Not that taut: Oil markets & geopolitical tension

The month of August has brought along a milestone for the Oilholics Synonymous Report, but let’s get going with crude matters for starters as oil markets continue to resist a risk premium driven spike.

The unfolding tragedy in Iraq, Libya’s troubles, Nigerian niggles and the fear of Ebola hitting exploration and production activity in West Africa, are more than enough to provide many paper traders with the pretext to go long and spook us all. Yet, the plentiful supply and stunted OECD demand scenario that’s carried over from last month has made geopolitical tension tolerable. As such its not percolating through to influence market sentiment in any appreciable fashion, bringing about a much needed price correction.

It wasn’t the news of US air strikes on ISIS that drove Brent down to a nine month low this week, rather the cautious mood of paper traders that did it. Among that lot were hedge fund guys n’ gals who burnt their fingers recently on long bets (that backfired spectacularly in July), and resisted going long as soon as news of the latest Iraqi flare-up surfaced, quite unlike last time.

According to ICE data, hedge funds and other money managers reduced net bullish bets on Brent futures to 97,351 contracts in the week to August 5; the lowest on books since February 4. Once bitten, twice shy and you all know why. Brent price is now comfortably within the Oilholic’s predicted price range for 2014.

Away from pricing, the other big news of course is about the megamerger of Kinder Morgan Inc (KMI), Kinder Morgan Energy Partners (KMP) and El Paso Pipeline Partners Operating (EPBO), into one entity. The $71 billion plus complicated acquisition would create the largest oil and gas infrastructure company in the US by some distance and the country’s third-largest corporation in the sector after ExxonMobil and Chevron.

Moody’s, which has suspended its ratings on the companies for the moment, says generally the ratings for KMP and its subsidiaries will be reviewed for downgrade, and the ratings for KMI and EPBO and their subsidiaries will be reviewed for upgrade.

Stuart Miller, Moody's Vice President and Senior Credit Officer, notes: "KMI's large portfolio of high-quality assets generates a stable and predictable level of cash flow which could support a strong investment grade rating. However, because of the high leverage along with a high dividend payout ratio, we expect the new Kinder Morgan to be weakly positioned with an investment grade rating."

Sticking with Moody’s, following Argentina’s default on paper, the agency has unsurprisingly changed its outlook on the country’s major companies from stable to negative. Those affected in the sector include YPF. However, Petrobras Argentina and Pan American Energy Argentina were spared a negative outlook given their subsidiary status and disconnect from headline Argentine sovereign risk.

Switching tack from ratings notes to a Reuters report, a recent one from the newswire noted that the volume of US crude exports to Canada now exceeds the export level of OPEC lightweight Ecuador. While the Oilholic remains unconvinced about US crude joining the global crude supply pool anytime soon, there’s no harm in a bit of legally permitted neighbourly help. Inflows and outflows between the countries even things out; though Canadian oil exports going the other way are, and have always been, higher.

On the subject of reports, here’s the Oilholic’s latest quip on Forbes regarding the demise of commodities trading at investment banks and another one on the crucial subject of furthering gender diversity in the oil and gas business. 

Finally, going back to where one began, it is time to say a big THANK YOU to all you readers out there for your encouragement, criticism, feedback, compliments (as applicable) and the time you make to read this blogger’s thoughts. Though ever grateful, one feels like reiterating the gratitude today as Google Analytics has confirmed that US readers have overtaken the Oilholic's ‘home’ readers as of last month.

It matters as this humble blog has moved from 50 local clicks in December 2009 to 148k global clicks (and counting) this year and its been one great journey. The US, UK and Norway are currently the top three countries in terms of pageviews in that order (see right), followed by China, Germany, Russia, Canada, France, India and Turkey completing the top ten. Traffic also continues to climb from Australia, Brazil, Benelux, Hong Kong, Japan and Ukraine; so onwards and upwards to new frontiers with your continuing support. Keep reading, keep it 'crude'!

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© Gaurav Sharma 2014. Photo: Oil rig, USA © Shell. Graphics: Oilholics Synonymous Report, July 2014 clickstats © Google Analytics

Crude market, Russia & fretting over Afren

There's been an unsurprising calm in the oil market given the existing supply-side scenario, although the WTI's slip below three figures is more down to local factors above anything else.

Demand stateside is low while supplies are up. Additionally, the CVR Refinery in Coffeyville, Kansas which uses crude from Cushing, Oklahoma and churns 115,000 barrels per day (bpd) is offline and will remain so for another four weeks owing to a fire. It all means that Brent's premium to the WTI is now above US$7 per barrel. Despite (sigh) the latest Libyan flare-up, Brent itself has been lurking either side of $105 level, not as much down to oversupply but rather stunted demand. And the benchmark's current price level has triggered some rather interesting events.

Brent's premium to Dubai crude hit its lowest level in four years this week. According to Reuters, at one point the spread was as low as $1.20 following Monday's settlement. The newswire also reported that Oman crude actually went above Brent following settlement on July 31, albeit down to thin trading volumes.

Away from pricing, the Oilholic has been busy reading agency reports on the impact of the latest round of sanctions on Russia. The most interesting one came from Maxim Edelson of Fitch Ratings, who opined that sanctions could accelerate the decline of Siberian oilfields.

Enhanced recovery techniques used in these fields are similar to those used for shale oil extraction, one of the target areas for the sanctions. As the curbs begin to hit home and technology sales to the Russian oil & gas sector dry up, it will become increasingly harder to maintain rate of production from depleting West Siberia brownfields.

As brownfields are mature, major Russian oil companies are moving into more difficult parts of the existing formations. For example, GazpromNeft, an oil subsidiary of Gazprom, is increasingly relying on wells with horizontal drilling, which accounted for 42% of all wells drilled in 2013 compared to 4% in 2011, and multi-stage fracking, which was used in 57% of high-tech wells completed in 2013, up from 3% in 2011.

"In the medium term, [EU and US] measures are also likely to delay some of Russia's more ambitious projects, particularly those on the Arctic shelf. If the sanctions remain for a very long time they could even undermine the feasibility of these projects, unless Russia can find alternative sources of technology or develop its own," Edelson wrote further.

Russian companies have limited experience in working with non-traditional deposits that require specialised equipment and "know-how" and are increasingly reliant on joint ventures (JVs) with western companies to provide technology and equipment. All such JVs could be hit by sanctions, with oil majors such as ExxonMobil, Shell and BP, oil service companies Schlumberger, Halliburton and Baker Hughes, and Russia's Rosneft, GazpromNeft and to a lesser extent LUKOIL, Novatek and Tatneft, all in the crude mix.

More importantly, whether or not Russia's oil & gas sector takes a knock, what's going on at the moment coupled with the potential for further US and EU sanctions on the horizon, is likely to reduce western companies' appetite for involvement in new projects, Edelson adds.

Of course, one notes that in tune with the EU's selfish need for Russian gas, its sanctions don't clobber the development of gas fields for the moment. On a related note, Fitch currently rates Gazprom's long-term foreign currency Issuer Default Rating (IDR) at 'BBB', with a 'Negative' outlook, influenced to a great extent by Russia's sovereign outlook.

Continuing with Russia, here is The Oilholic's Forbes article on why BP can withstand sanctions on Russia despite its 19.75% stake in Rosneft. Elsewhere, yours truly also discussed why North Sea exploration & production (E&P) isn't dead yet in another Forbes post.

Finally, news that the CEO and COO of Afren had been temporarily suspended pending investigation of alleged unauthorised payments, came as a bolt out of the blue. At one point, share price of the Africa and Iraqi Kurdistan-focussed E&P company dipped by 29%, as the suspension of CEO Osman Shahenshah and COO Shahid Ullah was revealed to the London Stock Exchange.

While the wider market set about shorting Afren, the company said its board had no reason to believe this will negatively affect its stated financial and operational position.

"In the course of an independent review on the board's behalf by Willkie Farr & Gallagher (UK) LLP of the potential need for disclosure of certain previous transactions to the market, evidence has been identified of the receipt of unauthorised payments potentially for the benefit of the CEO and COO. These payments were not made by Afren. The investigation has not found any evidence that any other Board members were involved," it added.

No conclusive findings have yet been reached and the investigation is ongoing. In the Oilholic's humble opinion the market has overreacted and a bit of perspective is required. The company itself remains in a healthy position with a solid income stream and steadily rising operating profits. Simply put, the underlying fundamentals remain sound.

As of March 31 this year, Afren had no short-term debt and cash reserves of $361 million. In 2013, the company improved its debt maturity profile by issuing a $360 million secured bond due 2020 and partially repaying its $500 million bond due 2016 (with $253 million currently outstanding) and $300 million bond due 2019 (with $250 million currently outstanding).

So despite the sell-off given the unusual development, many brokers have maintained a 'buy' rating on the stock pending more information, and rightly so. Some, like Investec, cautiously downgraded it to 'hold' from 'buy', while JPMorgan held its 'overweight' recommendation on the stock. There's a need to keep calm, and carry on the Afren front. That's all for the moment folks. Keep reading, keep it 'crude'!

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© Gaurav Sharma 2014. Photo: Russian Oilfields © Lukoil

Hedge Funds have been ‘contangoed’

Recent events may have pushed the Brent front month futures contract back towards US$108 per barrel; but there's no denying some have been 'contangoed'! Ukrainian tensions and lower Libyan production are hard to ignore, even if the latter is a bit of a given.

Nonetheless, for a change, the direction of both benchmark prices this month indicates that July did belong to the physical traders with papers traders, most notably Hedge Funds, taking a beating.

It's astonishing (or perhaps not) that many paper traders went long on Brent banking on the premise of "the only way is up" as the Iraqi insurgency escalated last month. The only problem was that Iraqi oil was still getting dispatched from its southern oil hub of Basra despite internal chaos. Furthermore, areas under ISIS control hardly included any major Iraqi oil production zone.

After spiking above $115, the Brent price soon plummeted to under $105 as the reality of the physical market began to bite. It seems European refiners were holding back from buying the expensive crude stuff faced with declining margins. In fact, North Sea shipments, which Brent is largely synced with, were at monthly lows. Let alone bothering to pull out a map of Iraqi oilfields, many paper traders didn't even bother with the ancillary warning signs.

As Fitch Ratings noted earlier this month, the European refining margins are likely to remain weak for at least the next one to two years due to overcapacity, demand and supply imbalances, and competition from overseas. Over the first half of 2014, the northwest European refining margin averaged $3.3 per barrel, down from $4 per barrel in 2013 and $6.8 barrel in 2012.

Many European refineries have been loss-making or only slightly profitable, depending on their complexity, location and efficiency. They are hardly the sort of buyers to purchase consignments by the tanker-load during a mini bull run. The weaker margin scenario itself is nothing new, resulting from factors including a stagnating economy and the bias of domestic consumption towards diesel due to EU energy regulations

"This means that surplus gasoline is exported and the diesel fuel deficit is filled by imports, prompting competition with Middle Eastern, Russian and US refineries, which have access to cheaper feedstock and lower energy costs on average. Mediterranean refiners are additionally hurt by the interruption of oil supplies from Libya, but this situation may improve with the resumption of eastern port exports," explains Fitch analyst Dmitry Marinchenko.

Of course tell that to Hedge Funds managers who still went long in June collectively holding just short of 600 million paper barrels on their books banking on backwardation. But thanks to smart, strategic buying by physical traders eyeing cargoes without firm buyers, contango set in hitting the hedge funds with massive losses.

When supply remains adequate (or shall we say perceived to be adequate) and key buyers are not in a mood to buy in the volumes they normally do down to operational constraints, you know you've been 'contangoed' as forward month delivery will come at a sharp discount to later contracts!

Now the retreat is clear as ICE's latest Commitments of Traders report for the week to July 15 saw Hedge Funds and other speculators cut their long bets by around 25%, reducing their net long futures and options positions in Brent to 151,981 from 201,568. If the window of scrutiny is extended to the last week of June, the Oilholic would say that's a reduction of nearly 40%.

As for the European refiners, competition from overseas is likely to remain high, although Fitch reckons margins may start to recover in the medium term as economic growth gradually improves and overall refining capacity in Europe decreases. For instance, a recent Bloomberg survey indicated that of the 104 refining facilities region wide, 10 will shut permanently by 2020 from France to Italy to the Czech Republic. No surprises there as both OPEC and the IEA see European fuel demand as being largely flat.

Speaking of the IEA, the Oilholic got a chance earlier this month to chat with its Chief Economist Dr Fatih Birol. Despite the latest tension, he sees Russian oil & gas as a key component of the global energy mix (Read all about it in The Oilholic's Forbes post.)

Meanwhile, Moody's sees new US sanctions on Russia as credit negative for Rosneft and Novatek. The latest round of curbs will effectively prohibit Rosneft, Novatek, and other sanctioned entities, including several Russian banks and defence companies, from procuring financing and new debt from US investors, companies and banks.

Rosneft and Novatek will in effect be barred from obtaining future loans with a maturity of more than 90 days or new equity, cutting them off from long-term US capital markets. As both companies' trade activities currently remain unaffected, Moody's is not taking ratings action yet. However, the agency says the sanctions will significantly limit both companies' financing options and could put pressure on development projects, such as Novatek's Yamal LNG.

No one is sure what the aftermath of the MH17 tragedy would be, how the Ukrainian crisis would be resolved, and what implications it has for Russian energy companies and their Western partners. All we can do is wait and see. That's all for the moment folks. Keep reading, keep it 'crude'!

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© Gaurav Sharma 2014. Photo: Oil pipeline © Cairn Energy

OPEC’s spare capacity & some corporate quips

Oil benchmarks have by and large remained calm in the face of escalating tensions in Iraq. Market sentiment was helped in no small parts by the US importing less crude and ISIS being kept at bay from Iraqi oilfields. Nonetheless, what does the current situation mean for OPEC's spare capacity, concerns over which have marginally eased as non-OPEC production is seen rising.

Over the first quarter of this year, OPEC's spare capacity was in the region on 1.9 million barrels per day (bpd), bulk of which – 1.75 million bpd – is in the hands of Saudi Arabia.

Société Générale CIB analysts Patrick Legland and Daniel Fermon, recently raised a very important question in a note to clients – so assuming that within OPEC, supply from Iran, Iraq, and Libya does not increase and Saudi spare capacity is not sufficient to offset a potential Iraqi crisis, what then? A scary prospect, especially if Iraqi tensions spill to southern oilfields.

SocGen's veteran analyst Mike Wittner assigns only a 20% probability of crude oil exports from southern Iraqi oil fields (of Basrah) being disrupted. Current output is in the region of 2.5-2.6 million bpd or 3% of global production. In line with other city commentators and the Oilholic's own conjecture, Wittner says were Basrah to be hit, Brent could move up quickly into the US$120-125 range.

Let's hope it doesn't get hit, as Legland and Fermon note, in the past 50 years, 5 out of 7 recessions coincided with an oil shock, with oil prices skyrocketing. "However, to date, no one is expecting the oil price to rise to $150 or above; so concerns over an oil-led recession appear exaggerated," they add.

Away from pricing matters, a couple of corporate quips starting with a small cap. London AiM-quoted North Africa focussed E&P firm Circle Oil has largely kept the market on its side despite niggles it faces in Egypt along with other operators in the country. From where this blogger stands, Circe Oil's operations in Morocco and Tunisia remain promising and its receivables position in Egypt is in line with most (around the 180 debtor day norm).

Investec analyst Brian Gallagher has reaffirmed the bank's buy rating. Explaining his decision in a note to clients, Gallagher observed that Circle Oil "generated operational cashflow in excess of $50 million in 2013 and we expect it to match or exceed this level again in 2014. This marks Circle out from many of its small cap E&P peers who struggle to fund exploration campaigns. Circle has two impact operations currently in process. Moroccan exploration recently began (successfully) while results from the Tunisian well, EMD-1, are imminent. In the background, Egypt continues to perform."

The company is busy prospecting in Oman as well, even though it's early days. So methinks, and Gallagher thinks, there's a lot to look forward to. Switching tack to a couple of large caps, Fitch Ratings revised BG Energy's outlook to negative at A- and maintained BP's at A+/stable.

Starting with the former, the agency said BG's negative outlook reflects completion risks associated with its new upstream projects, challenges that the company is facing in Egypt, and the potential that funds from operations (FFO) adjusted net leverage may stay above 2.5 times in the medium-term should there be any delays to project start-ups.

"Presently, we view the group's credit metrics as stretched for the current ratings because of BG's ambitious investments coinciding with declining production, despite a series of asset disposals intended to strengthen the group's balance sheet," Fitch noted, adding that it expects the company’s business profile to improve with the start-up of its major projects in Australia and Brazil.

On BP, Fitch views its operational profile as commensurate with the 'AA' category. "Presently, BP's rating direction depends largely on the outcome of legal proceedings related to the 2010 Macondo oil spill. At end the of the first quarter of 14, BP had provisioned $42.7 billion in total for claims and other related payments, of which it had paid out $34.9 billion."

Fitch says that total payments below $70 billion, including amounts already paid out and the balance paid over a period of several years, are likely to keep BP in the 'A' rating category, while payments exceeding this amount may push the company's ratings into the 'BBB' category.

On a broader footing, Fitch has maintained a stable outlook for its rated EMEA oil and gas companies. Senior director Jeffrey Woodruff says negative outlooks on certain companies such as BG was mainly due to company specific problems rather than broad based sector weakness. "It is worth highlighting, that more than 80% of issuers in Fitch's EMEA oil and gas portfolio have stable outlooks and the number of positive outlooks doubled since 2013 to 5% from 2.5%," he adds.

Finally, rounding the last four hectic weeks off, here is the Oilholic's latest article for Forbes touching on the recent jumpiness over the possibility of US crude oil exports. Yours truly does see a distinct possibility of it happening at some point in the future. However, it won’t happen any time soon and certainly not in an election year, with a race to the White House to follow.

Last month also saw this blogger head to Moscow for the 21st World Petroleum Congress and a predictable 165th OPEC summit prior to that, where the organisation maintained its quota and Abdalla Salem El-Badri stayed on as Secretary General. As usual there were TV soundbites aplenty - the Oilholic's including - plus hustle, bustle, bluster and differences of opinion that go along with events of this nature. So for a change, one is glad this month's pace would be a shade slower. That's all for the moment folks. Keep reading, keep it 'crude'!

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© Gaurav Sharma 2014. Photo 1: Oil pump in Russia © Lukoil. Photo 2: Gaurav Sharma speaking on OPEC Webcast © OPEC, June 11, 2014.

Maintaining 2014 price predictions for Brent

Since the initial flare-up in Iraq little over a fortnight ago, many commentators have been revising or tweaking their Brent price predictions and guidance for the remainder of 2014. The Oilholic won't be doing so for the moment, having monitored the situation, thought hard, gathered intelligence and discussed the issue at length with various observers at the last OPEC summit and 21st World Petroleum Congress earlier this month.

Based on intel and instinct, yours truly has decided to maintain his 2014 benchmark price assumptions made in January, i.e. a Brent price in the range of US$90 to $105 and WTI price range of $85 to $105. Brent's premium to the WTI should in all likelihood come down and average around $5 barrel. Nonetheless, geopolitical premium might ensure an upper range price for Brent and somewhere in the modest middle for the WTI range come the end of the year.

Why? For starters, all the news coming from Iraq seems to indicate that fears about the structural integrity of the country have eased. While much needed inward investment into Iraq's oil & gas industry will take a hit, majority of the oil production sites are not under ISIS control.

In fact, Oil Minister Abdul Kareem al-Luaibi recently claimed that Iraq's crude exports will increase next month. You can treat that claim with much deserved scepticism, but if anything, production levels aren't materially lower either, according to anecdotal evidence gathered from shipping agents in Southern Iraq.

The situation is in a flux, and who has the upper hand might change on a daily basis, but that the Iraqi Army has finally responded is reducing market fears. Additionally, the need to keep calm is bolstered by some of the supply-side positivity. For instance, of the two major crude oil consumers – US and China – the former is importing less and less crude oil from the Middle East, thereby easing pressure by the tanker load. Had this not been the case, we'd be in $120-plus territory by now, according to more than one City trader.

Some of the market revisions to oil price assumptions, while classified as 'revisions' have been pragmatic enough to reflect this. Many commentators have merely gone to the upper end of their previous forecasts, something which is entirely understandable.

For instance, Moody's increased the Brent crude price assumptions it uses for rating purposes to $105 per barrel for the remainder of 2014 and $95 in 2015. In case of the WTI, the ratings agency increased its price assumptions to $100 per barrel for the rest of 2014, and to $90 in 2015. Both assumptions are within the Oilholic's range, although they represent $10 per barrel increases from Moody's previous assumptions for both WTI and Brent in 2014 and a $5 increase for 2015.

"The new set of price assumptions reflects the agency's sense of firm demand for crude, even as supplies increase as a response to historically high prices. New violence in Iraq coupled with political turmoil in that general region in mid-2014 have led to supply constraints in the Middle East and North Africa," Moody's said.

But while these constraints exist, Moody's echoed vibes the Oilholic caught on at OPEC that Saudi Arabia, which can affect world global prices by adjusting its own production levels, has appeared unwilling to let Brent prices rise much above $110 per barrel on a sustained basis.

Away from pricing matters to some ratings matters with a few noteworthy notes – first off, Moody's has upgraded Schlumberger's issuer rating and the senior unsecured ratings of its guaranteed subsidiaries to Aa3 from A1.

Pete Speer, Senior Vice-President at the agency, said, "Schlumberger's industry leading technologies and dominant market position coupled with its conservative financial policies support the higher Aa3 rating through oilfield services cycles. The company's growing asset base and free cash flow generation also compares well to Aa3-rated peers in other industries."

Meanwhile, Fitch Ratings says the Iraqi situation does not pose an immediate threat to the ratings of its rated Western investment-grade oil companies. However, the agency reckons if conflict spreads and the market begins to doubt whether Iraq can increase its output in line with forecasts there could be a sharp rise in world oil prices because Iraqi oil production expansion is a major contributor to the long-term growth in global oil output.

The conflict is closest to Iraqi Kurdistan, where many Western companies including Afren (rated B+/Stable by Fitch) have production. However, due to ongoing disagreements between Baghdad and the Kurdish regional government, legal hurdles to export of Iraqi crude remain, and therefore production is a fraction of the potential output.

Other companies, such as Lukoil (rated BBB/Negative by Fitch), operate in the southeast near Basra, which is far from the areas of conflict and considered less volatile.

Alex Griffiths, Head of Natural Resources and Commodities at Fitch Ratings, said, "Even if the conflict were to spread throughout Iraq and disrupt other regions, the direct loss of revenues would not affect major investment-grade rated oil companies because Iraqi output is a very small component of their global production."

"In comparison, disruption of gas production in Egypt and oil production in Libya during the "Arab Spring" were potential rating drivers for BG Energy Holdings (A-/Stable) and Eni (A+/Negative), respectively," he added.

On a closing note, here is the Oilholic's latest Forbes article discussing natural gas pricing disparities around the world, and why abundance won't necessarily mitigate this. That's all for the moment folks. Keep reading, keep it 'crude'!

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© Gaurav Sharma 2014. Photo: Oil drilling site © Shell photo archives