Pakistan’s Oil and Gas Opportunity

Global Economy, On the cover, Sin categoría,

(This article was published in Cotizalia on May 5th 2011)Today we will talk of Pakistan, a very rich country in natural resources, which contrast with its extremely poor current state. A report to which I had access estimated that with a maximum of $20 billion in investments the country would increase its oil production by nearly 2.5 times and natural gas could be exported for the first time, including a new pipeline and liquefaction plant near Karachi.

Today Pakistan is a disaster. Despite having a U.S. aid of $7.500 billion over a period of five years, and important natural resources, it still sees its potential unfulfilled due to its poor security and geopolitical contradictions.

Starting with geopolitics, part of the problem in Pakistan can be explained by the mixture between modernity, tradition and support for radicalism embodied in Dr. Abdul Qadeer Khan, almost a national hero, responsible for a nuclear proliferation program in the country, named by Time Magazine as the “Merchant of Menace”, creator of a black market accused of selling nuclear technology secrets to Iran, North Korea and Libya. If we add that several provinces, including the largest, Baluchistan, and the border with Afghanistan, rich in oil and gas, are controlled by radical armed groups completely independent and separate from Islamabad, the capital, we have the perfect recipe for geopolitical unrest.

As for its natural resources, Pakistan has 436 million barrels of oil and 840BCM of gas in proven reserves, yet more than a third of its 827,000 square kilometers of sedimentary areas are under-exploited. Thus, the country imports more oil than it produces, doesn’t export any gas and has been unable to attract sufficient investment to reduce the decline of oil production, which will likely fall 46% in 2020 according to internal estimates. Despite being the 49th country in proven reserves, it is well below number 60 in production. Less than 60,000 barrels per day, which could easily be doubled if the legislative and regulatory environment was safer, and as such currently the country only extends about 40 exploration licenses annually.

Taking a brief look at the oil companies present in Pakistan proves the caution of the large oil companies to invest in the country. The first thing that surprises is the minimal presence of the largest players of the sector. The country boasts that there are 17 international companies operating, but the most relevant, Petronas (Malaysia), OMV (Austria) or MOL (Hungary) are not exactly the top groups in operational efficiency, and the two Europeans mentioned can not even presume of having a robust financial position. On the other hand, in 2010 BP sold almost all its exploration and production assets in Pakistan to United Energy Group, a Chinese holding company, for $775 million.

China seems very well positioned to gain a strong foothold in the country, with good ties to the government, and a historical track-record of managing quietly the most difficult geopolitical environments (Sudan, Nigeria, Iraq).

For Pakistan to regain a strong position in the oil and gas market I believe we would need to see three fundamental conditions

a) The end of the conflict in Afghanistan , which would close the geopolitical axis Turkmenistan-Afghanistan-Pakistan, isolating the influence of Iran and make attractive a large-scale presence of big oil investments. This is especially important to implement the infrastructure (a pipeline of more than $2 billion investment) to carry gas from Afghanistan to Pakistan and connect to a liquefaction plant to allow liquefied gas exports from Afghanistan and Pakistan to either China or the U.S.

b) The establishment of a strong government that recovers the lost provinces, particularly Balochistan, and to adopt a sustainable and predictable legal framework.

c) The involvement of China and U.S. in Pakistan to develop the fields (onshore and offshore) is essential to bring oil export production to 120,000 barrels per day and gas production from 37BCM year, primarily for domestic consumption, to export up to 67 BCM.

Who would win? The main beneficiary if Pakistan would rise would be Schlumberger, the U.S. oil services company, with expertise and resources to develop the fields and local staff. But Pakistan, at least in the short term, is much more a risk than an opportunity.

Improving the economic situation of Pakistan with a current estimated GDP growth (+2% 2011) ridiculous for the area, is really complicated and depends on the future access to natural resources development, which is intrinsically linked to political normalization in a country with the nuclear bomb and that remains a hotbed of support for radicalism. An unequivocal commitment to eradicate the terrorist support may be the key that opens the door to growth. Being “Merchant of Menace” only brings poverty.

Oil Sector down on the year, while oil +29%YTD

Global Economy, On the cover, Sin categoría

sxepMassive de-risking and fears of an economic recession are driving the sector down. Additionally the ETF impact causing a widespread sale of large caps, which are traditionally deemed as defensive for their large cash flow, low debt and high yield-buybacks.

The large cap oils have shown a very poor leverage to the commodity since 2001 and this last quarter results have proven it even more. Most companies have beat consensus in downstream (refining and chemicals) and eroded returns on E&P despite oil at high prices. This is because costs are rising, production growth has been poor and gas-heavy and share of economics of the fields from national companies (PSCs) increases with higher commodity prices.

The interesting thing is that services and E&Ps are benefitting from that environment but the market is pricing no earnings or margin recovery in services and no M&A-asset value upside.

E&P’s are discounting less than $85 crude (despite $110-$120 spot), suggests an economic crisis and market correction is expected. So E&Ps are selling off given higher capex spending, while services are not benefitting because of expected higher costs, and rotation out of Energy seems to be in full force.

Like in May-June 2010, we are likely to get a great entry point into attractive stocks. In the meantime, integrated megacaps have entered into negative EPS momentum, and with most dividend payments behind us, the yield protection is (mostly) gone.

Russian Energy Stocks To Watch

Global Economy, On the cover, Sin categoría

(This article was published in Spanish in Cotizalia on Thursday 28, 2011).

In Moscow there is no crisis. Russia is the world’s largest oil exporter, 10.2 million barrels a day, and the leading exporter of natural gas to Europe, 134 BCM per year, and it shows in all parts of the economy. The country will have its 2012 accounts in surplus at $125/bbl, but at $93/bbl still meets its goals with flying colours. Also, credit default risk is 14% below the annual average, the country has no risk of contagion from the European debt because Russia has almost nothing invested in EU bonds, the economy continues to grow by 4% annually and unemployment is at historical lows. With over $20 billion in scheduled IPOs, foreign fund flows at record highs and a reserve fund of at least 25 billion dollars to invest ahead of the elections, seems to me an environment that does not justify a discount of 40% to other emerging markets.

The Russian market (RTS) has been one of the best performers (+15%) so far this year. However, it is still trading at a discount, which in my opinion unjustified. Russia was accused of being “closed, corrupt and driven by state and oligarchic interests” Well, as half of the EU, then, in my opinion.

Not to be cynic, but I think we criticize other countries with faults that we have at home, and with many Russian companies the investor has the same guarantees as in Brazil, China or even Spain, Italy or France, increasingly interventionist countries, especially on energy. But Russia has much cheaper stocks, which enjoy higher growth, higher profitability and a better financial position than its peers in Europe.

In 2011 the average EBITDA growth of the Russian market is estimated at 49%, with margins of 29%. And with a 40% discount. I, therefore, believe that any “concern for corporate governance” is more than discounted.

My readers know I am a big supporter of several Russian energy companies, especially Novatek, Eurasia Drilling and Bashneft, which in terms of value creation, corporate governance, efficiency, and management team have nothing to envy of any international peer. Of course, my readers also know that having great stocks ​​such as these, I’m not a big fan of integrated state-owned stocks, Rosneft or Gazprom, mainly because I never liked semi-state owned stocks ​​(conflict between state interests and shareholders, from EDF to ENI, to Petrobras and Petrochina) or large conglomerates of any country, with the exception of Exxon and Chevron, which are the only ones who stand up to their government and defend the shareholder above all else.

To invest in Russia the first thing to do is to avoid betting that the government will do something that the rest of the world does not do (for example, thinking that the government will allow state enterprises to generate excessive profits when it does not happen in any EU country). Or that Russia is a joke and you have to go for it, as Yukos thought using state exploration licenses for private interests.

Another example is the disaster that BP has made when trying to trick its partner, TNK (25% of the reserves of BP), signing an agreement with Rosneft behind their back. BP thought that in Russia everything is arranged by dealing with the government and has seen the agreement canceled by a court of international arbitration and the most likely outlook for BP is it will have to sign a cheque for several billion (rumored $ 40 billion) to the shareholders of TNK (AAR) to “divorce” from their alliance. A partnership that was signed and prepared in detail by Tony Hayward, BP’s former CEO, where everything was tied up to the smallest detail. But his successor, Bob Dudley, thought that an agreement with a state company, Rosneft, and a supposed tacit government support would make this partnership with TNK and its shareholders interests (AAR) worthless. Bad idea.

Total, Statoil and Exxon invest in Russia with more logic.

There are several reasons to invest in Russia :

1. Despite being the most geared to oil prices, the Russian market is discounting an oil price below $90/bbl and traded only 7.2 times PER 2012. It is true that between Gazprom and Lukoil (30% of the index) there is more than a 40% discount in PE, but stock by stock the market is still significantly cheaper than the other EMs.

2. Although the economy grows by 4%, the budget is balanced at $125/bbl and corporate profits will rise 30% on average, Russia trades with a risk premium of 8.7% compared with China or Brazil at 6.5%.

3. Russia is the only country in the EU and emerging economies where I foresee widespread upward revisions to long-term profit forecasts. It is also the country where corporate and state debt is more controlled of the major economies.

4. Medvedev announced in March in Magnitogorsk a very ambitious set of measures of transparency and corporate governance. The market has not reacted yet, but we must remember that after his “Go Russia!” speech in September 2009 the market rose 22% despite the oil price staying flat.

In the energy market, Russia is, for obvious reasons, a goldmine. And it should continue to highlight four areas:

1. The creation of new oil and gas giants. Russia has decided, rightly, to support the creation of companies to develop their oil and gas fields more quickly, efficiently and cheaply than the big state conglomerates. The two beneficiaries of this process of optimizing the exploitation of natural resources are Novatek (gas) and Bashneft (oil). Total has bought 10% of Novatek, and is rumored that Statoil and Shell will participate in its flagship project, Yamal LNG. Despite the stock rally, it is still trading at just $3.33/boe (2P reserves) and 12x EBITDA for a company growing 20% ​​annually. Bashneft, meanwhile, is trading at $ 5.6/boe (2P) and with production growing by 4%, benefiting from an agreement with Lukoil to develop the mega fields of Trebs and Titov (7 million barrels per day in 2013) it is not surprising to see consensus estimates grow by 46%.
epidemic
2. The ridiculous antinuclear and anti-shale gas campaign around the EU benefits Russian gas exports. 145BCM in 2013. And the more interventionist that Europe is, the better and better for Gazprom, which could trade 40% higher if its investment plan was less “opaque” (nearly 40% of Gazprom’s investments generate returns below 7%),and this makes it trade at low multiples (5x PER). However, Novatek, domestic gas player, profits from the same environment (without such a “government-led” capex plan).

3. The goal to keep oil production at 10.2 million barrels a day and develop new fields in Siberia and the Arctic will benefit the efficient service companies, which compete with internationals as equals and have proven their effectiveness with their clients (Rosneft , Lukoil). Eurasia Drilling and Integra, two of the top ranked service companies may see its order book doubled and margins increased by 34%. Eurasia Drilling also has a very competitive cost structure and presence in countries such as Azerbaijan. From the integrated oils, Rosneft and Lukoil are obviously favorites of many funds given the large resource base, but the risks investors face is to bet that margins will recover or that taxes in Russia are reduced, which is unlikely, and investors should also take into account the risk (similar to that of all conglomerates) that these companies decide to move aggressively in their international expansion by buying assets at high prices.

4. The liberalization of utilities. The major European electric utilities have invested in Russia with great success. It is worth looking at those utilities partially controlled by European groups which generate very strong returns, with world class efficiency and transparency. E.On (OGK-4), Enel (OGK-5) and Fortum (TGK- 10) have been the first to invest large extensively. The TGKs and OGKs and trading at $250/Kw installed and 5.6x EV/ EBITDA 2012 on average. Discounts of over 20% compared with the European power groups, which are widely hit by regulatory risk and interventionism.

Many people ask me if it is too late to invest in Russia. I think not, and I think if there is a slight correction, as in May-June 2010, it can be a great opportunity to invest in a country that is becoming less “emerging”, which is the largest exporter of oil and gas to Europe and undertaking a very interesting process of reforms that recalls the one we saw in Spain in the late eighties and early nineties. But with oil and gas in abundance.

Exxon was right. Where will oil companies invest in 2015?

Global Economy, On the cover, Sin categoría,
(This article was published in Spanish in Cotizalia on 14th April 2011)

In 2008, Rex Tillerson, CEO of ExxonMobil, was facing a General Shareholders Meeting with a request, almost a demand, by a California pension fund, a group of nuns and the Rothschild family. The requirement: to dedicate a substantial portion of its investment program to renewable energy. It was the culmination of a process of harassment of U.S. oil majors that started with the then young administration of President Obama. The request was unsuccessful. The general meeting of shareholders rejected it by a majority. Not even to make a “wink” to an administration hostile to the sector.

The explanation was simple. It is a different business. It is valid for other companies, where the competitive advantage requires in sustained institutional support and where returns are well below those demanded by the Exxon group. With or without subsidies. Because, as Tillerson himself “if we really wanted to see subsidies for renewables eliminated, the only thing we should do is spend millions on those technologies, because then the government would immediately withdraw the premiums, or rather, retire them for us only.”

Today, Exxon is the most profitable oil company in the world, with a return on capital employed of 22%, has distributed $112 billion to shareholders over the past five years, has the highest return per barrel in the industry ($20 per barrel produced 2006 -2010), a reserve replacement ratio 210%, with virtually no debt and no divestiture requirements from ruinous adventures like other competitors. And the interesting thing is that these rates of return are not be generated because they are a very large company (just check the poor returns of comparable European companies), but because of the focus of its strategy on two principles that I would call:

a) Focus on the core business and activities where they have real competitive advantage to return those benefits to their shareholders. It’s a company that invests $35 billion a year of capital that belongs to its shareholders, not an NGO.

b) An organization focused on generating superior returns, not intangible objectives. Return on capital employed (ROCE) as an absolute objective. Intangible benefits and costs are imaginary inventions to justify losses.

Chevron and ConocoPhillips also turned away from experiments and generated significantly higher returns than those oil companies that diversified into other technologies, despite the weak dollar. Meanwhile, competitors who took to strategic adventures outside their industry are in the process of selling at a bargain price their “star” projects.

Many European oil companies boast in their advertising of their investments in alternative energy. But behind the image lies a very different reality. In fact, after years of multibillion-dollar losses, the reality is that most have returned to their core business.

We made a detailed analysis of the plans of oil companies for the next five years. The results (only Oil Majors, ie Big Oil) are:

. Over 85% of the annual investment in the sector, ie, well above the $200 billion annually, will be dedicated to Exploration and Production. Nearly half destined for natural gas and half oil. Of this amount, almost 30% will be dedicated to exploration of new reserves in “frontier areas” or areas where they expect to find the next mega-field, the new Kashagan, Tupi (Brazil), Uganda or Jubilee (Ghana). Greenland, the Russian Arctic, Mozambique and Namibia in addition to the large investments (over $10 billion in 2011) in the U.S. in shale oil, where it is estimated that we could see a revolution similar to the gas shale (shale gas).

. Less than 14% will be dedicated to refining, marketing and chemicals. The returns are relatively poor and do not justify further investments. The OECD industry is facing overcapacity with nearly 7 million barrels per day of excess capacity in refining and 65% of average utilization in chemicals.

. Less than 1% of investments will be devoted to “alternative energies.” And when the oil majors talk about alternative energy, over 67% of that money is for “biofuels” which is a derivative of refining, not wind turbines or solar panels. ExxonMobil invests in technology and development more than $200 million per year, mostly to improve transport efficiency and liquefied gas.

. The only companies that will explicitly invest in wind turbines and solar panels are BP ($10bn in ten years, less than 2% of their annual investment), and the market does not reward them for this low-return capex, Petrochina (a gigawatt in wind, less than 1% of their investment) and Total (a little solar and CO2 capture and storage). Shell divested most of its activities in solar and wind energy smartly at peak valuations (2009).

Why don’t these companies invest more in alternative energy?.

. First, because the returns are very low and more risky (politically) than its main activity, and as the average cost of capital of Big Oil is close to 9% upstream, the sector should require higher returns than those generated by regulated sectors. Alternative energies generate returns of 11-12% with a debt of c80% at project level, which is impossible to for oil companies, who know you can not gear by more than 25% an energy project, being a cyclical business. So the integrated utilities, which have a lower cost of capital and relatively low but stable returns, are more willing to include alternative energy in their investment plans. At the end of the day, renewable energies are utility-type of businesses, as we have seen now that the “supernormal growth” prospects have moderated to more logical 5-6% pa.

. Second, because the electric-utility model requires concentration in countries with great political influence and government control and concentration is exactly what the oil sector tries to avoid, following the disasters seen from 1975 to 1999. Thus, since the end of the era of nationalization and break-ups forced by anti-trusts, the oil companies want to avoid accumulating more than 20% of their assets in one country. Governments are very greedy when it comes to demanding long term investments from private companies but also very quick to cut private profits.

. Third, avoid subsidies because they are removed at the first opportunity. The oil industry endures some of the most onerous taxes (up to 80% in some countries) in the industrial sector, multi-million dollar investments with very long maturity periods in cyclical sectors, risks in unstable countries, PSCs (Production Sharing Contracts), and the sword of Damocles of “surprise” taxes, as we saw in France last week. $400 million into the pockets of government. that is the reason to avoid regulated activities, and the oil sector has divested more than $30 billion in these activities since 2008.

I read many articles saying that oil subsidies are enormous, but such analysis is flawed, by bringing together private companies and state owned ones. For the IEA and others to count as subsidies what Saudi Arabia gives to its company, Aramco, or what Rosneft and Gazprom get from Russia or China provides to PetroChina and Sinopec, etc. is a joke. When comparing subsidies to industries, these should not be included, that’s cheating. And most of what the articles call “subsidies” are deductions for double taxation. It is quite funny to expect that oil companies pay 60% tax in the North Sea, for example, and then pay for them also in the U.S or elsewhere.

For years the chief executives of American oil companies were criticized because they did everything wrong and were obsolete while counterparts in Europe and the United Kingdom were betting “on the future”, from investments in Business To Business and the Internet (in 2001 some oil companies spent more on this part of their strategic plans than in E&P), transmission networks, nuclear energy, healthcare (I swear), or hydrogen fuel (with multibillion-dollar losses). No more experiments. As an example, Shell, after the arrival of Peter Voser, immediately imposed a “back to basics” focus on exploration and production, generating cash flow and high returns on any part of the cycle. They reached in three years the goal of becoming the second most profitable company in the sector.

Now, with the sector at record levels of cash generation, investment plans in the oil sector are simple. No more adventures. Exxon was right.

Further read:

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

http://energyandmoney.blogspot.com/2010/07/five-risks-of-big-oil.html