Tag Archives: Energy

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.

Where US Gas Prices Start To Be a Concern for Independent E&Ps

Energy, Global Economy, On the cover, Sin categoría

us gas (1)

As I commented a few months ago, gas prices are at risk and have now fallen below $4/mcf on the Henry Hub 12 month strip, and we are at growing risk of a prolongued downturn in prices unless producer discipline is restored, as the weakness is occurring into shoulder season where marginal demand for power becomes very weak and its challenging to compensate the oversupply of gas by taking out coal of the merit order, so the risk is relevant until heating season. In the US total working storage is now at 3,052 Bcf versus the 5-year average of 2,875 Bcf and last year’s 3,250 Bcf level.

This is where finally I expect some producers to respond with a combination of capex cuts and asset disposals. This will drive prices back to more normalized $4.5/mcf levels. A few brokers are calling the seasonal nat gas trade this week (historically this is the low season for spot pricing which is what the equities trade off of). The only difference between this year and the last one is that the contango has weakened. This will make equities less reactive, but it will also make it less attractive to drill nonsensically and hedge as financial institutions will not be so keen when the curve flattens.

Yes, most of the independents claim to be the “low cost” producer, most will say they make money at $3.5/mcf, however, this is not 2008. On one hand, service charges have increased, and on the other hand, the benefits of scale achieved in the “fracking revolution” are becoming less apparent.

So in order to bring the market to balance we need to see a good cut to c62BCF/d from current 65-66BCF/d. I believe this environment will drive majors to look for M&A opportunities (they love their US gas acreage) and as such US gas independents are always a risk if you want to short them for more than 1-2 weeks. I would use this pull-back to play arbitrage winners (LNG) and look at those companies that remain disciplined, strong on balance sheet, low cost and well placed for M&A… and monitor the producer discipline very carefully. Unfortunately the rig count is not a good indicator any more (as we saw in 2009, rig count can drop severely and production still rises due to efficiency improvements). So it will all be about company messages.

One question to ask ourselves: What will Exxon do with XTO? Maximize production or be disciplined and look at high returns?. The new entity controls 15% of US gas production, and Exxon has been disappointing in results in the past four quarters. Surely sub-$4 gas is not ideal environment for mass growth in output for a company that prides itself in maximizing ROCE. I hope they will stick to that principle.

A Few Thoughts on Brazil E&P, Repsol and BG

Energy, Global Economy, On the cover, Sin categoría

This article was published in Spain’s Cotizalia on o8-06-2010

Eight months ago I wrote from Rio de Janeiro saying how wrong most analysts were in their estimates of development costs of the pre-salt discoveries in Brazil, and time has proved us right. Facts now show between 25 to 30% less than the $40/barrel estimated by consensus. Despite this, the market is not reflecting the incremental value of these reserves in the involved companies’ stocks (Petrobras, Repsol, BG and Galp).

For example, BG Group trades at a 25% discount to its NAV (Net Asset Value), despite being one of the most benefited from the discoveries in Brazil (with holdings of between 25% and 30% in the most attractive blocks, BMS- 9 and 11), showing excellent LNG trading results and being a clear takeover target. Even if we accept the valuation of its remaining assets at “conglomerate” multiples, BG Group at £10.5/share does not reflect in any way reflect the intrinsic value of its Brazilian assets in Tupi, Guara, Carioca, Iara, which, at $77/bbl would be worth about $16 billion. And BG is the only group exposed to Brazil able to finance its development with own free cash flow.

Part of the blame for the loss of interest in Brazil comes from the delay of Petrobras to complete its capital increase ($20-30 billion) and the lack of new information about the pre-salt assets and the improvements achieved.

In this comes Repsol, and says they cannot wait any longer. And it will IPO (or sell to a third party) 40% of its E&P assets in Brazil. Repsol, as Galp and Petrobras, does not swim in free cash flow and thus seeks to raise cash to finance the development program of the fields and diversify into other areas. For Repsol, unlike for BG, Brazil represents too large a percentage of its total E&P assets.

How much are these assets worth? Analysts estimate between $5 to $10 billion, or $8/bbl at the top end of the range for assets that to this day are undeveloped. It seems an excessive price, when BG’s Brazilian reserves are valued at $ 3/bbl, in Petrobras at $3.4/bbl and Galp at $2.8/bbl.

Additionally, Repsol’s assets are the most exposed to changes in the Petrobras development program. If developing the Franco area is the Petrobras focus after Tupi, then Guara + Carioca will not be starting up until 2020, which would severely impact the NPV of the Repsol assets, and put at risk any value above $2-3/bbl.

But let us not forget that out of these companies, two (Galp and Petrobras) are semi-state-owned, and therefore “not for sale”, the third, BG, is a very large leading independent global gas explorer and producer, so maybe Repsol Brazil is the only option for third parties to participate in the pre-salt opportunity. Additionally, the transaction multiples we have seen recently have reached up to $12/bbl (proven and probable reserves). Therefore, it is not surprising that the $8/bbl figure mentioned before would be more than acceptable in a private transaction.

However, it is more difficult to think that an IPO will reach the same valuation from day one due to market risk, the fact that the assets no longer provide an aggressive exploration potential (most of the discoveries have been announced already), and that the market would bear the risk of the previously mentioned delays or difficulties in the development schedule of the assets. And we have seen in Pacific Rubiales or OGX that the attractiveness for the stock market of pure exploration assets is diluted when these move into production. But it is worth bearing in mind the “scarcity value” of Repsol Brazil for other international oil companies, as Petrobras will be the only beneficiary of the new licenses in the country.

The IPO of Repsol Brazil, if it happens, would be great news. To begin with, because it would crystallize value and would allow investors to choose the part of the integrated group that interests them the most, without having to take the risk of refining, which terrifies me, or Argentina. But it is also a double-edged sword. If the listed subsidiary fails in the secondary stock market, it will de-rate the Repsol stub agressively. It is inevitable to see the “de-rating” of the parent when the subsidiary goes public, but even more if it loses value, and this has been seen in 100% of the cases of spin-offs, IPOs, or rearrangements of divisions priced “greedily”. Repsol Brazil also has to compete for investor interest against BG, Petrobras, which trades at a 15% discount to its peers, and OGX, its largest competitor in Brazil as a “pure play” in E & P.

For now, the commitment to crystallize value, re-organize the company and reduce the conglomerate discount has made Repsol trade at a deserved 11% premium over its peers (ENI, Total, Shell, OMV). For Repsol it is now time to make its Brazilian division a “must own” stock for investors. And that has to come from a good pricing and solid catalysts.