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

Libya & OPEC’s “Will they, Won’t they” Routine

As the situation in Libya worsens, depending on differing points of view of Gaddafi goons and rebel fighters, OPEC’s routine of sending conflicting messages does not harm the price of crude – something which I don’t think the cartel minds all that much over the short term. In fact the OPEC basket price of crude seems to be following Brent’s price more closely than ever.

In a nutshell according to various newswires, Gaddafi militia and rebel fighters are toughing it out near oil terminals over 500km east of the capital Tripoli. Heaviest of the skirmishes have been outside (& within) the oil town Ras Lanuf, with both sides claiming a position of strength. A rebel spokesperson even gave out a statesman like statement, telling the BBC they would “honour” oil contracts.

However, anyone looking towards OPEC to calm the markets got a ‘crude’ response and mixed signals in keeping with the cartel's well practised drill of letting the wider world indulge in a guessing game of whether a production increase was on cards or not. The Saudis sought to calm, the Venezuelans and Iranians tried to confuse and the rest were quite simply confused themselves.

Moving away to a corporate story, pre-tax profits announced last week by UK independent upstart Tullow Oil have jumped 361% to US$152 million with a 19% rise in revenues to US$1 billion in the year to 31 December. In a statement to investors, its chief executive Aidan Heavey said the outlook was "very positive". I’d say its much more than that sir!

Finally, one of UK’s signature refineries – Pembroke – would now be a proud member of San Antonio, Texas-based refining major Valero Energy Corp. That’s after its current owner Chevron announced on March 11 that Valero had agreed to pay US$730 million for the refinery and US$1 billion for the assets. Ratings agency Moody's views Valero's acquisition of Pembroke and associated marketing and logistics assets as credit neutral. It may well be noted that it took Chevron nearly a year to...ahem....get rid of it (??)

© Gaurav Sharma 2011. Photo © Gaurav Sharma 2009

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

Of PetroChina, Gazprom and Hackers!

But first...Brent remains well into US$100+ per barrel territory while WTI remains in sub-US$90 region. Let’s face it the Nymex WTI-ICE Brent spreads remain extremely weak and it is becoming a recurring theme. The front-month spread even capped -US$16 per barrel mark (US$16.29 to be exact) on Feb 11; the date of expiry of the Brent forward month futures contract.

Moving away from pricing, it emerged last week that Russia’s Gazprom reported a fall in profits from RUR173.5 billion to RUR160.5 billion; an annualised dip of 9% for the quarter from July to Sept 2010 period. The cost of purchasing oil and gas jumped 29% according to the state owned firm while operational costs rose 12%. Dip in profit even prompted Russian PM Putin to “ask” them to raise their game.

Elsewhere, the “All Hail Shale” brigade had to contend with PetroChina – the Chinese state-controlled energy firm – acquiring a 50% stake in a Canadian Shale Gas project run by Encana. The stake cost is pegged at a cool US$5.4 billion. PetroChina already has majority stakes in two oil projects in Canada with Encana. There doesn’t appear to be much of a ruckus about the Chinese shopping in Canada. I guess Canadians are less uptight about Chinese investment in perceived strategic energy assets than the Americans.

Finally, computer security firm McAfee claimed in a report published on February 10th that hackers have attacked networks of a number of oil and gas firms for a good few years now. The full report is available for downloading here and it makes for interesting reading. However, I am not entirely surprised by the revelations.

In a nutshell, McAfee claims that in a series of co-ordinated attempts at least a dozen multinational oil, gas and energy companies were targeted – named by it as Night Dragon attacks – which began in November 2009. Five firms have now confirmed the attacks, it adds.

© Gaurav Sharma 2011. Photo: Oil tanker © Michael S. Quinton/National Geographic Society