Category Archives: Energy

Energy

Three recommendations for utilities

Energy, Global Economy, On the cover, Sin categoría

(This article, like most in this blog, was published in Cotizalia in Spanish)

The utility sector faces this year the need to renew their strategic plans and give the market an attractive message for shareholders. It is not easy, as most companies have clear that the next five years will not see the electricity demand growth the industry enjoyed between 1990 and 2008. So the biggest risk facing the sector is to give overly optimistic messages or growth targets that are difficult to digest by the market, which would negatively impact their shares. And remember what a dreadful market performance we have seen in the past two years among large integrated utilities like Enel, Gaz de France-Suez and E. On even when they have published acceptable results.

Transmission companies are fully regulated, so they have it relatively easy, because their investment plans are guaranteed by the government with a minimum return. The complex part is to justify the multiples at which they trade (the highest since 2000) without giving the market an assessment of their minimum growth in regulated assets (RAB). Added to the equation the fact that the regulators have a nasty habit of delaying the simplest decisions for months, and the risk increases. It is therefore absolutely necessary to clarify the regulatory environment, and confirm the growth expectations. If not, we return to the regulatory risk discount that affected National Grid and the Spanish companies for years.

Large integrated groups have a harder task ahead. They face an environment without significant growth in demand, with some excess capacity in generation, and the industry no longer has the strong balance sheets that facilitated large corporate mergers. With a sector in Europe committed to divest more than €15 billion, it is difficult to see asset price inflation to levels of 2004-2006, as it’s a buyer’s market. Therefore, the challenge is to clarify how to create shareholder value when the macroeconomic environment is complex.

From my point of view, the Spanish companies can boast of having managed the 2009 crisis better than their European competitors. And they should exploit three key areas:

– The first is to clearly show their competitive advantage in costs. For example, compared with European companies, the Spanish, on average, have reduced their costs in 2009 by 7%. This ability to manage complex environments is essential to create value.

– The second is to focus on Return on Capital Employed and managing the investment process. Being bigger is not better or more profitable. Spanish companies have shown to be capable of generating superior returns to its peers (9.8% compared with those of Europe, 8%) while reducing unnecessary investments in over €8 billion despite the fall in demand for electricity and gas in Spain, which has been above the European average.

– The third is to commit to a policy of Total Shareholder Return. Once the process of reducing corporate debt has been completed, and so far it has been done remarkably well, with more than €13 billion average reduction in debt in the sector, the message should focus on profitability for shareholders. The key is to reduce exposure to low-return assets, crystallising value in the most attractive ones, as they did floating the renewables divisions, and could do again with the distribution or nuclear generation, while ensuring a minimum absolute dividend and the improvement in book equity.

This is a year in which companies will have to compare themselves with others, and show that they do better than average. Focusing on returns generated at the bottom of the cycle, ensuring shareholder remuneration and managing the balance sheet will be what differentiates the winners from the losers in the market. The empire-building strategies of European multinationals have driven the sector to a six-year relative minimum PE to the market. Now it’s time to differentiate strategies.

Energy Opportunities in Brazil

Energy, Global Economy, On the cover, Sin categoría

(This article was originally published in Spanish in Cotizalia.com)

Today I am writing from Rio de Janeiro, and while reviewing some news of the week, I am struck by the following: Jim Cramer recommends buying a bank, Santander, for their exposure to Brazil. Without questioning the merits of the financial institution as a stock, the first thing that comes to mind is: if you want to buy something, do not do it with hybrids. And I agree. It seems obvious to say but if you want to buy Brazil, buy Brazil directly. And there are many reasons to invest in the country: an expected increase of 5% of GDP, energy demand increase of 6% per annum, … And oil, a lot of oil. 14 Billion barrels in proven reserves and in the Santos basin, almost 7 billion barrels of resources, some of the largest discoveries of the decade.

On one side we have Petrobras, with increases of 6% p.a. in production. Petrobras also offers very competitive costs (average cost $ 13/bbl total F&D). However, it suffers from the forthcoming $55bn capital increase and, as Shell or Conoco, also suffers from the discount of large business conglomerates. It is cheap, but its huge investment needs in diversified businesses weigh on their return on capital employed.
Therefore, if you are interested in the almost 7 billion barrel discoveries in Brazil I would encourage you to analyze the two companies that offer absolute exposure in this area: Lupatech and OGX.

The first, Lupatech, as priority local oil services firm for Petrobras, is the great beneficiary of the investment needed to develop the discovered fields. It has an attractive balance sheet, expected growth of 12-15% and higher margins than their European competitors. And remember that Brazil needs to monetize quickly these discoveries, since the government sold in the last ten years oil concessions for a price of $1bn that today are worth approximately $50bn.

The second company, OGX, specialized in exploration, bought at 20 cents per barrel fields that seemed unproductive and nobody wanted and that have proven to contain at least 2.5 billion barrels recoverable, an amount that could be expanded to 7 bn as shown by the 3D seismic exploratory studies, which so far have been successful. OGX has $ 1.5 billion of cash to fund the exploration program of its five fields. And instead of gearing up to develop these reserves, with estimated costs of $ 14/barrel given that they are all shallow water finds, OGX is likely going to sell minority stakes to other investors. From a conservative standpoint, these 2.5 billion barrels could be worth between $10 and $ 12/barrel.
Brazil also offers opportunities in the electricity sector, which expects to increase its installed capacity from 102 GW to 153 in 8 years. 85% of generation is hydro while domestically produced natural gas will play a key role in the future. The sector delivers low-cost production and margin expansion as prices for electricity are higher than the Europeans (by more than 15%), also offering dividend yields above 6 -7%. There are more opportunities for low risk, high yield than the market would normally expect from an emerging country.

The Olympics and oil will be two factors to contribute to a dramatic growth in infrastructure investments. And energy companies are the major beneficiaries of this momentum. It is worth looking at Brazil in detail.

Iraq, the last hope for Big Oil

Energy, Global Economy, On the cover, Sin categoría,

IRAK (1)

(This article was originally published in Spanish in Cotizalia.com)

We’ve talked on other occasions of the difficulties that big oil companies find to grow. The reserve replacement ratio is still more than disappointing, below 100% since 2004. But in 2010 the industry could change course. In my opinion, the true hope of the sector is Iraq, the third country in the world in proven reserves, 115 billion barrels of oil, behind Saudi Arabia, with 264 and Iran with 138.

The country has generated much controversy in the press for the war but, since Saddam Hussein was overthrown, Iraq has achieved a production increase that was unthinkable under the previous regime, generating tax revenues for the domestic economy of almost $20 billion more that in the period 1980-2005.

Currently the geopolitical environment has improved substantially. Service firms are established, but the risks are not negligible, with nearby local elections, conflicts with the Kurdish minority and the gradual withdrawal of U.S. troops. For example, it remains unclear if the city of Kirkuk, home to a giant oil field, belongs to the Arabs or the Kurds, which prevents investment there.

The local government has advanced rapidly, licensing more than ten fields in the last year. After a false start in which the license auction was declared void (except the Rumaila field, BP -CNPC) because the conditions imposed by the government were too expensive, between the second half of 2009 and 2010 the government has auctioned licenses to operate up to 60 billion barrels in estimated reserves, with a national strategy to increase production from 2.5 million barrels per day today to a very ambitious target of 12 million. From BP, Shell, Statoil and ENI, to Russia’s Lukoil, China’s CNPC or Exxon, most big oil companies have participated in the process.

From my point of view, the goal of exceeding Saudi Arabia’s production is very ambitious. No one has managed to multiply by 5, as intended, the production of a country in 10 years. I think it’s much more logical to assume that production will rise to 3.5 million barrels per day in 2015, in line with the history of typical production recovery in this region (including Iran).

And the problem now is the costs, estimated at $ 19/barrel (F&D), plus an additional fee of nearly $ 2/barrel. The contracts allow the oil companies to cover costs up to a minimum production level. Until there is a contract typical of the industry,within what is called a PSC(production sharingcontract).

But if minimum production targets are not met, oil companies will suffer from profits lower than the average cost of capital, or even losses. The Zubair field, won by ENI and their partners, for example, will likely generate an internal rate of return of less than 20% below $55/barrel, while requiring investments in excess of $20 billion over 20 years.

If you have enjoyed Avatar (great movie, by the way) and the not-so-subtle allegory about the oil companies, you probably think that this whole process is abominable, but the increase in gross domestic product, infrastructure and wealth for the country that these projects, neglected or poorly managed so far, will generate, will be a giant leap for the country’s ailing economy. The investments to be carried out are astronomical, nearly $ 100,000 million between 2009 and 2029, including infrastructure, water, schools, hospitals , almost the construction of entire cities. Consider that some of these fields require about 500 workers. And the fact that contracts are aggressive and costly conditions for oil is a minor problem, because for them it is probably the last opportunity to improve their low reserve replacement for once.

The Revolution of Shale Gas

Energy, On the cover, Sin categoría

As I expected in my predictions for 2010, the process of mergers and acquisitions in the energy sector is not waiting. Total surprised us last week following on the footsteps of Exxon and embarking on the adventure of shale gas, through a joint venture with Chesapeake. The benefits of shale gas for oil companies are many and varied. Let me try to explain the environment as concisely as possible.

The technologies that allow the extraction of gas have proven to be much more competitive than it was initially estimated. We will not expand in technical terms, but basically through a process of fracturing the rock with water injection or horizontal extraction companies can stimulate the production of a gas that otherwise would not be economically produced. In fact, large companies are extracting gas at costs of $1.8 to $3/MMBTU compared with previous estimates of $ 5.5-$ 7. This cost levels allow very attractive returns, over 30% ROCE, even at current gas prices in the U.S., despite how much these have fallen from levels near $12 to $6/MMBTU today.

Moreover, the geological differences between areas of the United States that have shale gas (Haynesville, Marcellus, Barnett, and others) have proved to be lower than estimated, which allows a more comfortable environment for investment, as the potential economies of scale are very important. This is why the companies are buying large areas of land, as the shale gas production grows very fast but declines quickly once reached plateu. After this abrupt decline, production can be sustained for a long time at economical levels.

Furthermore, for companies like BP, Exxon, or Total it is an excellent opportunity to access abundant reserves of gas in a country with almost no risk (United States). Not to mention that it is a platform to learn and explore opportunities in shale gas in Europe, mainly in the North Sea and some Eastern European countries.

Matt Simmons and his team expect that by mid 2020 half of the US gas production will comes from U.S. shale gas, and the estimated reserves of unconventional gas in the most conservative scenario would cover 65 years of production, c1.35 billion cubic feet.

Total has paid the equivalent of $30,000 per acre of land in its joint venture with Chesapeake in Haynesville. In 2008, BP paid an average of $19,400 in Woodford. 2007 saw how Shell paid for Duvernay $13,100 per acre. Meanwhile, Statoil paid for their participation in the Marcellus area c$7,000 per acre. The price has jumped fourfold in just over two years. Not surprisingly, therefore, that US independent exploration and production stocks with shale gas exposure have soared, even though gas prices continue to be low.

Interestingly, amid all this, the financial market assumes that the oil majors are kind of large NGOs, which will exploit the reserves purchased in an indiscriminate manner, flooding the market and accepting gas prices well below the current ones. I can not believe that companies which operate under a strict target of return on capital employed will accumulate reserves to lose money monetizing the production at suboptimal prices. Meanwhile, the six big oil companies control more than 25% of the reserves of U.S. shale gas. What do you think are going to do? The consolidation process will continue and we will see that the profits will be very substantial in the medium term.