Looming embargo on Iran, Nigeria & few other bits

An EU ban on Iranian crude imports in response to the country’s continued nuclear programme is imminent but not immediate or so the City analysts and government sources would have you believe. Furthermore, news agency Bloomberg adds that the planned embargo is likely to be delayed by up to six months as European governments scramble to seek alternative sources.

The Japanese and Indian governments are also looking to reduce dependence on Iranian imports according to broadcasts from both countries while OPEC has indicated that it does not wish to be involved in row. Add the ongoing threats strike threats by Nigeria’s largest oil workers union, the Pengassan, as well the second largest, Nupeng, and political tension in the country to the Iranian situation and you don’t need the Oilholic to tell you that the short term risk premium is going mildly barmy.

It is nearly the end of the week and both benchmarks have rebounded with City analysts forecasting short term bullishness. With everyone scrambling for alternative sources, pressure is rising on already tight supply conditions notes Sucden Financial analyst Jack Pollard. “With the near-term geopolitical risk premium being priced in, Brent’s backwardation looks fairly assured as the front spreads continue to widen. Well-bid Italian and Spanish auctions have no doubt supported risk appetite, as the US dollar tracks back to lend upward pressure on commodities,” he adds.

When the Oilholic checked on Thursday, the Brent forward month futurex contract was resisting the US$110 per barrel level while WTI was resisting the US$99 level sandwiched between a bearish IEA report and geopolitical football. The next few weeks would surely be interesting.

Away from crude pricing, to a few corporate stories, ratings agency Moody’s has affirmed LSE-listed Indian natural resources company Vedanta Resources Plc's Corporate Family Rating of Ba1 but has lowered the Senior Unsecured Bond Rating to Ba3 from Ba2. The outlook on both ratings is maintained at negative following the completion of the acquisition of a controlling stake in Cairn India, on December 8, 2011.

Since announcing the move in August 2010, Vedanta has successfully negotiated the course of approvals, objections and amended production contract arrangements and now holds 38.5% of Cairn India directly, with a further 20% of the company held by Sesa Goa Ltd., Vedanta's 55.1%-owned subsidiary.

Moody’s believes the acquisition of Cairn India should considerably enhance Vedanta's EBITDA, but the agency is concerned with the sharply higher debt burden placed on the Parent company. In order to lift its stake from 28.5% to 58.5%, Vedanta drew US$2.78 billion from its pre-arranged acquisition facilities. Coupled with the issue of US$1.65 billion of bonds in June 2011, debt at the Parent company level is now in excess of US$9 billion on a pro forma basis. This compares with a reported Parent equity of US$1 billion at FYE March 2011.

Moving on, Venezuelan oil minister Rafael Ramírez said earlier this week that his country had decided to compensate ExxonMobil for up to US$250 million after President Hugo Chávez nationalised all resources in 2007. Earlier this month the International Chamber of Commerce in Paris, already stated that the country must pay Exxon Mobil a total of US$907 million, which after numerous reductions results in - well US$250 million.

Elsewhere, law firm Herbert Smith has been advising HSBC Bank Plc and HSBC Bank (Egypt) on a US$50 million financing for the IPR group of companies, to refinance existing facilities and to finance the ongoing development of IPR's petroleum assets in Egypt – one of a limited number of financings in the project finance space in Egypt since the revolution. It follows four other recent financings for oil and gas assets in Egypt on which Herbert Smith has advised namely – Sea Dragon Energy, Pico Petroleum, Perenco Petroleum and TransGlobe Energy.

On a closing note and sticking with law firms, McDermott Will & Emery has launched a new energy business blog – Energy Business Law – which according to a media communiqué will provide updates on energy law developments, and insights into the evolving regulatory, business, tax and legal issues affecting the US and international energy markets and how stakeholders might respond. The Oilholic applauds MWE for entering the energy blogosphere and hopes others in the legal community will follow suit to enliven the debate. Keep reading, keep it 'crude'!

© Gaurav Sharma 2012. Photo: Pipeline, South Asia © Cairn Energy.

Well ‘Why-EA’? Agency wilts as politicians win!

Earlier this afternoon, for only the third time in its history, the IEA asked its members to release an extra 60 million barrels of their oil stockpiles on to the world markets.

The previous two occasions were the first gulf war (1991) and the aftermath of Hurricane Katrina (2005). That it has happened given the political clamour for it is no surprise and whether or not one questions the wisdom behind the decision, it is a significant event.

The impact of the move designed to stem the rise of crude prices was felt immediately. At 17:15GMT ICE Brent forward month futures contract was trading at US$108.45 down 4.99% or US$5.74 in intraday trading while the WTI contract fell 3.64% or US$3.51 to US$91.46.

Nearly half of the 60 million barrels would be released from the US government’s Strategic Petroleum Reserve (SPR). In relative terms, UK’s contribution would be three million barrels – which tells you which nation the IEA was mostly looking to. The agency’s executive director Nobuo Tanaka feels the move will contribute to “well-supplied markets” and ensure a soft landing for the world economy.

This begs the question if the market is “well-supplied” especially with overcapacity at Cushing (Stateside) why now? Why here? For starters, and as the Oilholic blogged earlier, some politicians like Senator Jeff Bingaman – a Democrat from New Mexico and chairman of the US Senate energy committee – have been clamouring for his country’s SPR to be raided to relieve price pressures since April.

OPEC’s shenanigans earlier this month gave them further ammunition amid concerns that the summer or “driving season” rise in US demand would cause prices to rise further still. That is despite the fact that the American market remains well supplied and largely unaffected by 132 million barrels of Libyan light sweet crude oil which the IEA reckons have disappeared from the market (until the end of May since the hostilities began).

Nonetheless, all this mega event does is add to the market fear and confirm that a perceptively short term problem is worsening! Long term hope remains that the Libyan supply gap would be plugged. Releasing portions of the SPRs would not alleviate market concerns and could even be a disincentive for the Saudis to pump more oil – although they made it blatantly obvious after the OPEC meeting deadlock on June 8 that they will up production. Now how they will react is anybody's guess?

Jason Schenker, President and Chief Economist of Prestige Economics, feels that while the decision is price bearish for crude oil in the immediate term, these measures are being implemented with the intent to stave off significantly higher prices in the near and medium term.

In a note to clients, Schenker notes: “The fact that the IEA had to go to these lengths in the second year of an expanding business cycle says something very bullish about crude oil prices in the medium and long term. The global economy is up against a wall in terms of receiving additional oil supplies to meet demand. Additional demand or supply disruption would have a massively bullish impact on prices. After all, releasing emergency inventories is a last resort.”

But must we resort to last resorts, just yet? While Sen. Bingaman would be happy, most in the market are worried. Some moan that Venezuelan and Iranian intransigence in Vienna brought this about. For what it is worth, the market trend was already bearish, Libya or no Libya. Concerns triggered by doubts about the US, EU and Chinese economies were aplenty as well as the end of QE2 liquidity injections coupled with high levels of non-commercial net length in the oil markets.

Some for instance like Phil Flynn, analyst at PFG Best, think the IEA’s move was “the final nail in the coffin for the embattled oil markets.” Let’s see what the agency itself makes of its move 30 days from now when it reassesses the situation.

Those interested in the intricacies of this event would perhaps also like to know how the sale takes place but we only have the US example to go by. Last time it happened – under the Bush administration on September 6, 2005 – of the 30 million barrels made available, only 11 million were actually sold to five bidders by the US energy department. Nine of a total of 14 bidders were rejected, with deliveries commencing in the third week of the month. What the take-up would be in all IEA jurisdictions this time around remains to be seen.

Medium term price sentiments according to the Oilholic’s feedback have not materially altered and so they shouldn’t either. An average of five City forecasts sees Brent at US$113.50 in Q3 2011, US$112.50 in Q4 11 and US$115 in Q1 2012. Finally, most city forecasters, and to cite one, remain “marginally” bullish for 2012 though no one, this blogger including, sees a US$150 price over 2012.

Finally to all of the Oilholic's American readers concerned about the rising price of gas, spare a thought for some of us across the pond. OPEC’s research suggests (click graph above) that much higher taxes in most national jurisdictions in this part of the world means we pay way more than you guys. That is not changing any time soon. Releases of SPRs woould not meaningfully ease price pressures at the pump for us.

© Gaurav Sharma 2011. Photo: Gas Station, Sunnyvale, California, USA © Gaurav Sharma, April 2011. Graphics: Who gets what from a litre of Oil? © OPEC Secretariat, Vienna 2010.

OPEC’s 'problem' and Dr. Chalabi’s book

The decision or rather non-decision of not raising the OPEC production quota taken earlier here in Vienna is as damaging for OPEC as it is problematic. A cartel is supposed to show solidarity, but internal sparring awaited the world’s press. The meeting even concluded without a formal production decision or even a communiqué.

It is clear now that those members in favour of a rise in production quota were Saudi Arabia, Kuwait, Qatar and UAE while those against were Algeria, Libya (Gaddafi’s lot), Angola, Venezuela, Iran and Iraq. However, majority of the sparring was between the Saudis on one side and the Iranians and Venezuelans on the other. In the end, it was not only messy but made the cartel look increasingly dysfunctional and an archaic union heading slowly towards geopolitical insignificance. However, what appears on the face of it is not so straightforward.

To followers of crude matters, it is becoming increasingly clear that as in the past, the Saudis will act to raise their production unilaterally, more so because they left Vienna irked by what they saw as Iranian and Venezuelan belligerence. Furthermore, the cartel’s own spare capacity of around 4 million b/d is squarely in the hands of Saudi Arabia, Kuwait and UAE. Of these, the Saudis pumped an extra 200,000 b/d last month. Most analysts expect this to be mirrored in their June output and it would imply that the Saudis would be producing at least 1 m b/d over the now largely theoretic OPEC binding quota of 24.85 million b/d.

Almost 41% of the global crude oil output is in the hands of OPEC. If within this close-knit group, there is sparring between those with spare capacity and those without in full view of the world’s press then the cartel’s central purpose takes a hammering. Mighty worried about the negative impact of high prices on GDP growth of their potential export markets and by default on the growth of crude oil demand, the Saudis appeared to the Oilholic to be firm believers that it was in their interest to increase quotas and actual production – so they will raise their own.

Yet I do not totally agree with market conjecture that the “end of OPEC is nigh”. Neither does veteran market commentator Jason Schenker of Prestige Economics. He notes: “Some market mavens have heralded this event as 'The end of OPEC' or 'The beginning of the end of OPEC', we do not believe it. Although no formal production decision was reached, there are precedents for what has been going on with the organisation’s production. After all, the group quota was suspended at the peak of the last business cycle in 2008.”

“Furthermore, and more recently, the individual member county quotas were suspended last October. On a more practical note, group cohesion for affecting production and crude oil prices is less critical when the price of crude is over US$100 per barrel and the global economy is rising, along with oil demand. The division within OPEC is likely to heal, and we are confident that group cohesion will be seen again when prices fall,” he concludes.

Additionally with half of those at the table being newcomers to the job, the situation in Libya and their representative, and an Iranian ‘acting’ oil minister with no experience of OPEC negotiations or of ‘crude’ affairs (he was previously the country’s minister for sport) all combined to complicate the situation as well as infuriate the Saudis. This situation should not arise at the next meeting.

Now if all this has left you yearning for a slice of OPEC’s history – whether you are an observer, derider or admirer of the cartel – there is no better place to start than Dr. Fadhil Chalabi’s latest book Oil policies, oil myths: Observations of an OPEC insider.

If there is any such thing as a ringside view of the wheeling and dealing inside OPEC then Dr. Chalabi more than anyone else had that view. The Oilholic found his book, which serves as the author’s memoir of his time at OPEC as well as charts the history of OPEC and its policies, to be a thoroughly good read.

He was the deputy secretary general of OPEC from 1979-89 and its acting secretary general from 1983-88. The book is, in more ways than one, a coupling of an account of his time at OPEC and an objective analysis of what has transpired in the energy business over last four decades. Looking through either prism - both the book's "memoir aspect" as well as the author's charting of the history of OPEC and its policies, it comes across as a thoroughly good read.

The book is just over 300 pages split by 16 chapters over which the author offers his thoughts in some detail about why OPEC is relevant. He also sets about exploding a few myths about the cartel, what has shaped it and how it has impacted the wider industry as well as the global economy.

To substantiate his case, he offers facts, figures, graphics, a glossary and a noteworthy and useful chronology of key events affecting the oil industry. The world has come a long way from the days when the “Seven Sisters” simply posted the oil prices in Platt’s Oilgram news bulletins. The era of price volatility-free cheap oil ended with the price shock of 1973 in the author’s opinion, before which the world had scarcely heard of OPEC.

Gaddafi’s Libya, Saddam’s Iraq and Nasser’s Egypt are all there but the Oilholic found Chapter 7 narrating the episode when Carlos the Jackal struck OPEC (in 1975) to be riveting, for among the hostages taken by the Jackal was the author himself. The book understandably has many fans at OPEC and officials from member nations as seen in its endorsements. However, what makes it enjoyable is that it is no glorification or advert of the cartel.

Rather it is an objective analysis of how crude oil has shaped the diplomatic relations of OPEC members with the oil-consuming nations globally and by default how an oil exporting cartel’s presence triggered ancillary developments in the crude business. This includes changing the investment perspective of IOCs who began facing dominant NOCs. In summation, if you would like to probe the supposed opacity of OPEC, Dr. Chalabi’s book would be a good starting point.

© Gaurav Sharma 2011. Photo 1: OPEC Flag © Gaurav Sharma 2011, Photo 2: Cover: Oil Policies Oil Myths © I.B. Tauris Publishers. Book available here.

Valero, BP, Crude price & the week that was!

The seven days that have passed have been ‘crudely’ interesting to say the least. First off, early May saw one of the biggest market sell-offs in recent memory as commodities of all descriptions did a mini battle with price volatility. Brent crude for its part fell nearly 6% before recovering and stabilising above US$110 per barrel.

Macroeconomic factors aside many in the City believe the ongoing conflict in Libya no longer appears to be a key driver of oil prices as the loss of Libyan oil exports were fully discounted by the market some time ago. The profit takers agree! Société Générale CIB analysts noted in a report to clients that they estimate:

“the fair value for the Brent price would be about US$100 if no MENA risk premium were included. It is difficult to see the MENA risk premium rising much further near-term unless significant unrest emerges in countries with substantial oil exports such as Algeria and Saudi Arabia.”

That is not happening and Syria is of peripheral importance from near term instability premium perspective. Société Générale CIB analysts further note that the Brent crude oil price may correct lower over coming weeks as speculative traders may be tempted to take some profit on long positions as:

• recent significant events in the Middle East & North Africa (MENA) have been limited to countries with little oil exports


• tentative signs of demand destruction in the US, and


• growing concerns of a bumpy or hard landing in China.

Moving away from the crude price, heads of the big five oil firms Shell, Exxon, Conoco, BP America and Chevron and some Democrats on the Senate finance committee squared up to each other on May 6^th over the age-old issue of tax subsidies for oil companies. The latter want the tax subsidies removed, but big oil contests that they are benefitting from the subsidies like any other US business does and furthermore they are heavily taxed already.

That same day BP’s shares rallied in the UK following news that an arbitral panel has issued a consent order permitting BP and the AAR consortium to assign an Arctic opportunity to TNK-BP, subject to consent from Russian state-controlled firm Rosneft. The long drawn out saga may finally be reaching a favourable conclusion for BP.

Also last week ratings agency Moody’s changed US refiner Valero Energy's rating outlook to stable from negative and at the same time affirmed Valero's existing Baa2 senior unsecured note ratings. It said the stabilisation in the rating outlook reflects the expectation that Valero's cash flow will remain strong over the short term due to rising industrial activity pushing modest growth in demand for distillates and the expectation of supportive light/heavy spreads.

The stable outlook also reflects the assumption that Valero will maintain investment grade leverage metrics over the next 12-18 months as it continues to pursue organic growth and acquisition opportunities.

Additionally Moody's expects Valero's earnings to remain highly cyclical, and noted that the 2010 sale of the company's secularly weaker US East Coast refining assets, willingness and financial capacity to idle underperforming assets, as well as its recent cost reduction efforts should enhance the company's ability to withstand the inherent cyclicality of the sector. Moody's also expects that Valero will remain acquisitive. In March of this year, Valero announced the purchase of Chevron's Pembroke refinery in the UK for US $1.7 billion.

Rounding off - the Oilholic turned 33 years young today, last seven of which have been a ‘crude’ affair ;-) Thanks for all the birthday messages!

© Gaurav Sharma 2011. Photo: Alaska Pipeline with Brooks Range in background © Michael S. Quinton / National Geographic

North Sea murmurs, Q1 profits & Bin Laden

To begin with good riddance to Bin Laden! The tragedy of 9/11 still feels like yesterday. I can never forget that morning as a junior reporter watching the BBC when initial reports began trickling in and we were asked to vacate the Canary Wharf building I was at. Miles away across the pond a great tragedy was unfolding – this brings closure to the many who suffered, many known to me.

Being mechanical, there is a near negligible impact on the wider market or crude market despite brave efforts of the popular press to find connections. How markets fluctuated since morning has no direct connection with Bin Laden being killed and instability premium reflected in the price of crude remains untroubled. The threat of Al-Qaeda remains just as real in a geopolitical sense and a Middle Eastern context.

Moving away from today’s news, ratings agency Moody’s noted last week that sharply higher prices for oil and natural gas liquids have boosted business conditions for the independent exploration and production (E&P) industry, and should remain high well into 2012, offsetting persistently weak natural gas prices. In the same week, ExxonMobil and Royal Dutch Shell reported appreciable rises in Q1 profits.

ExxonMobil posted quarterly profits of US$10.7 billion, up 69% over the corresponding quarter last year. It also announced a spend of US$7.8 billion over the quarter on developing new energy supplies and said its shareholders had benefited to the tune of US$7 billion in Q1 dividends.

Shell for its part reported quarterly profits of US$6.9 billion on a current cost of supply basis, up 41% on an annualised basis. It said cost saving measures as well as higher oil prices had contributed to its Q1 profitability. Earlier, BP reported first quarter profits of US$5.5 billion, down marginally from the corresponding period last year. Its production over the quarter was also down 11% after asset sales to help pay for the cost of Macondo clean-up.

Finally, unhappy murmurs about rising taxation amid the North Sea oil & gas producers are growing. In his Budget tabled in March, UK Chancellor George Osborne raised supplementary tax on production from 20% to 32%. Reports in the British media this morning suggest the owner of British Gas Centrica says it might shut one of its major gas fields because of increased UK taxes. It is closing three fields in Morecambe Bay for a month of maintenance, may not reopen one of them.

A fortnight ago, Chevron warned of possible "unintended consequences" from the UK Budget decision to raise North Sea taxes. Its Chairman John Watson told the Financial Times, “When you increase taxes every few years, particularly without consulting with industry, there will be unintended consequences of that in terms of where we choose to invest."

In 2010, Chevron received UK government’s permission to drill an exploration well to evaluate a major prospect - the deep-water Lagavulin prospect - is 160 miles north of Shetland Islands. All this comes after a report published on April 8th by Deloitte’s Petroleum Services Group noted that North Sea offshore drilling activity fell 25% over Q1 2011.

The North West Europe Review, which documents drilling and licensing in the UK Continental Shelf (UKCS), reveals just five exploration and four appraisal wells were spudded in the UK sector between January 1 and March 31; compared to a total of 12 during the fourth quarter of 2010.

Analysts at Deloitte’s Petroleum Services Group said while the drop cannot be attributed to the recent Budget announcement, which proposed increased tax rates for oil and gas companies, it could set the pattern for activity in the future.

Graham Sadler, managing director of Deloitte’s Petroleum Services Group said, “It is important to clarify that we are talking about a relatively small number of wells that were drilled during the first quarter of the year - the traditionally quieter winter months - so this is not, in itself, an unexpected decrease. The lead-in time on drilling planning cycles can be long – even up to several years - so any impact from the recent changes to fiscal terms are unlikely to be seen until much later in the year.”

“What is clear is that despite the decrease in drilling activity towards the end of last year, and during the first months of 2011, the outlook for exploration and appraisal activity in the North Sea appeared positive. The oil price continued to rise and there were indications that this, combined with earlier UK government tax incentives, was encouraging companies to return to their pre-recession strategies. Since the Budget, a number of companies have announced that they intend to put appraisal and development projects on hold and we will have to wait to see the full effect of this change on North Sea activity levels over the coming months,” he concluded.

Deloitte’s review shows that the Central North Sea has seen the highest level of drilling activity, with the region representing 55% of all exploration and appraisal wells spudded on the UKCS during the first quarter of this year.

It also showed that the price of Brent Crude oil has experienced sustained growth throughout the period, rising 20% between December 2010 and March 2011 to a monthly average of US$114.38. This increase in price is a continuation of a trend that started in 2010, however, so far this year, the rate and pattern of growth has been much more constant with regular increases rather than the rise and dip pattern seen during 2010.

© Gaurav Sharma 2011. Photo: ExxonMobil plaque outside its building, Houston, Texas, USA © Gaurav Sharma, March 2011

Goodbye Houston; first thoughts from Calgary

Instability or risk premium is not being reflected in the US Mid West as much as it is in Europe in light of the Libyan situation. Following accidents in San Bruno, CA and Michigan, MI – pipeline safety legislation is likely to be added to the pile of regulatory activity related to the energy business which followed BP’s Gulf of Mexico fiasco. In fact, a bill on pipeline safety is already making its way through the US senate.

There is also common conjecture that retirement of coal-fired power plants may assist in shifting established gas flow patterns (& prices). However, the Oilholic feels while this is likely to happen at some point, it will not happen in a meaningful way any time soon. Mid West’s problem is akin to that of Australia’s when it comes to power generation – a traditional dependence on coal which is hard to tackle. Gas prices, in any case, are likely to remain low as there are abundant supplies and storage levels are solid.

Given that the US overtook Russia as the leading gas producer courtesy of shale gas, it is not bravado to assume that it could meaningfully export to Europe or that US-bound LNG could well be diverted to Europe.

Moving on to refining, some local analysts are following the “things can only get better” logic for North American refiners – who they feel are well positioned to demonstrate a recovery (or some form of stabilisation) of their margins after six troubled quarters to end-2010. The speed of the economic recovery will have a big say in the state of affairs.

After leaving Houston, the Oilholic has now arrived in its sister Canadian city of Calgary – quite a switch from a sweltering 30 C on a Texan morning to about -4 C on an Albertan evening. While both cities do not share their climate – they do share the same sense of frustration about the delays associated with the expansion project of the Keystone pipeline.

It seems Alberta and Texas are quite keen on the expansion – it’s just that everyone in between is the problem. The politics associated with this pipeline, as with other projects of its ilk is deeply complicated. However, this one involves cross-border politics, some of which has turned ugly especially in relation to the “cleanness” of Canadian oil.

And by the way its “oil sands” not “tar sands” stupid, say the locals! I’ll have more from Calgary shortly when I soak in and refine the local commentators’ viewpoints.

© Gaurav Sharma 2011. Photo: Calgary Tower, Alberta, Canada © Gaurav Sharma, March 2011

First thoughts from Houston…mine & others'

It is good to be back in the city that made the oil trade a business! With both ICE Brent and West Texas Intermediate forward month futures contract benchmarks above US$100 per barrel, Houston should be a happy place on this beautiful Thursday morning. Following a breakfast meeting with some ‘crude’ contacts, the viewpoints to emerge were more nuanced than I’d thought and some were in line with my chain of thoughts.

But first things first, last I checked WTI forward month futures contract was at US$106.35/b and ICE Brent at US$115.60/b. An energy partner at a law firm, a commodities trader, an industry veteran and an oil executive were all in agreement that geopolitical bias for crude prices – well – is almost always to the upside. Recent events in the Middle East and whats going on Libya in particular is having more of an impact on the Brent spread, as it is more reflective of global conditions. WTI is more reflective of conditions in the US mid-west and as such many here believe even US$100-plus does not reflect market demand vs. supply fundamentals.

Only medium term concern here, moving away from the geopolitical bias, is the perceived bottleneck associated with pipeline capacity (from Alberta, Canada) to Cushing and then southwards. This is unlikely to be relieved until 2013 (TCPL Keystone XL) or 2014 (Enbridge) and lets not forget the associated politics of it all.

The Libya situation, most experts here say, may create a short-term spike for both crude benchmarks, more so in Brent’s case – but it is not going to be 2008 all over again – in the words of four experienced Texans and the pragmatic SocGen analyst Mike Wittner.

Furthermore, market commentators here believe that over the next three quarters both speculative activity and investor capital flow in to the crude market (or shall we say the paper crude market) will be highly tactical as the current geopolitical risk premium (hopefully) eases gradually.

As expected, local feedback suggests utilisation rates of refineries and LNG terminals locally is still low. While I attach a caveat that four experts do not speak for the whole state, the belief here in Texas is that refining margins, which have been pathetic for the past six quarters may show some recovery towards the end of 2011.

© Gaurav Sharma 2011. Photo: Pump Jacks, Perryton, Texas © Joel Sartore/National Geographic

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

In the Realm of Crude “What Ifs”

Last time I checked the ICE Brent forward month futures contract was trading at US$110.46 per barrel up US$4.68 or 4.43% in intraday trading (click on chart to enlarge). It is my considered belief, since fundamentals do not support such a high price at this moment in time that there is at least US$10 worth of instability premium factored in to the price.

Given the number of “what if” analysts doing the rounds of the TV stations today, it is worth noting with the Libyan situation that not only are supply concerns propping up the price but the type of crude that the country supplies is also having an impact. I feel it is the latter point which is reflected more in the crude price than supply disruption. Light sweet crude is the most cost effective variety to refine and while Libyan crude is not as good as American light sweet crude, it is still of a very good quality relative to its OPEC peers.

Now, if exporters such as Saudi Arabia talk of making up the short supply, not all of the Libyan export shortfall can be compensated for with a type of crude the country exports. This is what the speculators are factoring in, though it is worth stating the obvious that Libya is the world 12th largest exporter of crude.

Furthermore, the age-old “what if” question is also hounding trading sentiment, i.e. “What if the house of Saud collapses and there is a supply disruption to the Saudi output?” The question is not new and has been around for decades. Problem is that a lot of the “what ifs” in Middle East and North Africa have turned to reality in recent weeks. If the House of Saud were to fall, it will be a geopolitical impact on crude markets of a magnitude that we have not seen since the Arab oil embargo.

Elsewhere at the International Petroleum Week, advisory firm Deloitte revealed its second full year ranking of UK upstream independent oil companies by market capitalisation. The top three are Tullow, Cairn and Premier Oil in that order, a result similar to end-2009. Tullow’s strength in Ghana helped it to maintain top spot in the sector. Its £11 billion market capitalisation is more than twice the valuation of its closest rival Cairn Energy, which in turn is more than twice the size of third placed Premier Oil. (Click on table below to enlarge)

Cairn continues to excite after agreeing to sell its Indian interests to Vedanta last year and concentrating on Arctic exploration. However, its drilling off the coast of Greenland has yet to yield anything ‘crudely’ meaningful. Another noteworthy point is the entry of Rockhopper Exploration, which is prospecting for crude off the coast of the Falkland Islands, into the top ten at 9th (up from 26th at end-2009).

“We have seen a great deal of volatility in the ranking showing the transformational growth achievable through exploration success. Overall, 2010 was a year of recovery for the UK upstream independent oil and gas sector, with rising oil prices and greater access to capital improving investor sentiment in the sector,” says Ian Sperling-Tyler, associate partner of energy transaction services at Deloitte.

“The improved environment was reflected in a 28% increase in the market capitalisation of the 25 biggest companies in the sector from £25.3 billion to £32.2 billion. In contrast, the FTSE 100 posted a 9% gain,” he adds.

Moving away from UK independent upstarts to a British major’s deal with an Indian behemoth. Following the BP/Reliance Industries Limited (RIL) announcement about a joint venture, ratings agency Moody's has changed the outlook of the Baa2 local currency issuer rating of RIL from stable to positive. RIL's foreign currency issuer and debt ratings remain unchanged at Baa2 with a stable outlook, as these are constrained by India's sovereign foreign currency ceiling of Baa2.

The rating action follows the company's recent announcement of a transformational partnership agreement with BP that will see the British major take a 30% stake in RIL's 23 Indian oil and gas blocks, including the substantial KG D6 gas field, for an initial consideration of US$ 7.2 billion plus further performance related payments of up to US$ 1.8 billion.

Philipp Lotter, a Senior Vice President at Moody's in Singapore believes the partnership agreement has generally positive credit implications for RIL, both operationally and financially. "The decision to bring on board BP in support of India's domestic gas market development will benefit RIL from BP's deep-water drilling expertise, as well as allow it to share risks and costs of future exploration and infrastructure projects, thus significantly de-risking its upstream exposure," he adds.

However, according to Moody's it is worth noting that the outlook could revert back to stable, if RIL undertakes transformational debt-funded acquisitions, or allocates material liquidity to finance growth that entails higher business risk. A deterioration of retained cash flow to debt below 30% is also likely to reverse any upward rating pressure.

© Gaurav Sharma 2011. Graphics 1: Brent crude oil chart © Digital Look/BBC Feb 23, 2011, Graphics 2: Leading UK independent oil companies © Deloitte LLP

Shell Divests, BP Invests and Libya Implodes!

Earlier on Monday, oil giant Shell announced its intentions to sell most of its African downstream businesses to Swiss group Vitol and Helios Investment Partners for US$1 billion adding that it will create two new joint ventures under the proposed deal.

The first of these JVs will own and operate Shell's existing oil products, distribution and retailing businesses in 14 African countries, most notably in Egypt, Morocco, Kenya, Uganda and Madagascar.

The second JV will own and operate Shell's existing lubricants blending plants in seven countries. The move is in line with Shell’s policy of divesting its non-core assets. It sold US$7 billion of non-core assets in 2010. While Shell was divesting in Africa, BP was investing in India via a strategic oil & gas partnership with Reliance Industries.

Both companies will form a 50:50 joint venture for sourcing and marketing hydrocarbons in India. The agreement will give BP a 30% stake in 23 oil and gas blocks owned by Reliance including 19 off the east coast of India. Market feedback suggests the deal is heavily weighted towards gas rather than the crude stuff.

In return for the stake, BP will invest US$7.2 billion in the venture and a further US$1.8 billion in future performance-related investments. The combined capital costs are slated to be in the region of US$20 billon with local media already branding it as the largest foreign direct investment deal in India by a foreign company.

Switching focus to the Middle Eastern unrest, what is happening from Morocco to Bahrain is having a massive bearing on the instability premium factoring in to the price of crude. However, the impact of each country’s regional upheaval on the crude price is not uniform. I summarise it as follows based on the perceived oil endowment (or the lack of it) for each country:

• Morocco (negligible)
• Algeria (marginal)
• Egypt (marginal)
• Iran (difficult to gauge at the moment)
• Tunisia (negligible)
• Bahrain (marginal)
• Libya (substantial)

Of these, it is obvious to the wider market that what is happening in Libya is one of concern. More so as the unrest has become unruly and the future may well be uncertain as the OPEC member country accounts for around 2% of the daily global crude production.

Italian and French oil companies with historic ties to the region are among those most vulnerable, though having said so BP also has substantial assets there. Austria’s OMV and Norway’s Statoil are other notable operators in Libya. A bigger worry could be if Iran erupts in a similar unruly way. Given the international sanctions against Iran, oil majors are not as involved there as they are in Libya. However, the question Iran’s crude oil endowment and its impact on the oil markets is an entirely different matter.

Finally, the ICE Brent crude forward month futures contract stood at US$108.25 per barrel, up 5.6% in intraday trading last time checked. I feel there is at least US$10 worth of instability premium in there, although one city source reckons it could be as high as US$15. The "What if" side analysts (as I call them) are having a field day - having already moved their focus from Iran to Saudi Arabia.

© Gaurav Sharma 2011. Photo: Vintage Shell gasoline pump, Ghirardelli Square, San Francisco, California, USA © Gaurav Sharma, March 2010