Repsol's challenge

(Published in Cotizalia on Oct 29th 2009)

Interesting times for Repsol, with plenty of corporate rumors.

Since 2004 the company has focused primarily on controlling capex, in a group that needed to invest more than € 6 billion annually, almost 25% of its market capitalization to keep the net income flat, and find ways to sell YPF, trying to reduce the high exposure to Argentina, almost 40% of its assets. A similar problem to that of OMV in Romania, and to a lesser extent, BP with TNK (Russia). Still, the stock has behaved almost exactly with the rest of the industry, thanks to its exposure to Brazil, Venezuela, Sierra Leone and other assets of high exploration potential, which enabled it to be one of the few who will to replace 100% of its reserves in 2009. This despite the capital increase of Gas Natural Gas and Repsol's Refining business unit, highly capital intensive and of low added value.

One hears rumors of a possible dividend cut, but this does not only affect Repsol. The industry tries to maintain a proper debt to the underlying asset, given its cyclical nature, can not afford adventures on its balance sheet. See the case of ENI, or OMV, with capital increase of € 1,000 million added.

The challenge of Repsol, and the integrated oil sector, is to create shareholder value, and that's difficult in a sector as poorly differentiated. The integrated model has traded for years at 9-11x PE, with a discount on the sum of the parts which at the top of the cycle reaches 20% and at the bottom reaches 30%. A large discount to E&Ps or specialized services firms, for example, but also a lower-risk model due, in part, to the lower debt. It is difficult, as investor, to demand high multiples and dividend stability while seeking large investments and long term perspectives. More difficult, moreover, if Repsol requires € 3 billion per year in maintenance investments and € 15 billion to develop the fields of Brazil, since it has less margin than others, and needs high oil prices and refining margins much higher to generate free cash while developing these assets.

The stock appreciation of an oil company can only come from increasing the return on capital employed, which requires specialization and strict control of the return on investment, and crystallize value by separating assets. So it's worth trying to sell YPF, refineries or Gas Natural with a premium, but it's not easy, and political issues do not allow it in certain cases.

Repsol has before it the challenge of deciding what it wants to be in the next ten years. As British Gas or GALP are proving, it can not be in the whole energy chain at a time and maximize value in their growth areas. Controlling costs, develop the business of exploration and production, manage the portfolio of assets to avoid having more than 15% in each country, and reduce exposure to refining and regulated activities remains the appropriate strategy. If not, they must wait for the miracle of the expansion of multiples of the entire sector. And that is risky.

Oil and Nat Gas, two diverging commodities

(Published in Spanish in Cotizalia on Thursday 15th Oct)

Oil has reached $80 a barrel. On the demand side, there has been an upward revision of estimates of the International Energy Agency, IEA and EIA. On the supply side, the fact is that in the last five years, increased investment in exploration and production ($220 billion per year), has not helped to replace 100% of the reserves consumed. Moreover, extraction costs are still too high and declines are affecting production in countries like Norway and Mexico, with falls of 6% and 3% respectively.

In natural gas, the situation is almost the reverse. The world has 60 years of life of proved reserves, which compares with fewer than 45 in oil, and to the estimate we must add large unconventional gas reserves. Proof of such excess is that in early 2009, British Gas decided to sell long-term 85% of its gas production expecting an environment of overcapacity in the medium term. Back then gas was trading at $ 7 per million BTU. Today is at $ 4.

On the demand side Eurogas expects zero growth in demand for gas in 2010, after a fall of 7% in 2009. This occurs while Qatar, Yemen and Australia, among others, are setting up more than 90 million additional tons per year of LNG capacity between 2009 and 2012. The projects in Qatar are competitive at $ 1.5 per million BTU, a level "only" three times less than the current one. This means nearly 9 trillion cubic feet per day of spare capacity. Um, does not look good.

As from 2013, the overcapacity created by excessive liquefied natural gas is reduced by lack of new projects. Since, according to international agencies, we will probably see a very moderate increase in demand in coming years, the supply of gas will remain ample. As for China, it can cover the vast majority of its gas demand with its own production, with the ability to have five times the current domestic production through its 756 trillion cubic feet of recoverable reserves.

Interestingly, gas E&P stocks have performed in line with their of oil peers, although the oil price has risen by 30% and gas has fallen by 4%, showing the market is already anticipating a return of oil-gas convergence. I do not know on what basis. I just came from a few days with gas producing companies and the expected returns on their investments remain significant. Is that what investors buy? We'll see if the results prove it and if valuations are justified.

A little love for the electric utilities

(published Thursday 22nd in Cotizalia)

What a bad two years of stock market behavior. The "utilities" sector (SX6E Index) is one of the worst performers in 2009 and also did not do well in 2008. Since the process of mergers and acquisitions was completed, the industry suffers the hangover of debt, falling demand, electricity prices stalling and, lest we forget, these European regulators that do so much damage to the investment process.From the UK to Belgium and Finland we read news of interventionism and regulatory decisions that make impossible the proper management of a business that has become more cyclical and capital intensive over the years. Here in the UK, the government has repeatedly threatened with windfall profit taxes. Perception of public service, it is called. But when the sectors of water or gas are drowned out by generating returns below their cost of capital, the only one who comes to the rescue is the market. As proof, three figures: €12bn euros in capital increases, €65bn in debt refinancing and €22bn in forced divestments due to the high debt in European utilities between 2008 and 2009.

In Spain it's similar. It is almost impossible to manage long-term investments with fluctuations in something as essential as is the policy on nuclear power, delays in the collection of the tariff deficit, endless delays in regasification regulation and without a coherent policy and planning capacity. When the government is striving to manage the country's reserve margin without the sector ends up having to give subsidies to coal generation.

But let's look at the positives. For there are a lot. The sector is clearly oversold on technicals. Additionally, two recent reports from Merrill Lynch and Citigroup indicated that it is the most underweight sector in the portfolios of investors. It trades at a PE compared to the market of 0.8, the lowest level since October 2000 and gives an average dividend yield 5.5%. Moreover, debt is being corrected quickly with good divestitures.
In an industry that has seen a drop in earnings per share of only 10% on average during a period of recession, current multiples are not demanding. At a PE of 12x average, the lowest since 2005, investing in this sector is a low risk bet if investors anticipate the return of inflation and improving demand.

The market has done well to play the cyclical sectors anticipating a recovery, but, for example, the percentage of exploration and production (E&P) stocks that are trading at higher prices than those when oil was at $ 140/barrel is almost 100%. I still see value in the cyclical, but I get the feeling that it's time to give a little love to the "utilities".

Careful with German power prices

Looking at the way German power prices have lagged other commodities over the past couple of weeks, German power looks to be heading into the low €50s/MWh… but NOT higher:

• Gas prices have stalled and open cycled plants still meet peak demand needs in Germany; and
• Coal looks solid given ongoing Chinese coal import data and current difficulties in exporting out of South Africa.

However, upside to the mid-€50s/MWh looks too much of a stretch:

• French supply-demand balances are extremely tight but for transitory reasons;
• South African coal export difficulties are related to the current expansion project which is said to be about to commission (some 4 months late).
• Underlying clean dark spreads look high for the oversupplied power market we are currently experiencing.

So targeting a move to just €51-52/MWh makes sense (5-10% upside from 8^th October) but not the 15-20% plus that there might be in some other commodities (from early 8^th October).

Open cycle gas plants represent about one-fifth of the price setting merit order. Given the six month lag in contract prices, there could be about a €3-4/MWh rise in the contracted gas price (given the lag in the contracted price, it is easy to predict the German gas price going to €18-19/MWh in 3 months), which would equate to about €2/MWh onto the baseload power price. The gas purchase agreements that the German buyers have with Gazprom are under intense renegotiations currently (the buyers can’t take the volumes they’re contracted to take, let alone at the price they’re contracted at) which I expect to be resolved by reducing volumes whilst maintaining the oil price linkage.

Surging spot prices in France have helped German 2010 prices, but that may wane. Spot prices (within day) have hit several thousand euros per MWh in France as capacity failed to meet forecast levels this week. The week ahead French price is up 22% over the past ten days. This caused power prices to surge and has lifted the forward curve, so the French 2010 baseload contract is now over €6/MWh above the German equivalent. This level of premium is not unprecedented (especially for this shoulder period as demand builds seasonally and stations are slow to come back online from maintenance outages); however, a more usual level would be €2-3/MWh.

Clean dark spreads look a bit generous given the lack of capacity tightness in Germany. Clean dark spreads of around €20/MWh would be needed to justify new coal stations (if operators could get comfortable with the carbon risk) but no-one is racing to build so likely to see downside to the spread.

German power is in strong contango. This though can be explained by the contango in European coal. This does not make sense over the medium-term: (a) China will lift domestic thermal output so will no longer be a significant buyer on the seaborne markets, and (b) expansion plans in South Africa will mean exports rise by around 30mt annualized, and (c) renewables will take any medium-term load growth from fossil fuels. However, Chinese coal imports for September may not have fallen (last datapoint on third chart to be confirmed) and there’s no evidence that the export terminal problems out of South Africa have been resolved (the final chart shows how annualized exports out of South Africa have fallen, although the expansion project is lifting throughput capacity to 92mt). The combination of China importing at an annualized rate of 70-80mt (of thermal coal) and South Africa falling 20-30mt short of annualized supply, is likely to keep European coal prices high despite excessive inventory levels in the UK and Europe.

Statoilhydro: Worth a punt

What is the only commodity that has not been played as a recovery theme? Gas. I am bullish UK Gas winter 2010 as LNG supply dries off and diverts into Asia, and on coal-to-gas switch (those CCGTs will burn gas to 60% utilization)

Statoil is the master hand managing pipeline gas volumes into the UK. Look at NBP pipeline volumes. Statoil is carefully managing up to 40mcm every day... The ONLY UK gas recovery play that trades at 10xPE (15% discount to peers).

I like Statoil ahead of expected bullish Q3 previews (out in 1 week) and Q3 report (out 4 Nov.) And because it's the only UK gas exposed name that manages the volumes for profit, not cash.

Company specifics set to be great on the parameters that give higher multiples: Q3 production growth (gas) +10%, EPS growth ahead and Reserve Replacement improving for 2009 (to be published in the Q4 report in February).

With gas bottomed down at $4/Mcf and the oil price at $75 and a P/E of 10-11x, the Statoil share should be NOK170-173.

Afren: One to look into weakness

The way I see it the stock has short term downside to 80p on fund flows (some large hedge funds are sellers) and technicals… but enters FTSE 250 January or February, RDS are looking to sell them some really cheap assets, small 40-50mnbbls type assets currently too small for the big guys to work and which benefi from better fiscal terms under a Nigerian entity .. ie netbacks go from 2.50-5 per bbl .. so if you are RDS, why not give the assets to Afren, let them get $5 per barrel and take a royalty of around $2 ..less hassle, no political issues , everyone happy !. Ebok field could add 35p/sh unrisked and I am hearing solid things from RDS people. Obviously Addax must have strong views on it too.Expect 6 well exploration program next year targeting 685 bbls vs 129 bbls 2P today (easy 95p valuation then)

The stock, at 80p, will be at 8xPE and 3.4x EV/EBITDA 2010 at $70/bbl, so looks undemanding once we pass the 2009 cornerstone.

ENI and its alleged break-up value

Over recent weeks,Knight Vinke has suggested that splitting the company into utility gas and traditional oil businesses would unlock significant value.

They value ENI between €27.8 and €32.

My biggest discrepancy with them is a) that the issue is not the Gas & Power business but the E&P, and b) I find it hard to believe that both parts would trade at top-of-subsector multiples if separate.

First in the Snam and Gas & Power business… They take the assumption of Snam trading at a 20% premium to RAB, which is crazy compared to other utility stocks. They also use the rest of the gas & power division at a 30% premium to Enel, Edison, Hera, Acea (which all trade at 5.6-6x EBITDA 1yr fwd). They totally disregard the constant process of de-rating of the Italian utilities in the past six years and the impact on power prices of stalled demand and excessive capacity from gas oversupply.

The refining business is put at Neste multiples, which is OK to me

Chemicals are valued at much higher than anyone can imagine (7.5x EBITDA)

Corporate charges are drastically reduced (probably as part o the assumption that, as separate entities, cost savings and job cuts would happen). This is difficult to believe in Italy, but can be acceptable as a thesis.

Then Knight Vinke value the E&P business at the multiples of a BG, which is too radical given the poor growth, high capex and returns.

In essence they use consensus Sum of the Parts, reduce the traditional Megacap oil discount (21% to 15%) to zero by cutting corporate charges and others, pumping up the valuation of the Italian G&P to multiples of non-Italian (and therefore more attractive) utilities and applying a premium to the Snam RAB that it has never enjoyed in the past (Snam is a mature asset and growth RAB is very limited versus maintenance RAB, something that KV seem to value in the same way).

The key, as some analysts (e.g Nomura) point out is that where Eni trades (a 40% discount to its invested capital) is no different to that of other large-cap oils (BP, RDS, FP and STL). I think the value argument can be applied equally to all these companies, but unlocking it is not about addressing a small part (Gas & Power is only 15% of Eni's invested capital base) but about turning around the core E&P businesses where returns have fallen a staggering 400-500 basis points in four years (while oil prices rose).

That is why, even if separated, it is an illusion to believe that oil investors would see ENI as a high multiple E&P and see it trade at the same multiples as Tullow, Dana, etc... First, because it would still be a State owned entity and its resource base would still be heavily impacted by resource nationalism, low returns and OPEC quotas.

In the meantime, the bet on the stock from here is a full break up not only of the utility assets (which as Scaroni has said, would be regulaywise impossible) but also the disposal (at current market price, no discount) of the Saipem stake.

Short Term Commodity Dynamics

Oil markets have seen several points on the supply side. Nothing major but Russian output edging up to 10mmbpd, while OPEC sailings are expected to remain very low at c22.59 mbpd, leaving them 1.77 mbpd (7.3%) below last year’s level. Oil should continue in its $65-75/bbl range, but I still believe that the break-out from this range will be on the upside as the steady recovery seen outside China lifts distillate demand and as non-OPEC supplies disappoint as the year progresses. These data points will obviously become apparent closer to the 4th quarter, so short term dynamics will likely be driven by inventories, which can continue to build as refinery utilization reaches 83% from current 84.5%.

On gas, two issues are paramount – how much gas the Russians will pipe into Europe just as Europe is supposed to be lined up for rising LNG supplies, and how sharply US domestic gas production will tail off. With Ukraine’s gas transport company taking further steps to shore up its balance sheet and with Russia saying it’ll start to buy Turkmen gas, the signs are that Gazprom is expecting its pipeline deliveries to be substantially boosted from low H1 levels. My analysis remains bearish - new LNG supplies will struggle to be absorbed without pushing prices down, with Q1 2010 prices below $5/mmbtu necessary to clear the market (15-20% down). This week should see the first significant reduction in the official data for monthly US gas production, but nevertheless it is hard to create a bull case in the face of rising LNG supplies destined for the US.