US Natural Gas … The picture gets bleak(er)

Global Economy, On the cover, Sin categoría,

US GAS

As I mentioned a few weeks ago… It could get worse, and it did. The bulls of the market have been calling for the need of a drastic cut in production in US gas and it hasn’t happened. No wonder the Hedge Funds net long positions on US gas have been reduced by 50%.

The environment is still strong for producers to keep increasing volumes, credit is abundant, hedges are in place and companies still think that growth and production is more important than supply management and economics. As an example, Chesapeake has entered into a 5 year VPP with Barclays on the Barnett 280 mmcfed of production relating to 390 BCF of 1P for $1.15 bn. This is after costs, so I imagine the price of the hedge is $4.50 (considering 20% royalty and $0.80 operating costs). Over the past three years Chesapeake has averaged $4.70 per mcf on their VPPs. This is generating utility-type returns in a very cyclical industry where everyone claims to be the low cost producer. So as long as there is credit, gas will flow regardless of diminishing returns.

Not only have we broken through 2003 lows (these are nominal prices), we are doing so in an environment where gas drilling and services day-rates remain robust, activity flush and inventories at cyclically long highs.

What has happened? Oil at $81/bbl, for starters. Wet gas changes the economics of drilling, so loads of ‘uneconomic’ gas fields are made economic by selling the liquids. Tough for dry gas-dominated producers, like in the Barnett shale.

Additionally, efficiencies in extraction, principally in horizontal drilling are forcing the cost curve lower despite the stronger environment for services. So day-rates are up, but cost per mcf produced is down.

Credit is also an important factor. Almost any producer of size can tap higher amounts of debt financing to keep drilling.

However, gas can self-correct rapidly. Once the situation becomes A few months of drastically curtailed production; or a few months of ultra-low prices like $2.50 would quickly re-equilibrate supply and demand, and force us back to long-term averages on the cost curve…but that cost curve itself is not static.

Meanwhile, the curve contango steepens. Cal 2012 is 16% above 2011. The bull case here is that by 2012 we could see conventional decline (6% pa) meet unconventional plateau, added to a view o demand improving, albeit slightly. The risk to believe this case is that the forward curve is slightly polluted by the hedges being taken in the financial markets.

The Increased Isolation of Iran versus Saudi Arabia and Israel

Global Economy, On the cover, Sin categoría

(Article published in Spanish in Cotizalia on Sept 30th, 2010)

It is the largest arms contract signed in U.S. history. $60 billion in weapons to Saudi Arabia. More importantly, that huge contract probably includes a long-term agreement to ensure oil supplies to the U.S. from the Saudi Kingdom. After so many empty words about energy independence from the Middle East, it seems that gone are the days of anti-OPEC messages from the current administration. But it is also of paramount importance to secure the protection of Israel from the threats of the Iran regime. After all, the Saudi Kingdom has as much to fear from Iran as Israel has.

The United States faces a future that needs Israel and Saudi Arabia as much as it did twenty years ago, if not more. Israel as the representative of Western values and democracy in the region, and Saudi Arabia as the best balancing factor as a West-friendly regime versus Iran and other radical Arab nations. And this is needed because the US will only be able to focus on recovering economic growth on the foundation that is provided by cheap energy, the only possible way, and through three pillars: the abundant reserves of conventional natural gas and shale gas (more than 250 years of supply, as Peter Voser, CEO of Royal Dutch Shell, says), oil from the Saudi + U.S. + Canada triangle and to a lesser extent, clean energy (nuclear and wind).

Of course, this agreement is intended to send a message to Iran, that is continuing with its nuclear program, despite the virus threats to its IT systems, and its anti-Israel but also anti-Saudi messages. It is not just a prevention message, it is a way to strengthen the Saudi government as leader of the moderate wing of the Arab countries. The Iranian regime is not supporting the King Abdullah, and continues to try to grab influence in the Shia community versus the Suni majority, while Saudi Arabia is undertaking the most ambitious program of modernization and opening up in its history, more than a billion dollars of investment in infrastructure and services, and, after sporadic protests in August, a very specific focus on education and securing employment for the population younger than 25 years, more than half of its 18 million inhabitants. A stronger Saudi Arabia and a lower influence of Iran on the Shia muslims means also a safer Israel and a better balance in the region.

We are aware that arming the Saudi Kingdom with $60 billion to send a message to a country, Iran, whose military budget is less than the $10 billion a year, must start from the view that conflict is most likely than what we believe or obey other strategic objectives. That goal may be the security of oil supplies ahead of an eventual geopolitical problem that significantly reduces exports from the Persian country.

Since March we have seen all Western oil companies cancel, reluctantly, supplies to Iran. The embargo is effective and is already evident in the prices of oil and the increase of Saudi crude exports to the United States that has analysts all over the world scratching their heads.

Why grow imports when U.S. demand is not really rising and inventories are at a five year high? At the end of the day, imports are going up because someone is buying these boats, and not, as some analysts seem to assume, because suddenly, lo and behold, boats appeared out of the blue one afternoon to download. Are the US building a cushion, an additional strategic reserve? Maybe.

Add to that the increase in the number of vessels storing oil on sea, which has risen 10% in two months, and it is plausible to estimate that if they are not preparing an environment of conflict, at least they may be seeking to ensure supplies of oil in a more complex geopolitical environment, taking advantage that oil trades with virtually no political risk premium.

It is true that OPEC now has 6.3 million barrels per day of spare capacity and that between Russia and Iraq they are expected to increase global supply by 2.5 million barrels per day in 2013, but I fear that not even Hussain al-Shahristani , Iraq’s oil minister, assumes the country’s goals as easily achievable in the medium term, particularly if the investments of international business concession of the fields start to slow down following the recent local incidents at the premises of the Al-Ahdab East field (CNPC, China).

But if Iran has to be considered out of the equation in a tense geopolitical environment, spare capacity is gone, and the additional barrels will only be able to come from the only country that can immediately increase capacity from 9 to 11 million barrels a day … You guessed it, Saudi Arabia.

Oil in Greenland… A New Frontier?

Global Economy, On the cover, Sin categoría,

greenland(Article published in Cotizalia.com in Spanish on Sept 23 2010)

Today we will talk again about finding new oil frontiers. And it’s time to talk about the arctic. Until recently a disappointing area for oil exploration, both due to environmental constraints, water limit disputes and dry wells. But the war for natural resources, the recent encouraging exploration results, and the constant global goal to diversify and achieve energy independence, is bringing back billions of dollars in investments to Greenland.

Greenland has a lot of oil. Studies of various consultants, PFC and the U.S. government estimate that it has the second largest oil reserves yet to discover, larger than the discovery of Brazil and Kashagan and behind Iran (Zagros). We talk of more than 45 billion barrels. And yet we have only seen minimal exploration activity in the last ten years.

The technical difficulties and costs are not negligible. Now, however, everything can change, and turn Greenland in the great new frontier for the oil industry after Uganda, Ghana and Brazil.

In the 70’s, companies such as Chevron, Total, Mobil and Statoil explored Arctic waters without success, and until recently the results have been more than disappointing, as all wells explored were not viable. I do not want to bore you with technical details, but one of the reasons that there were no discoveries was the type of oil accumulations that were being sought, focusing on concentrations in sediments of the Tertiary or Cenozoic era, ie about 65 million years old . However, the oil discoveries in Brazil and Ghana have made the industry more recently set its targets in sediments from the Cretaceous era (about 145 million years old) and in deep water, more expensive and riskier, but with enormous potential .

West Greenland can be one of those surprises. Just the same as in the first part of this decade the industry doubted the exploration potential of Brazil, West Greenland probably shows a very similar accumulation.

However, some media say, erroneously, that the exploration in Greenland is only possible thanks to global warming, which allegedly contributed to the melting of the ice in the area and using alarmist arguments about the impact of the oil industry in the area and the ecosystem. For starters, exploration in the area has been carried out since the 70’s, as I said, with no environmental impact. The difference is that the technology of deepwater drilling has improved substantially, allowing access as already mentioned sediment depths greater than, 2,200 feet and 300 km from the coast, completely away from any ecosystem to be preserved.

The challenge of industry in Greenland is not to take advantage of the alleged global warming, which of course is not evident in the area, with oversized icebergs migrating from North to South that have grown, not shrunk, and temperatures which have dropped two degrees on average since Statoil prove its last well, Qulleq 1, in 2001. The industry challenge is to prove the commercial viability of this enormous potential. Considering the current cost environment, projects in Greenland recover investment at $ 60/bbl, with development costs of about $ 25/bbl and operating costs of $ 12-14/bbl. In other words, to get a return on investment (IRR) of 25% on a typical minimum investment of 5 billion dollars, you need an oil price of $80/barril.

Independent explorers, good friends of ours many of them, are the ones taking the lead in the new frontiers. Cairn Energy, is conducting an exploratory program of 14 wells in Greenland, the highest risk (especially in the south, where it is less obvious to see the oil accumulation), but high potential. And the big oil companies are already participating in the race for operating licenses in the area. Exxon, Chevron and others are already prepared. We will follow this closely.

The Oil Services Sector Continues to Show Recovery Signs

Global Economy, On the cover, Sin categoría

Tecnicas Reunidas

(This article was published in Spanish in Cotizalia on Thursday 2 Sep 10) The above graph shows the E&P spending in Europe, North America and Emerging Markets in $m.

If there is a sector that has surprised the market in the energy world this August it has been the oil services one. Not to us, as we already anticipated in March a very favourable environment for selected stocks in a highly fragmented sector, each in its speciality, such as Petrofac, Seadrill, Amec and Tecnicas Reunidas. And indeed, companies have shown an ability to increase margins and order book in a difficult macroeconomic environment. And in a sector,oil & gas, which is one of the worst performers of 2010 (deservedly, as we have explained on several occasions), these stocks are showing their relative strength.

And make no mistake, the environment is still difficult. Despite the overall increase in investment in exploration, production, refining and development the service sector still suffers from excess capacity in some of its segments (deep-water drilling, due to the ban at the Gulf of Mexico, or seismic and seamless pipes, for example) . The oil services industry, on average, still works at 65-70% capacity, but there are companies that take advantage of this situation to gain market share and increase margins at the same time. How is this done? Thanks to historical better cost control, better execution of projects, specialization and focus on improving returns.

When companies do not not commit excesses in the top of the investment cycle and focus on a segment of highest profitability and best suited to their technical strength, is when you get to have a winning combination at the bottom of the cycle. Petrofac, for example, increased its order book between 2007 and 2008 with investments in the oil sector, its customers, falling by 12%. Now that the big oil companies expect to increase investments by 13% and 12% in 2010 and 2011, companies that lived the crisis as winners are ready to generate superior returns. So a company like Seadrill, which specializes in drilling platforms, can pay dividend yields of 10% and still deliver backlog growth.

The services sector is an indication of the anomaly we see in the market. Large companies are swimming in cash, generating good returns and reducing costs, so their ability to invest through the cycle has improved significantly from previous troughs. However, the market is still seeing more risks than rewards despite this. Furthermore, NOCs (national oil companies) are in a much better position financially than the international quoted peers and do not need to preserve cash to pay gigantic dividends, so this allows them to invest more and more aggressively through a down cycle.

What is the main risk to the sector? Obviously a slash in investments in the oil sector. The two main drivers would come from either new episodes of drilling bans as Macondo (that affect the entire capex chain), or from oil price (and therefore revenue) falls. If oil prices were to drop below $60/bbl it would cause the cash surplus in the oil sector to shrink to a level where we would see significant cuts in investments. In my view, this could mean going back to 2008 levels of capex, and possible renegotiation of conditions and margins with service companies. But 2008 also taught us that it is very difficult to reduce these investments well below the $200 billion annually, and that costs are sticky throughout the chain as projects become more complex, larger and more labour intensive. And labour remains a big challenge in the industry, as skilled professionals are still relatively scarce. And if we consider the cost of developing Brazil, Iraq, Greenland, East Siberia and West Africa, the five frontiers of the future for the sector, it is very difficult to predict a negative environment for service companies in the key niches.

In August we have seen the oil sector fall 1.2%, 13% annualized. Meanwhile, Petrofac has risen 45% in 2010, Amec by 16% and Seadrill by 5%. Amec, an engineering and project developer from nuclear and renewables to oil, published results 8% above consensus and raised its margin expectations for 2010. Petrofac, which specializes in large engineering and construction projects, increased results by 52%, 7% above consensus and broke its own record of order intake. Seadrill, key company to look at for its exposure to drilling, published results 6% above consensus and improved margins, with the market for premium jack-ups continuing to show relative strength as the utilization of such units remains above 90% with dayrates around 130k$/day, and in the underwater market getting $450-495k/day, a negligible drop from the 2006-07 peak of day-rates.

On top of this we are seeing consolidation coming back. This underpins an environment in which it will be difficult for large companies to try to negotiate costs down, as the most inefficient players are absorbed and the industry re-focuses. If we add that Brazil will spend $224bn in the next years to develop its offshore fields, it is difficult to see a sustained environment of overcapacity.

With minimal debt and 13x PE 2011 average, a 9% discount compared to average cycle multiples of the sector, the services industry looks still relatively cheap, and in a relevant number of cases consensus has to raise estimates for 2011 and 2012 between 4% and 7%, just as the investment process resumes its cruise speed . So, as we said in March, look at companies that can increase orders and margins, well capitalized and with low costs. They will continue to surprise.