, which notes that the airline sector is by far the most vulnerable to rising oil and gas prices of all corporate sectors in the EMEA region given the heavy weight of fuel costs in operating cost structures (20%-30%), execution risks from companies' use of hedging instruments to mitigate their fuel exposure and fierce industry competition. (Graph 2: Price movement - Jet fuel vs. Brent oil. Click on graph to enlarge)

Erwin van Lumich, a Managing Director in Fitch's corporate departments, said, "The gap between the jet fuel price curve and the Brent curve narrowed to approximately 13% during 2010, with airlines in emerging markets generally most exposed to fuel price fluctuations due to a lack of market development for fuel hedging."

It gives food for thought that a temporary impact of the Icelandic volcanic ash can send jitters down the spine of airline investors but the jet fuel pricing spread, airlines’ hedging techniques (or the lack of it) and how it might impact operating margins is mostly raised at their AGMs. Where there are losers, there are bound to be winners but Fitch notes that the ratings of companies in the extractive industries are not expected to benefit from the price increases as the agency uses a mid-cycle pricing approach to avoid cyclical price changes having an impact on ratings. At this stage, Fitch does not anticipate a revision to its mid-cycle price deck to an extent that it would result in rating changes.

Finally, a couple of things about BP. To begin with, BP’s share swap deal with Rosneft failing to meet the May 16th deadline does not imply by default that that deal would not happen. In wake of the objection of AAR – its TNK-BP joint venture partner – there are still issues to be resolved and they will be in the fullness of time contrary to reports on the deal’s demise. A source close to the negotiations (at AAR not Rosneft) says talks are continuing.

Continuing with BP, it finally got recognition that blame for the Macondo incident is not exclusively its. Mitsui (which holds 10% of the well’s licence) and Anadarko (25%) had both blamed accident on BP’s negligence, refusing to pay or bear costs. However, Mitsui finally agreed to settle claims relating to the disaster with BP. It now agrees with BP that it was the result of oversights and mistakes by multiple parties. Undoubtedly, the pressure will now be on Anadarko to settle with BP.

According to US government figures, BP has paid out US$20.8 billion. It has invoiced Mitsui for approximately US$2.0 billion with the Japanese company expected to pay half of that at the present moment in time. A US trial on limitation of liabilities is expected to rule on the issue of gross negligence by parties concerned sometime over Q1 2012. Watch this space!

© Gaurav Sharma 2011. Graphics © Fitch Ratings, May 2011

Market Chatter on ‘Crude’ effects of Instability

As allied forces start bombing Libya and the full damage – both physical and reputational – to the nuclear generated power industry in wake of the earthquake in Japan is known, it is time to move beyond ranting about how much instability premium is actually there in the price of crude oil to what its impact may be. Using the Brent forward month futures contract as a benchmark, conservative estimates put the premium at US$10 but yet looser ones put it at US$20 per barrel at the very least.

It is also getting a bit repetitive to suggest that fundamentals do not support such a high price of crude, even if the geopolitics is taken out of it. Thing is even profit taking at some point is not likely to cool the hot prices in the short term and the market has already started chatting about the impact. The tragic earthquake in Japan has added another dimension. Until nuclear power generation gets back on track in Japan, in order to meet their power demand the Japanese will increase the use of hydrocarbons as they have no other choice.

Regarding the latter point, Ratings agency Moody's says that displaced demand from Japan's nuclear shutdown will shift to Asia-Pacific thermal-energy producers such as Australia's upstream Woodside Petroleum (Moody’s rating Baa1 negative), Indonesia's thermal-coal miner Adaro (Ba1 stable), Korea's refiner SK Innovation (Baa3 Stable), and Thailand's petrochemical firm PTT Chemical (Baa3 review for upgrade).

Renee Lam, a Moody's vice president in Hong Kong, says, "These firms and others in the region can capitalise on near- and longer-term displaced demand as Japan must now rely more on non-nuclear fuel." Lam also expects global crude prices to remain high, despite a near-term drop from dislocation in Japan.

She further notes, "Refinery shutdowns in Japan, accounting for 9% of Asian capacity and 2% of global capacity, have pushed up Asian refining margins. Strong margins benefiting non-Japanese, regional refineries should continue at least in the near term. We expect strong results for our rated refiners in the first half of this year."

Additionally, Fitch Ratings says airlines and European Gas-Fired Utilities Unprepared for Current Oil Spike and that the substantial increase in oil prices in a short time frame has caught many corporate energy consumers off guard, as they are not properly hedged to cope with such high oil price levels. In a scenario of sustained high oil prices, corporate issuers that are heavily exposed to oil-related commodities feedstock are likely to face a direct impact on their earnings.

In the agency’s view, management teams may be reluctant to hedge the oil price at these high levels, in anticipation of a softening in the oil price once geopolitical tensions subside. Fitch also considers it possible that banks might be less keen to finance oil option contracts at such high levels, as they do not want to take the risk of a continued rally in the price of crude.

As oil price volatility remained fairly low in 2010, airlines seem to have been hedging less and are now more vulnerable to the current spike. In the current high oil price environment, an increasing number of airlines are taking a wait-and-see approach in anticipation of a softening of the oil price and perhaps due to higher hedging costs. In Fitch's view, sustained oil prices well in excess of US$100 per barrel could negatively affect the operating performance and creditworthiness of high intensity corporate energy consumers and may also hamper the global economic recovery.

Analysts at SocGen CIB note that the forward curve for Brent is currently in backwardation (nearby premium, forward discount) for the next 5 years, reflecting concerns over growing physical tightness in the crude markets. Especially, in light of the NATO/allied forces bombardment of Gaddafi forces last night, the market is pricing in an extended Libyan shutdown of crude exports. About 1 million barrels per day of crude oil production has been cut and Libya’s major exporting ports are now closed.

As Nymex WTI-ICE Brent spreads have been less weak, SocGen analysts note that the front month spread has traded around -US$9.75/b on Tuesday vs -US$15/b one week ago. They opine that the recent strength of the WTI / Brent spreads has not really been due to the decreasing risk-premium of Brent, but more to very strong inflows of money on WTI-linked instruments.

In a note to clients last week, they note and I quote: “Indeed, the last CFTC COT report shows that the net position of the non-leveraged investments on WTI hit a new record high. This is so large that even the swap dealers now have a negative net position on WTI futures.”

I feel it is prudent to mention (again!!!) that this blogger, all main ratings agencies and a substantial chunk of commentators in the City believe that a large portion of the current oil price spike has been driven by speculative activity rather than supply fundamentals. Oil supply has remained more or less balanced as most other oil producing nations have raised their production levels in order to keep overall production largely unaffected – so far that is!

Finally, here’s an interesting segment of CNBC's Mad Money programme, where Jim Cramer talks oil n’ gas in the US state of North Dakota. It’s relatively small from a global standpoint, but could be important from an American one.

© Gaurav Sharma 2011. Photo: Oil Drill Pump, North Dakota © Phil Schermeister, National Geographic Society

Final Notes of Crude Year 2010

Recapping the last fortnight, I noted some pretty interesting market chatter in the run-up to the end of the year. Crude talk cannot be complete without a discussion on the economic recovery and market conjecture is that it remains on track.

In its latest quarterly Global Economic Outlook (GEO) Dec. edition, Fitch Ratings recently noted that despite significant financial market volatility, the global economic recovery is proceeding in line with its expectations, largely due to accommodative policy support in developed markets and continued emerging-market dynamism.

In the GEO, Fitch has marginally revised up its projections for world growth to 3.4% for 2010 (from 3.2%), 3.0% for 2011 (from 2.9%), and 3.3% for 2012 (from 3.0%) compared to the October edition of the GEO. Emerging markets continue to outperform expectations and Fitch has raised its 2010 forecasts for China, Brazil, and India due to still buoyant economic growth. However, the agency has revised down its Russian forecast as the pace of recovery proved weak, partly as a result of the severe drought and heatwave in the summer.

Fitch forecasts growth of 8.4% for these four countries (the BRICs) in 2010, and 7.4% for each of 2011 and 2012. While there are ancillary factors, there is ample evidence that crude prices are responding to positive chatter. Before uncorking something alcoholic to usher in the New Year, the oilholic noted that either side of the pond, the forward month crude futures contract capped US$90 per barrel for the first time in two years. Even the OPEC basket was US$90-plus.

Most analysts expect Brent to end 2012 at around US$105-110 a barrel and some are predicting higher prices. The city clearly feels a US$15-20 appreciation from end-2010 prices is not unrealistic.

Moving away from prices, in a report published on December 15th, Moody's changed its Oilfield Services Outlook to positive from stable reflecting higher earnings expectations for most oilfield services and land drilling companies in 2011.

However, the report also notes that the oilfield services sector remains exposed to significant declines in oil and natural gas prices, as well as heightened US regulatory scrutiny of hydraulic fracturing and onshore drilling activity, which could push costs higher and limit the pace and scale of E&P capital investment.

Peter Speer, the agency’s Senior Credit Officer, makes a noteworthy comment. He opines that although natural gas drilling is likely to decline moderately in 2011, many E&Ps will probably keep drilling despite the weak economics to retain their leases or avoid steep production declines. Any declines in gas-directed drilling are likely to be offset by oil drilling, leading to a higher US rig count in 2011.

However, Speer notes that offshore drillers and related logistics service providers pose a notable exception to these positive trends. "We expect many of these companies to experience further earnings declines in 2011, as the U.S. develops new regulatory requirements and permitting processes following the Macondo accident in April 2010, and as activity slowly increases in this large offshore market," he concludes.

Couldn’t possibly have ended the last post for the year without mentioning Macondo; BP’s asset sale by total valuation in the aftermath of the incident has risen to US$20 billion plus and rising. Sadly, Macondo will be the defining image of crude year 2010.

© Gaurav Sharma 2010. Photo: Oil Rig © Cairn Energy Plc

Talking Refinery Infrastructure on CNBC

This week marked the culmination of almost a month and a half of my research work for Infrastructure Journal on the subject of oil refinery infrastructure and how it is fairing. Putting things into context, like many others in the media I too share an obsession with the price of crude oil and upstream investment. I wanted to redress the balance and analyse investment in the one crucial piece of infrastructure that makes (or cracks) crude into gasoline, i.e. refineries. After all, the consumer gets his/her gasoline at the gas station – not the oil well. The depth of Infrastructure Journal's industry data (wherein a project’s details from inception to financial close are meticulously recorded) and the resources the publication made available to me made this study possible. It was published on Wednesday, following which I went over to discuss my findings with the team of CNBC’s Squawk Box Europe.

I told CNBC (click to watch) that my findings suggest activity in private or public sector finance for oil refinery projects, hitherto a very cyclical and capital-intensive industry currently facing poor margins, is likely to remain muted, a scenario which is not going to materially alter before 2012.

The evidence is clear, integrated oil companies have and will continue to divest in downstream assets particularly refineries because upstream investment culture of high risk, high rewards trumps it.

Growth in finance activity is likely to come from Asia in general and surprise, surprise India and China in particular. It is not that margins are any better in these two countries but given their respective consumers’ need for gasoline and diesel – margins become a lesser concern.

However, in the west, while refiners’ margins remain tight, new and large refinery infrastructure projects would see postponements, if not cancellations. In order to mitigate overcapacity, a number of mainly North American and European refiners or integrated companies will shutdown existing facilities, albeit quite a few of the shutdowns will be temporary.

Geoff Cutmore and Maithreyi Seetharaman probed me over what had materially changed, after all margins have always been tight? Tight yes, but my conjecture is that over the last five years they have taken a plastering. On a 2010 pricing basis, BP Statistical Review of World Energy notes that the 2009 refining average of US$4.00 per barrel fell below the 2008 figure of $6.50 per barrel; a fall of 38.5%. In fact, moving away from the average, on an annualised basis, margins fell in all regions except the US Midwest last year while margins in Singapore were barely positive.

Negative demand has in effect exasperated overcapacity both in Europe and North America. BP notes that global crude runs fell by 1.5 million bpd in 2009 with the only growth coming from India and China where several new refining capacities, either private or publicly financed, were commissioned. Its research further reveals that most of the 2 million bpd increase in global refining capacity in 2009 was also in China and India. Furthermore, global refinery utilisation fell to 81.1% last year; the lowest level since 1994.

In fact does it surprise anyone that non-OECD refinery capacity exceeded that of the OECD for the first time in 2009? It doesn’t surprise me one jot. I see this trend continuing in 2010 and what happens thereafter would depend on how many OECD existing refineries facing temporary shutdown are brought back onstream and/or if an uptick in demand is duly noted by the OECD nations. A hope for positive vibes on both fronts in the short to medium term is well...wishful thinking.

Refineries were once trophy assets for integrated oil companies but in the energy business people tend to have short memories. Alas, as I wrote for Infrastructure Journal (my current employers) and told CNBC Europe (my former employers), now they are the unloved assets of the energy business.

© Gaurav Sharma 2010. Photo 1: Gaurav Sharma on Squawk Box Europe © CNBC, Nov 10, 2010, Photo 2: Oil Refinery Billings, Montana © Gordon Wiltsie / National Geographic Society