Oil Price, Petroaggressors & a Few Books I've Read

Since last week, the wider commodities market has continued to mirror equities. This trend intensified towards the end of last week and shows no sign of abating. Furthermore, it is worth noting that Brent crude is trading at a premium to its American cousin, a gap which widened over USD$2. On Tuesday (August 31) at 13:00 GMT, the Brent forward month futures contract was trading at US$76.10 a barrel (down 1.1%) versus WTI crude at US$73.83 (down 3.1%) in intraday trading.

This of course is ahead of the US energy department’s supplies update, due for publication on Wednesday. The report is widely tipped to show a rise in crude stockpiles and the US market is seen factoring that in. Overall, the average drop in WTI crude for the month of August is around 8.89% as the month draws to a close.

Having duly noted this, I believe that compared to other asset classes, the slant in oil still seems a more attractively priced hedge than say forex or equities. Nonetheless, with there being much talk of a double-dip recession, many commentators have revised their oil price targets for the second half of 2010.

Last month, the talk in the city of London was that crude might cap US$85 a barrel by the end of the year; maybe even US$90 according to Total’s CEO. Crude prices seen in August have tempered market sentiment. Analysts at BofA Merrill Lynch now believe the oil price should average US$78 per barrel over H2 2010 owing to lower global oil demand growth and higher-than-expected non-OPEC supply.

“Following robust increases in oil demand over the past 12 months on a stimulus-driven rebound, we now see some downside risk as slower growth sets in and OECD oil inventories remain high. Beyond 2011, oil markets should remain tight on solid EM fundamentals and potentially a looser monetary policy stance by EM central banks on the back of the recent crisis in Europe. Curves may flatten further as inventories return to normal levels and seasonal hedging activity picks up,” they wrote in an investment note.

Elsewhere, Russia's largest privately held oil company - Lukoil - reported a 16% drop in quarterly profits with net profit coming at US$1.95 billion for the April-June period. Revenues rose 28% to US$25.9 billion on an annualised basis. In statement to the Moscow stock exchange, Lukoil said it is coping with the difficult macroeconomic situation and securing positive cash flow thanks to implementing measures aimed at higher efficiency which were developed at the beginning of the year.

The company largely blamed production costs for a dip in its profits which rose 24% for the first half of 2010. In July, US oil firm ConocoPhillips, which owns a 20% stake in Lukoil, said it would sell its holdings. However, the Russian oil major issued no comment on whether it would buy-out ConocoPhillips’ holdings.

Reading investment notes and following the fortunes of Lukoil aside, I recently stumbled upon a brilliantly coined term – “petroaggressors” – courtesy of author and journalist Robert Slater. After all, little else can be said of Iran, Venezuela, Russia and others who are seeking to alter the energy security hegemony from the developed world in favour of the Third world.

In his latest book – Seizing Power: the global grab for oil wealth – Slater notes that the ranks of petroaggressors are flanked by countries such as India and China who are desperate to secure the supply of crude oil with very few scruples to fuel their respective economic growth.

It is mighty hard to imagine life without oil; such has been the dominance of the internal combustion engine on life in the developed world over the last six decades. Now the developing world is catching-up fast with the burgeoning economies of China and India leading the pack. End result is every economy, regardless of its scale is suddenly worried about its energy security. Slater opines that a grab for this finite hydrocarbon may and in some cases already is turning ugly.

In fact he writes that the West, led by the US (currently the world's largest consumer of crude oil), largely ignored the initial signs regarding supply and demand permutations. As the star of the major oil companies declines, Slater writes that their market share and place is being taken not by something better - but rather by state-run, unproductive and politics-ridden behemoths dubbed as National Oil Companies (NOCs).

If the peak oil hypothesis, ethical concerns, price speculation and crude price volatility were not enough, geopolitics and NOCs run by despots could make this 'crude' world reach a tipping point. Continuing on the subject of books, journalist Katherine Burton's latest work - Hedge Hunters: How Hedge Fund Masters Survived is a thoroughly decent one.

In it, she examines the fortunes of key players in the much maligned, but still surviving hedge fund industry. In the spirit of a true oilholic, I jumped straight to Chapter 9 on the inimitable Boone Pickens, before immersing myself in the rest of her book.

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

Cairn Energy "Smells" Black Gold in Greenland

Barely a week after announcing the proposed sale of a 51% stake in its Indian unit to Vedanta in order to concentrate on its Greenland operations, Cairn Energy claims to have discovered gas in the self-governing Danish protectorate. It is usually a sign that the crude stuff may follow. In a statement, the company said its personnel had observed "early indications of a working hydrocarbon system" off Greenland’s coast at its Baffin Bay T8-1 prospection well. Apart from the T8-1 site, the energy company said plans to drill at least two other wells over the course summer were also on track.

Cairn chief executive Sir Bill Gammell says he is looking forward to assessing results of the remainder of the 2010 drilling programme. So does rest of the market; except for Greenpeace who have promptly dispatched a protest ship to the region.

The company's planned drilling target depth is in the region of 4,000 metres (or above) and energy sector analysts are not yet jumping with joy. Perhaps a knee-jerk reaction to Cairn’s announcement has been tempered by the fact that Scandinavian, British and American teams have all attempted drilling off the coast of Greenland in the past, i.e. in 1970-75 and then again in 2000. Neither of the drives resulted in success.

Still the Greenland Bureau of Minerals and Petroleum, which has made developing oil activities one of its most important priorities aimed at creating enough revenues to replace the subsidy the protectorate receives from Denmark, would be hoping Cairn is lucky in striking black gold this time.

Meanwhile, the forward month crude oil futures contract dipped below US$72 a barrel in intraday trading across the pond as the wider commodities market mirrored equties trading; a trend noted over the last six trading sessions. I quite agree with Phil Flynn, analyst at PFG Best, who wrote in an investment note that: "Just when it seems oil is going to rally on strong economic optimism; it gets crushed with the realty of gluttonous supply."

London Brent crude was just about maintaining resistance above US$72 down 89 cents or 1.2% at US$72.55 around 14:45 BST. However, weaker economic data on either side of the Atlantic and fears of a double dip recession, most recently stoked by Bank of England’s MPC member Martin Weale have certainly not helped.

©Gaurav Sharma 2010. Photo: Oil tanker ©Michael S. Quinton/National Geographic Society

Cairn Energy: Choosing Greenland over India?

It seems Cairn Energy has shifted its attention from India to Greenland. What else can be said of the Edinburgh-based independent upstream upstart’s announcement of plans to sell a 51% stake in its Indian operations to mining group Vedanta for up to US$8.5 billion?

After a week of nudges and winks, Cairn confirmed rumours of the sale doing the rounds in the city of London. The company’s Indian operations have a market capitalisation of just over US$14 billion which makes Cairn India, the country’s fourth largest oil company.

Apart from seeking a "substantial return of cash" to shareholders, it is now clear that Cairn hopes to pursue its drilling ambitions in Greenland with some vigour. In a media statement, Cairn’s chief executive Sir Bill Gammell said, “I am delighted to announce the proposed disposal of a significant shareholding in Cairn India in line with our objective of adding and realising value for shareholders.”

To fathom what the announcement means for Cairn energy is easy. In fact, market analysts I have spoken to reckon the sale would generate more than adequate capital for Cairn's Greenland prospection in the medium term. This makes Cairn pretty cash rich and the market wonders what the inimitable Bill Gammell has up his sleeve. That it could bag another similarly scaled production asset akin to its fields in India’s Rajasthan state is doubtful.

Working out what the deal means for Vedanta is trickier. Its chief executive Anil Agarwal gave a rather simplistic explanation. In a statement he said, “The proposed acquisition significantly enhances Vedanta's position as a natural resources champion in India. Cairn India's Rajasthan asset is world class in terms of scale and cost, delivering strong and growing cash flow.”

Hence, simply put Vedanta has stated its intentions of venturing beyond metals and make a headline grabbing foray into the oil and gas sector. The market would be watching how the two aspects of the business gel under the Vedanta umbrella, but there are precedents of success – most notably at BHP Billiton.

In a related development, Cairn energy was featured in Deloitte’s half-yearly assessment of UK independent oil and gas companies. At the end of H1 2010, according to Deloitte the top five UK independent oil companies by market capitalisation were - Tullow Oil, Cairn Energy, Premier Oil, SOCO International and Heritage Oil in that order. The top three have maintained their respective positions from December 2009 while SOCO International entered the top five with a 31% increase in market capitalisation.

Overall, the first half of the year was broadly positive for the UK independents, with market capitalisation of the majority of companies in the league table increasing by 4.6% over the 6 month period to 30 June 2010. It stood at £26.482 billion as of end-June. (Click box on the left for the entire list)

On the oil price front, the crude stuff plummeted nearly 7% over the course of the week ended Fri 13th on either side of the pond. The price resistance is presently above US$75 a barrel and I expect it to remain there despite some pretty disappointing economic data doing the rounds these days. Looking further ahead, analysts at Société Générale’s Cross Asset Research team forecast NYMEX WTI to average US$80 in Q3 2010 (revised down by $10) and $85 in Q4 2010 (revised down by $5).

Looking further ahead, an investment note states that they expect NYMEX WTI of US$92.30 in 2011 (revised down by $8.70). NYMEX WTI is forecast at US$88.30/$87.50 in Q1 2011/Q2 2011, increasing to $95/$98.30 in Q3 2011/Q4 2011. On a monthly average basis, Société Générale expects NYMEX WTI of US$87.50 in December 2010 and $100 in December 2011.

In truth, fear of a double dip recession persists in wider market, especially in the US, EU and UK. However, many crude traders are quietly confident that in such an event, India and China’s crude oil consumption will help maintain the oil price at US$70 plus levels.

© Gaurav Sharma 2010. Photo courtesy © Cairn Energy Plc. Chart Courtesy © Deloitte LLP

Talking Crude: Of Profits, Tax rebates & Asset Sales

Last week was an eventful one in crude terms. Well it’d have to be if Shell and Exxon Mobil declare bumper profits. Both saw their quarterly profits almost double. Beginning with Shell, the Anglo-Dutch firm reported profits of US$4.5 billion on a current cost (of supply) basis, up from US$2.3 billion noted over the corresponding quarter last year.

Excluding one-off items, Shell's profit was $4.2 billion, compared with $3.1 billion last year. Unlike BP, Shell said it would pay a second quarter dividend of $0.42 per share. The oil giant's restructuring plans also appear to be bearing fruit achieving cost savings of $3.5 billion, beating the stated corporate savings target by about 15% and some six months ahead of schedule.

Furthermore, it is thought that as a result of the restructuring, 7,000 employees would leave Shell nearly 18 months ahead of schedule. It also said it expected to sell $7-$8 billion of assets over 2010-11. Concurrently, oil giant Exxon Mobil reported quarterly profits of $7.6 billion, well above the $4.1 billion it posted over the corresponding quarter last year. Revenue for the quarter rose 23% in year over year terms on annualised basis from $72.5 billion to $92.5 billion.

Meanwhile, rival BP reported a record $17 billion second quarter loss which the market half expected. The figure included funds to the tune of $32 billion set aside to cover the costs of the oil spill in the Gulf of Mexico.

Sticking with BP, it has emerged that the beleaguered oil giant included a tax credit claim of almost $10 billion in its Q2 results as it seeks to take the edge off the impact of the Gulf of Mexico oil spill on its corporate finances. Its income statement for the second quarter carries a pre-tax charge of $32.2 billion related to the oil spill and a tax credit of $9.79 billion.

Under domestic tax laws in the US, BP is entitled to deduct a proportion of its losses against US tax. The issue is likely to turn political – especially in an election year, when much more has been made out of far less. However, legally the US government can do precious little to prevent BP from claiming the tax credit.

Crude asset sales seem to be the order of the day. Following on from BP’s sale of assets and Shell’s announcement that it will sell too, news emerged that the Russian government also wants to join the party.

It plans to sell $29 billion worth of assets (not all which are energy sector assets) on the open markets. In the absence of official confirmation, local media speculation suggests minor stakes in Rosneft and Transneft may be put up for sale.

However, speaking to reporters in Moscow on July 29th, the country’s Finance Minister Alexei Kudrin said, "We will sell significant stakes in state companies on the market. We plan to keep controlling stakes. Assets will be valued publicly, in line with market prices and tenders will be open. We are fully ruling out a situation when somebody sells something to someone at an artificially low price."

According to communiqués, the Russian government wanted to rake in $10 billion next year from asset sales. It has also approved a decision to increase mineral extraction taxes on gas producers by 61% from 2011.

Finally from a macro strandpoint, market consensus and comments from BP, Shell and Exxon officials seem to indicate that the top bosses of all three see mixed signals in the global economy. While their earnings figures, excluding BP for obvious reasons, have improved markedly from the quarterly lows of 2009, the overall industry outlook remains uncertain.

© Gaurav Sharma 2010. Photo courtesy © Shell

Trying to Decipher Oil Majors’ Debt Ratings

Last month, BP’s image and shares were not the only things taking a plastering. Its bonds, due for repayment in 2013 were nearly downgraded to junk status trading at a price of less than 90 cents in the dollar. Given BP’s asset base, even if the ultimate cost of the Gulf of Mexico clean-up and legal costs amount to US$50 billion, there is not a cat in hell’s chance of the company defaulting on its debt obligation unless the oil price plummets dramatically. So quite frankly, the development was a load of rubbish which piled up owing to media pressure.

Now, it gets even more interesting. Following, BP’s asset sales to the tune of US$7 billion, Moody's cautiously placed the asset purchaser Apache Corporation’s ratings, including its A3 senior unsecured ratings, under review for downgrade on July 21st. However, Its P-2 commercial paper rating is not under review.

The ratings agency observes that while substantial existing cash and equity will fund the BP transaction, the: “leverage is amplified by the fairly low proportion of production and producing reserves relative to the price paid for the BP assets (by Apache), the corresponding substantial proportion of undrilled yet-to-be-funded proven undeveloped reserves and probable and possible acreage, the pending $3.9 billion acquisition of Mariner Energy and the June closing of its $1.050 billion acquisition of Devon Energy properties.”

Overall nearly US$5 billion of Apache’s rated debt is affected. Moody’s says that if Apache were to be downgraded, it would be no more than one notch. The principal methodology used in rating was the Independent Exploration and Production (E&P) Industry rating methodology published in December 2009.

I have reason to question the knee-jerk reaction of the markets to BP’s debt and but can find no reason to question Moody’s downgrade – except that caution has prevailed following the financial tsunami of 2008. Furthermore, a “who’s to say what might happen” sentiment is doing the rounds in the city of London. We’ve said time and again – from Enron to Lehman – that they were too big to fail. BP won’t fail, but the sentiment does not help and permeates across the oil and gas sector, with agencies being stricter than ever. Ratings agency, at the present moment in time are damned if they do and damned if they don’t. They’d rather “do” then “don’t” seems to be the consensus.

In a speech at the British Bankers Association (BBA) International conference that I attended on July 13th, Deven Sharma, President of Standard & Poor's, said that the industry realised the issue of transparency and accountability. He added that sound, consistent oversight of ratings firms will help build confidence in ratings, which has clearly been affected by the crisis.

However, Sharma also noted that, "Most of our ratings during the last three years have performed broadly in line with previous periods of economic stress - including our ratings of corporates and sovereigns globally and our ratings of European structured securities. However, the performance of our ratings on US mortgage-related securities clearly has been disappointing, which we very much regret."

Sharma said serious steps are being taken to address the scenario through major changes to ratings process and analytics. "S&P's aim is to make our ratings more forward looking, more stable and more comparable across asset classes," he added. We hope so too Sir!

© Gaurav Sharma 2010. Photo courtesy © Cairn Energy Plc