Category Archives: On the cover

On the cover

US Natural Gas Dynamics

Energy, English, gas, On the cover, US

US natural gas is set to continue rising but fundamentals keep it capped at $6.5/MMBTU mid-term. The conclusion is that US gas is likely to be in a tight range of plus/minus 15% of the marginal cost of production (downside to $3.5/MMBTU and upside to a c$6/MMBTU short-term) as the contango flattens.

I would highlight three data points:

  1. Current 55-60% decrease in gas directed drilling activity in the US has not been sufficient to balance 2009 supply and demand. These rigs will gladly come back any time gas reaches $5-$5.5/MMBTU. Additionally, onshore rigs are being moved to Russia and West Africa, where there are stronger conomics. On the support side, coal-to-gas switching tends to kick off at $4/MMBTU
  2. Estimated base decline with current drilling activity (33%) can be misleading as production will still be c54BCF/day in the US in a worst case scenario and there is plenty of resources (if demand stays weak as predicted) in unconventional gas plus ample new reserves in the US (Marcellus, Barnett) .
  3. I do however believe the LNG “threat” is less than what market anticipates (although I am happy to assume 2-2.5BCF/d LNG into the US in 2010). Case in point is that all of consensus expects Chevron-Exxon’s Gorgon and BG’s Queenland Curtis to supply at sub-target ROCE levels (DB expects them to make 13% versus a target of 20%). This (in my view) is unlikely to happen as these are companies that ruthlessly monitor and manage ROCE, and have proven, to everyone’s surprise, that delays in LNG happen. The LNG overcapacity disappears in 2012 (no more LNG projects commissioned post 2011) so waiting and monitoring is not an issue.

European Power Reserve Margins

Energy, On the cover, Sin categoría

reserve marginsReserve margins are clearly acceptable in Europe, even to 2015, assuming capex as planned. There is however a risk of excess capacity if the economic slowdown continues beyond 2010 and renewable investments continue growing aggressively yet nuclear lives are extended. Capex cuts in liberalized markets should take care of this and it becomes a defining factor to monitor as new strategy plans are unveiled. In my view, current forward curves are justified by supply management (including in this nuclear closures) and demand recovery. If we doubt the recovery of demand, I believe capex management will happen more abruptly than estimated as companies become more aware of their optimal gearing.

In the past three weeks we have received data from different banks using the UCTE adequacy reference report. The unanimous analysis is that reserve margins in Europe are adequate assuming there is growth in demand. The positive outcome could be that the progressive increase in renewable energy and gas puts upward pressure on power prices, as well as the gradual loss of base load generation (nuclear, hydro from lower rainfall) relative to the overall generation park. However, renewables have proven to be less “positive” for prices due to perceived overcapacity.

The sector spends c33% of its market cap on capex every year in the 2009-2012 period. I believe we have seen the peak of capex and a move into managing existing assets and returns.

The reason why the forward curves on spark spreads remains positive comes mainly from the perception that demand growth will return in 2010 (driven by return of industrial sector) to a level of 1.2% pa and the general perception of a good oligopolistic nature of the sector in Europe, where companies can manage output. The interesting thing is that with current capex the reserve margins in all of Europe are solid.

Three things can put pressure on power prices:

. Renewable roll-out beyond requirement.

. CCGTs working at cash break-even to offset cost of take-or-pays.

. Demand flat beyond 2010 due to increased efficiency and lower industrial output.

In Europe under the conservative scenario used by UCTE, the adequacy reference margin rises from 50 to 59. More importantly, the “reliable available capacity” figure rises from 462GW to 521GW (a 1.1% annual increase for an expected total 1.5% annual demand growth).

This basically means that new capacity is expected to cover demand growth with no relevant impact in reserve margins. If demand does not return, capex cuts (or delays) can easily manage reserve margins in countries where companies control their investments with limited government intervention.

Two important facts to mention: a) Nuclear power availability comes down from 111.7GW to 96.7GW. This is because the UCTE assumes nuclear life will not be extended in Germany(where the reserve margin is expected to stay flat on new hard coal plants and renewables). B) renewable capacity seems underestimated. The estimate of EU increasing renewables (ex-Hydro) to 85GW seems very low. On my numbers we have 65GW of wind in European as at end 2008, with projections of 145GW by 2013. Today we have less than 10GW of PV but that could easily double or triple over the same period.

The worst country in terms of risk of overcapacity is Spain driven by the excessive installation of gas plants and renewables, driving reserve margins up c3% per annum, which basically assumed the optimistic demand scenarios Spain has enjoyed in the past. Portugal, and Italyto a lower extent, looks also at risk given the unnecessary roll-out of CCGTs and inflexible take-or-pays. This is a key element. As in Spain, companies have found difficulties renegotiating the terms of their gas contracts and take-or-pays remain at top of industry levels (75-25) despite some scattered successful gas contract re-negotiations (notably EDP with Sonatrach and Italians with ENI), but this is predominantly price more than volume.

Under normal weather conditions, France and Portugal would achieve comfortable reserve margin levels (13.3% and 13.90%, respectively) while Germany shows the tightest at 8.60%. Please bear in mind that German data differs between research.

However, under severe weather conditions, the UCTE report highlights potential strains in France (average reserve margin of 4.4% with a low of 0.6% anticipated in the first weeks of January) because of the country’s significant exports and in the UK (average reserve margin of 6.4% with a low of 1.7% in the last weeks of December).

In the UK, shut-downs of coal-fired power plants will not be entirely offset by new CCGTs, renewables and new nuclear (which will be brought into service no earlier than 2017). The reserve margin is tight but new nuclear explains the relatively modest forward curve.

Spain and Portugal look adequate even in severe conditions at reserve margin of 8.5% and 9.10% respectively. However, there looks to be a huge decline in Iberian spare capacity from 12GW in 2010 to around 5GW in 2020 (driven by Endesa and Gas-UNF cuts).

Germany’s adequate capacity depends entirely on nuclear life extensions. However, a likely scenario remains where new plants are delayed significantly, particularly for new entrants. InGermany there is a good chance of losing part of new build from the economic downturn.

Energy, On the cover, Sin categoría

Picture2

Just wanted to share some thoughts as I am seeing brokers call a bounce on utilities based on mean reversion and sector rotation. 

Despite being the biggest underperformer YTD, the utilities sector has four mounting problems:

a) €65bn to refinance to 2010
b) €35bn in asset disposals to keep single A rating
c) ROCE keeps sliding after five years of M&A at peak multiples
d) €20bn in capital increases (Enel, Gas Nat, Snam, Vestas, SSE, Centrica…)
Look at the chart attached, because it’s scary. The utilities have been re-rating year on year on commodity exposure, asset valuation increase from M&A and multiple expansion from new technologies (renewables) and at the same time it has become more cyclical, but with very inflexible capex (the sector spends 33% of its market cap every year on capex to deliver 3-4% EPS growth)… while ROCE has been deteriorating steadily (see chart).
On top of this, the sector trades on “growth” multiples (7x EV/EBITDA), but considering the loss of industrial demand and the forward cruve on spark and dark spreads, we could see a continued de-rating of the sector to ex-growth multiples.

The Illusion of Natural Gas Liquids

Energy, On the cover, Sin categoría

I have been reading in detail with interest (but not joy) the reports from OPEC, IEA and EIA.

The main argument raised by the bears about these reports has been to highlight the increase in supply estimates month on month, with different degrees of conviction by the three entities.

There are two main observations to make:

  1. Seems the consensus has stalled on demand around 83-84 million barrels a day. IEA sees demand down 3% year on year. EIA catched up with this figure and OPEC lowers it a bit (still 0.8mbpd above IEA at 84mbpd).
  2. Supply estimates remain optimistic: Effective spare capacity has contracted slightly to 5.3mbpd (versus 5.5mbpd) for IEA, which is more optimistic about non-OPEC supply than OPEC (which basically sees non-OPEC output down around 200,000 bpd less than the others).

Two interesting things come in the details though. The fact that supply estimates come predominantly from higher natural gas liquids and production of heavier crudes from mature basins (EIA calls for all projects forecasted in 2009 to deliver in line with expectations in 2009, something that has never happened). Additionally heavier oil means more refining costs and lower quantity of output. Heavy Arabian is trading at $54/bbl. While WTI is trading at $58. Crack spreads are at $10.3/bbl ($8.8 in Cushing). Heavy oils and the increasing cost of de-sulphurization are putting part of the floor on oil prices.

But the interesting point to me comes from what I call the illusion of Natural Gas Liquids (NGLs) which we saw in the past oil “down” cycle (which I painfully lived in the industry). Natural gas liquids are the hydrocarbons in natural gas that are separated from the gas as liquids through the process of (mainly) absorption or condensation. While the EIA, OPEC and EIA estimates continue to put current oil production at around 86m bbl/day, over 10% of this daily production is not oil at all but NGLs. More importantly, all the upward revisions in the three studies about non-OPEC supply come from NGLs. While these liquids are valuable, especially propane and butane, they are not a viable substitute for oil. Fractioning is a highly expensive process and neither can be economically used as a feedstock for gasoline or diesel and cannot be used for current diesel or gasoline engines.

So it is interesting to assess why the estimates are worthy but should be taken with caution. Obviously demand is poor and a clear concern, and while it remains weak it will be a strong driver of oil price movements