European Crisis, Falling Demand and Increasing Interventionism

Global Economy, On the cover, Sin categoría

EUROZONE/CONTAGION CJuly 8th, 2011

Today the 2 year greek bond reached 30% gross yield for the first time ever. Italy’s 10 year is now at 5.3%. Portugal 5 year CDS above 1000. The Euro debt crisis is in full swing. And apart from piles of leverage and out-of-control spending, the reckless subsidization and manipulation of power and gas markets has been partially to blame.

We are in July and the figures for energy demand are troubling, since they are a true reflection of the evolution of the economy and GDP.

The numbers are frightening, mainly because except Germany and some Nordic countries the rest of Europe languishes in spite of the optimistic expectations of “recovery” announced with great fanfare in 2008. It is even more worrying to note that the effect of stimulus plans, which accounted for more than 3.5% of EU GDP between 2007 and 2009, not only have been dissipated, but industrial activity has fallen to levels similar to those of 2008. So all the EU is left with is the debt generated by those stimulus plans, but no significant effect on GDP.

According to Societe Generale, the demand for natural gas in the countries surveyed (France, Portugal, Spain, UK and Italy) in May fell 11.8% over 2010.The cumulative year 2011 shows a drop of 9.7% year on year. The demand for natural gas in Spain in the first half, including June, has fallen 1.9% compared to 2010.

As for electricity demand, the countries surveyed in Europe (France, UK, Italy, Belgium, Greece, Portugal, Denmark, Poland and Spain) show a decrease of -2.5% annual cumulative. Electricity demand in Spain in the first half remained relatively stable compared to 2010, but not growing.

2011070621IPI-2-DEFIn this environment, the EU launched its Energy Efficiency Directive, which, if approved, would force the electricity and gas sector to achieve savings in annual consumption equivalent to 1.5% of sales. This would result in an improvement in energy efficiency 20% by 2020. Another interventionist measure from our friends in Brussels.

The proposed directive contains very detailed and wide-ranging proposals but according to Eurelectric it’s easy to already identify some preliminary areas of concern and ambiguity:

. Administrative burden: The proposal adds further uncertainties in permitting and authorisation procedures, potentially deterring investments and resulting in additional costs to meet the EU’s energy-climate targets. One example is the ambition to pre-define a technology mix for electricity generation.

. Inconsistency with the third liberalisation package: Europe ha forgotten about liberalisation. Now it’s all about obligation and central planning, and the consumer will pay for it all (the cost could exceed €1 trillion including infrastructure). Many provisions (obligation on smart metering/billing or on energy storage) contradict the EU legislation currently under implementation.

. Subsidiarity in delivering energy savings: Market mechanisms are ignored in favour of Soviet-style planning, but also the conditions required to deliver energy savings vary between and even within member states, creating an obligation but also a difference in cost.

Screen-shot-2011-01-06-at-6.38.31-AM-e1294324806568

So on one side, systems are more inefficient, overcapacity remains, political intervention is forcing a pre-defined energy mix regardless of cost and feasibility, and at the same time demand is falling and industrial production remains weak.

And what is the problem? That if the GDP does not recover aggressively, the borrowing cost of economies grows, and given the voracity and debt demand of governments, industries get limited access to credit, just as we approach 2013, a year in which industrial groups have a higher concentration of debt maturities (2013-2014). And with more than €50 billion a year in subsidies in the European power systems, that the EU wants to triple, the cost of energy for industries and consumers will rise even with falling GDP, making countries less competitive.

If demand remains weak, overcapacity in the electricity and gas systems will not fall, just as Europe announces several incentives for investing in new capacity, from nuclear (in the UK, 10GW), wind (7GW pa) and solar (10GW pa), but also coal (Germany, lignite, 5GW planned). Investments that can be very valid in a process of displacement of other technologies, but the policy so far is to subsidize not only the “emerging” technologies but the “dying” ones too.

What is striking about the European Union that is so fond of  forced planning, intervention and patronizing the world on what to do is how it benefits on the industrial level from exporting to “polluting” countries like China or India and how it ignores the “externalization of pollution” that de-industrialization creates (as those same European industries move to other countries with less stringent environmental requirements). The pollution created by the thousands of tons of rare earths required for our high-tech and green lifestyle results in millions of tons of water polluted in China from the extraction process. The EU doesn’t care, but still patronises about CO2 and environmental policies.

Now the EU, in the middle of social revolts, austerity plans, budget cuts and a debt crisis, wants to increase its budget by 12%, three times the rate of inflation, after a 30% increase before. This also looks to increase the €126bn budget up to c€150bn in 2015.
The problem of the energy systems of the EU has not been liberalization, but intervention.

Interventionism means higher costs and mass subsidies, even to coal, for example (€1.5 billion in Spain only including direct subsidies and capacity payments), reaching the ironic situation of having countries where all the technologies are subsidized.

The liberalization of the electricity and gas markets between 1999 and 2004 brought the longest period of investments, improved infrastructure, service quality and better cost since the time of supply shortages of the seventies. It was then, as the EU ballooned in 2004, when governments decided to intervene, changing the laws in mid-game, subsidizing some technologies over others, restricting the free movement of capital, creating fictitious markets (like CO2) and generating capricious signals of demand and price through subsidies. And without risk, because either through tariffs or through taxes, planning errors have always been paid the consumer.

It is this devilish myriad of costs added to the final bills, and added to taxes, which in the EU are the highest in the OECD, what makes the final prices rise despite demand falls. The EU loaded the system with an infinity of small items, which always begin with the presumption of being “small”, but are slowly adding to the total bill. Capacity payments, restriction costs, ancillary services, subsidies…

The solution? Well, very simple. Market, market. If a coal-fired or gas plant must be reduced or disappear, so be it. If the price of electricity or the gas system that the EU has voted is expensive, the consumer should know clearly the cost of what is being promoted.

I am sure that if customers in Europe, suffering the austerity measures and cuts, knew that the cost of implementation of the so-called “low carbon economy” is conservatively €900bn, they would not be so happy.  

If we keep inefficient technologies based on subsidies and anti-economic measures forgetting the market, not only we will keep unnecessary overcapacity in the system, but the consumer will not see the advantages of the lower parts of the cycle.

Further read:

http://energyandmoney.blogspot.com/2011/06/state-of-fear-german-nuclear-shutdown.html

http://energyandmoney.blogspot.com/2011/06/co2-collapses-20-in-two-days.html#frameId=uWidget20a9e6e60130f5c6a6f0&height=130

http://energyandmoney.blogspot.com/2009/06/calling-bottom-on-power-prices-in.html

Is BP Really A Takeover Target For Exxon?

Global Economy, On the cover, Sin categoría
bpexxon
I find interesting that in the past weeks we have seen a few reports stating that BP could be taken over by Exxon.
Given that the idea seems to be taking hold at a couple of banks, I believe that in order to properly analyse that possibility, apart from brokers’ speculation, one would have to answer a few questions, critical to assess if a $400bn company would bid for a $139bn one at a premium (which inevitably would require masses of synergies and benefits, as it would have to be done with a capital increase). I would suggest an academic thought process that answered these:
A) Does Exxon want Amoco at a higher price after the history since 1998?. When BP merged with Amoco in 1998, the energy world was shocked. Shocked partly because Amoco was seen as a “less attractive” set of assets in the industry. Exxon’s current CEO, Rex Tillerson, was a top manager then and knew Amoco well. Since the $110bn merger of BP-Amoco in 1998, what we have seen out of the integration have been challenging returns, unfortunate incidents from Texas City, to Thunderhorse and Prudhoe Bay, culminating in Macondo. Considering that the liabilities and risk of gross negligence of Macondo are better understood but not fully clarified, would Exxon pay premium multiples for a replica of their core business and such a risk?.
B) Is BP much cheaper than other Big Oil stocks? It does not look massively cheaper than its peers, it is simply more of a conglomerate due to TNK. The entire sector has de-rated (see here), and BP only trades at a small discount to its peers (c5%), yet trades at a premium to mid-sized US integrateds. Exxon is much more expensive than BP on multiples, but that is a reflection of its industry leading ROCE position, lack of quoted divisions and centralized structure.Just on ROCE metrics, a very important one for the US giants, BP would be highly dilutive (Exxon’s ROCE stands at the top end of the industry range, at 23%, BP at 17.6% ex-Macondo costs).Meanwhile, BP is conducting a very logical and commendable “shrink to grow” strategy that will inevitably make the company focus in re-structuring. And selling legacy assets means also selling high return, fully depreciated assets, at good price admittedly, but puts pressure on delivering super-normal returns on growth projects like Rumaila (Iraq). And would any other supermajor want to conduct that same re-structuring?.
BP only really looks cheap against peers on PE and that may be a function of its corporate structure. On PE, BP trades at 6xPE 2012E versus 7.2x for Shell, but 6.4x ENI, for example, and 6.9x the sector. BP trades at 4x P/CF 2012E versus Shell at 4.5x and sector at 3.91x. BP offers a 4.35% yield 2012E vs. sector 5.21% (consensus estimates).
C) Would Exxon want to pay a premium for the Russian risk that TNK can provide (and TNK is c20% of BP’s reserves)?. The situation with the partners of TNK (AAR) would probably not be any better with a change of ownership, and some would argue it could get worse if the buyer was an American, as the Russian government might not approve of the deal.
D) Would Exxon pay up and do a corporate giant merger for more exposure to Thunderhorse, a bigger exposure to Angola, and new exposure to Libya?.
E) Does Exxon really want a giant refinery complex? c24% of BP’s assets are in refining and marketing. With 7mmbpd of ovecapacity in global refining, would Exxon pay a premium for those assets?. Exxon owns 37 refineries worldwide already.
F) The “resource” opportunity… is it so evident?. Those who sell BP as a takeover candidate mention 18bn boe of proven reserves and 45bn of unproven that could be very attractive priced. But the same giant resources can be seen to be very cheap at Exxon itself (24.8bn boe of proven reserves, adding c3bn only last year). But people fail to mention how much of that enormous BP resource base is Russia’s TNK (20%).
G) Does Exxon want more US downstream assets, with the risk that they can be targeted by any administration?. would anti-trust issues make the deal too costly, maybe not worth doing, because of the sheer scale of the divestments required (est $10bn)?.
H) What would BP do to Exxon’s growth profile? BP is expected to grow production by 2% pa to 2015, c1% pa less than Exxon. Dilution in growth could mean dilution in multiples for Exxon. BP produces 2.3mmbpd. Exxon produces 3% of the world’s output (3.9mboepd). Does Exxon need to buy more production in areas where they are already present?.

I) The “other businesses”. Almost 16% of BP’s invested capital is outside the traditional oil areas (exploation, production, refining and marketing). With businesses that range from travel to solar pv. BP is a global company with the largest exposure of any oil company to alternative energies, $10-15bn (valuation range) worth of renewable (solar, wind) investments as well as biofuels, and one of the leading shipping companies (BP shipping). Is Exxon interested in adding renewables and shipping to their portfolio?.

The debate is on. BP is an interesting company on its own. It is slowly recovering from two major strategic blows. But I fear that the time of multibillion mergers between integrateds ended a few years ago. The reason why XOM bought XTO was clear (see http://energyandmoney.blogspot.com/2010/01/revolution-of-shale-gas.html). This idea? Probably as plausible as the much trumpeted “Shell for BP” of 2005, or “Petrochina for BP” of 2009.
Disclaimer: This is an academic analysis, not a recommendation to buy or sell a security.

Brazil continues to surprise: BG doubles its resource base

Global Economy, On the cover, Sin categoría
BrazilOil

BG has upgraded its reserves and resources for Brazil from a range of 3 to 6bn boe to maximum of 8bn boe. The mean estimate for discovered resources is now 5.8bn boe (excluding risked exploration), which compares to previous estimates of 4.5bn boe.  The group increased the previous estimate of 3 billion barrels after analyzing data from 29 wells, 19 drill stems and 14,400 square kilometers (5,500 square miles) of 3D seismic data, according to the press release.

The company is not at this stage moving estimated production from Brazil (of 550 kboed by 2015), but this is likely to be reviewed by year end.

Total reserves and resources now stand at a mid case of 5.8bn boe (4-8bnboe, P90-P10) up from an estimate of 3bnboe the last time the company disclosed a total resource estimate in February 2010.

The reserves and resources have been driven by a number of factors including better technical data from the EWTs (better reservoir properties), enhanced recovery rates and incorporating recent discoveries (Macunaíma). BG are indicating an upside potential of 8bn boe.

Assuming an average of US$5/boe for Brazil barrels, the increase of 1.25bn boe would be an incremental US$6bn, according to Citigroup, whose previous estimate on resources of 4.5bn boe was split as follows:

Lula 1.8bn
Iracema 0.4bn
Guara 0.5bn
Lara 1bn
Other discoveries 0.7bn

Further read:

http://energyandmoney.blogspot.com/2010/08/few-thoughts-on-brazil-e-through-repsol.html

http://energyandmoney.blogspot.com/2010/01/energy-opportunities-in-brazil.html

 

IEA Releasing Strategic Oil Reserves Reminds Me Of When UK Sold All Its Gold.

Global Economy, On the cover, Sin categoría
brent iea

Oil fell 5.5% on Thursday 23rd June on news that the IEA’s member states are to release 60mb of their strategic stockpiles, 30mb from the US and 30mmb from elsewhere.

This could look in time as one of the dumbest decisions, in my opinion, since the day when the UK sold all its gold reserves between 1999 and 2002 at around $280/ounce… unless the IEA sees a material economic recession ahead and then the new QE of the economy is artificially lowering the price of oil.

The U.S. strategic petroleum reserve is at a historically high level with 727 millions barrels, of which 293 millions barrels (40%) are sweet and 434 millions barrels (60%) are sour. The International Energy Agency reported in April 2011 that SPR in OECD Europe and OECD Pacific totaled 186 millions barrels and 391 millions barrels, respectively.

The release of SPR crude announced today thus represents approximately 4% of U.S. reserves and 5% of SPR reserves in OECD Europe & Pacific.

This is the 3rd time in the past 50 years that IEA has released strategic reserves. The last three times, the improvement in oil prices that they looked for resulted in three subsequent super-spikes. This, I fear, will be the outcome again soon. Furthermore, this time we do not have the price-cushioning barrels of the North Sea (declining at 7% pa, as we mentioned here) or Mexico, which is falling as well. So the call on OPEC, even if demand continues to slow down, will increase to 30.1mbpd, making prices go higher.

The IEA, yet again, is panicking about the impact of the Libyan conflict. It is seeing that the war is unlikely to end soon, and sees the loss of Libyan barrels (1.5mmbpd) as  an issue after the failed OPEC meeting. But the market is well supplied. The only issue they worry about is price, which has been caused by the insane money-printing of the Fed not by demand-supply dynamics (hence the wild inflation in all dollar denominated commodities, of which oil incidentally is the third least appreciated since 2008, by the way).

Also, the US failed to pressure Saudi Arabia into discounting its crudes on world markets, which was one of the most paternalistic requests ever seen. Obviously, Saudi Arabia didn’t agree, because, to start with, the reason why OPEC didn’t raise quotas was because demand is weakening (as we said here), and given the 5-year high levels of inventories at Cushing, they would essentially pump oil to be added to more storage.

The IEA decision could also  come from fears of escalating tensions between Iran and Saudi Arabia, with calls from the latter to “squeeze out” Iran from the oil market. Given that Iran and Venezuela stand at the highest-end of the OPEC countries’ break-even price (close to $70-80/bbl, versus peers at $45-50/bbl), the IEA might be doing Saudi Arabia a favour, but a very short term one as it can create a geopolitical issue that brings oil back right up.

But this measure is meaningless in the grand scheme of things. 60mb is about 43 days of lost Libyan barrels and, wait for this, less than 0.2% of annual global oil demand (considering 87m bpd). It will achieve only one thing: to increase the OECD dependence on OPEC by September.

Meanwhile, the drought in China is poised to drive a spike in short term diesel demand. Severe drought conditions have curtailed China’s hydroelectricity generation… and electricity consumers will look to replace state electricity with their own power generation, oil. Middle distillates already account for the largest part of Chinese oil demand, so the entire IEA decision could be absorbed by the Chinese increase in diesel consumption in two months before the rain season.

So the analysis says that give that the market is well supplied and economic data in the OECD is weakening, the IEA only wants to cover the drought-driven demand spike from China, avoid oil prices from over-heating and help the debilitated OECD recovery.

OECD inventory

The only way in which the measure will work is if, in effect, demand will weaken into 3Q and the call on OPEC does not rise. If the demand analysis is incorrect, China and India continue to grow or geopolitical supply issues get worse (13 dead in Baghdad today not helping) then the oil market will go back to price a tighter environment. Any move in demand above 88mbpd and the entire measure is absorbed.

It doesn’t matter if OPEC has 4.5mmbpd of spare capacity, because this spare capacity is centred in Saudi Arabia, UAE and Kuwait, and is predominantly heavy-sour oil. And this measure will not help diplomatic relations with any of them, will be seen as desperate and in any way could be absorbed immediately.

Granted, the IEA can release more Strategic Reserve barrels, but then the weakness of the OECD and the call on OPEC rise. It’s a catch-22 measure and will not be of great aid to  the OECD economies, which are not weakening due to high oil prices (oil burden is less than 5% of OECD GDP), but due to out-of-control spending, rampant deficit, printing of currencies and EU’s puzzling management of the Greek-PIIG crisis.

Finally, two of my industry friends rightly highlight that “we are heading into a US election year and the political dividend from appearing to push oil prices lower is very attractive (Bill Clinton knows it well, he did it too)”. “President Obama wants to appear tough on oil and keep gasoline prices low in July. But a few weeks later we will be back where we started. Lower prices only accelerate demand anyway”.

Well done, IEA. another QE in disguise.

Link to my interview in Spanish radio, go to minute 12.30 (http://gestionaradio.com/getplayer.php?aud=16502)

Reuters video

Other posts:

http://energyandmoney.blogspot.com/2011/01/some-energy-thoughts-for-2011.html

http://energyandmoney.blogspot.com/2011/05/impact-of-chinese-slowdown-on-oil-and.html

http://energyandmoney.blogspot.com/2011/06/china-slows-down-as-saudi-arabia.html

http://energyandmoney.blogspot.com/2011/03/war-in-lybia-and-possible-algerian.html

http://energyandmoney.blogspot.com/2011/02/lybia-in-flames-and-clash-of.html

http://energyandmoney.blogspot.com/2009/11/china-exxon-and-war-for-resources.html