A 2010 Warning Risk for Non-OPEC supply

(Graph above shows Russian Crude Production). From an article I published in Cotizalia on Dec 3rd 2009.

Today we saw Rosneft production figures reach a disappointing 2.119mbpd (only +1.5% y-o-y). This includes Vankor production at 160kpd in October (104kbpd in 3Q).

While Vankor crude output is expected to increase from 3.5MMt this year to 11.5-13.5MMt, production in the rest of the upstream portfolio (including the Priobskoye field) is expected to go down, leaving 2010 output "close to 2009 levels". This is new and somewhat disappointing, taking into account that previously the company had expected crude output from the Priobskoye field to reach peak in 2012. This suggests that output growth at the Priobskoye field has been probably too high in 2005-09 and the field may stabilize lower than 2009 even after pick-up in drilling expected in the next two years. Investors will be concerned that Priobskoye might repeat the Sibneft fate when its fast production growth phase (2001-05) was followed by a steep decline in 2006-08. This is also new.

The market had continued to have a positive view of non-OPEC supply growth 2010-2012 despite the warning signs that we have highlighted for months. We already saw Lukoil back down from their strategic growth targets (from 4-7% production growth to flat), predominantly due to the fact that under the current tax system that eats 90% of revenues, Caspian and West Siberian oil fields are uneconomical. Furthermore, the other Russians are declining steeply: Surgut’s year-to-date production declined 3.2%, Tatneft declined 0.9% and Slavneft 3.7%.

Consensus on non-OPEC supply for 2009 versus 2008 calls for a 400,000 bpd increase, and the subsequent reduction of the call on OPEC, predicated on Russia growing to a level that offsets Norway-North Sea and Mexico declines.

I believe my bearish view on non-OPEC supply needs to be even more bearish for 2010, probably by 200kbpd given the capex, high tax and credit environment hitting Russia, Mexico and Norway.

So far YTD:

Norwegian volumes are at 2.24mbpd (below consensus estimates of 2.3-2.4mbpd)

Mexico volumes are at 2.65mbpd versus consensus at 2.96mbpd

Russian volumes are close to 10mbpd versus consensus at 10.3 mmbpd.

Total oil production by countries outside of OPEC averaged 50.1 million bbl/d during the first 3 quarters of 2009.

Over 1.2 Billion Chinese can’t be wrong

(Published in Cotizalia in Spanish on Nov 26th 2009). Chart shows monthly car sales in USA vs China.

"Data from China is not credible." This phrase and similar ones have led many funds, especially traditional ones, to miss part of the rally in stocks and commodities, to give just one example. It seems to me that in 2009 many suffered from a bit of excess of caution and a lot of looking at the growth data in the wrong places (USA, Europe). And it’s already more than a year since the launch of China's economic stimulus program and the data continue to surprise on the rise.

In 2010, China's GDP will grow c9%. But more importantly, it is likely to do so with very moderate inflation, around 2.5%, thanks to the fact that OECD countries will continue to be in a difficult economic environment and therefore, prices of products imported by China will probably not increase dramatically, as has happened with oil, coal and gas between 2008 and 2009.

Remember that China imports 3.6 million barrels per day of oil, and growing. Well, that consumption is only 2 barrels a year per capita, c4% of global demand. Meanwhile the U.S. remains about 24 barrels a year per capita, 24% of the total, but falling. This scenario, moderate rise in prices of imported commodities as high domestic growth is financed, is ideal for China to deliver long term economic growth and credit expansion without causing major inflationary moves, and that will likely generate the next local stock market rally. Do you remember Europe in 1950? The same.

Investments in fixed assets in the country will continue growing by c30% in 2010. Over 300 projects implemented on a large scale in 2009 lead me to think that we will see an increase in infrastructure investment over several years. This investment will force Chinese authorities to keep the current loose monetary policy at least for the medium term. Thus, according to several analysts, the figure of bank loans will double in three years. And this expansion of credit obviously generates a massive increase in consumption and spending power of families. The increase in disposable income is what is leading car sales to exceed U.S. figures, and we will see the same for other assets.

The important thing to remember is that the figures for 2009 are the result of a recovery from a downward cycle, and do not include the results of credit expansion and domestic demand, so China will be able to harness the greatest growth in its history without depending so much on exports and with relatively moderate inflation.
And what keeps me comfortably optimistic about Chinese stocks and those companies exposed to the growth of the country is this period of expansion, which coincides with the decline of the OECD, which makes it impossible for Western Central Banks to raise rates in a relevant way, and which will likely make investors increase exposure to risk assets. Alternatively we might lose the other 50% rally worrying about data from mature economies in decline.

Dragon Oil... A cool 11.5% return to December

Dragon Oil and its takeover bid (rejected by big shareholders) is set to deliver a minimum 11.5% return.

The critical step is the Court Meeting and EGM of Dragon shareholders which are scheduled for 10.00 and 10.15 on December 11th respectively, at the Grosvenor House Hotel in London.

ENOC needs to achieve 75% of the minority votes by weighting and 50% of the number of votes cast. While the decision to hold the meeting in London rather than in Ireland may appear to place an obstacle in the way of smaller Irish retail investors, voting may be done by proxy up to 48 hours before the Court Meeting. I believe that the vote will be tight, as already indicated by the statements of rejection issued by some of the major shareholders, and the failure of ENOC to respond by even a small increase in the bid strongly confirms that the 455p reflects what ENOC can afford to pay, not what the assets are worth.

The statement repeats that ENOC has undertaken not to sell its shares in Dragon until at least August 2009. If the offer lapses, ENOC could sell its stake at a higher price. So 11.5% is a minimum to make,

China, Exxon and the war for resources

Graph above shows the valuation of independent E&Ps (EV/Core NAV) compared to Brent.

(Published in Cotizalia on November 19th 2009)

What an incredible week. Warren Buffett buys $60 million in Exxon shares, the independent E&P stocks (Dana, Dragon) rose to near-all-year highs on takeover speculation and we witness the evidence of what PetroChina said recently: the war for natural resources has only just begun. And the EU is losing.

While large European oil companies still fail to know what they will do to keep their businesses afloat if prices fall $1 or $2/bbl, the world is experiencing a revolution. So far in 2009, China has invested $16.5 billion to acquire oil assets. And what some disdained as excessive valuations has proven very reasonable, as PetroChina, Sinopec and CNOOC have demonstrated an exquisite discipline buying, but also by refusing opportunities.

Following are the Top-10 acquisitions by Chinese companies in the oil and gas sector so far in 2009. (Billions of US dollars)

RANK VALUE ACQUIRER TARGET

1. 7.15 Sinopec Addax Petroleum Corp

2. 3.30 China National PC OAO MangistauMunaiGaz

3. 1.73 PetroChina Athabasca Oil Sands

4. 1.30 CNOOC, Sinopec Block 32 Offshore, Angola

5. 0.93 China Investment C KazMunaiGas Expl & Prodn

6. 0.87 Sinochem Resources Emerald Energy PLC

7. 0.41 Petrochina South Oil E&D Co Ltd

8. 0.31 CNOOC Talisman Energy Inc (gas)

9. 0.27 Xinjiang New Energy

10. 0.13 XinAo Gas Holdings Various oil reserves

You see, Europe's efforts to invest in alternative energy and the electric car are very laudable and very necessary, but also very expensive, and even in the best case we should not lose sight of the importance of increasing access to natural resources . Especially when the International Energy Agency estimated that the use of electric vehicles in 2050 will not reach 35% of the worldwide fleet.

For me the problem is that the major oil companies are losing the best chance they ever had to buy relatively cheap assets and businesses in the OECD (see graph). For years we heard from Big Oil that E&P companies were too expensive, that they should wait for lower valuations to acquire assets. But that moment came in 2009, with the big oil companies full of cash and independents trading at historical lows ... and they missed it.

However, China is demonstrating belief in the value of increasing its resources. But Exxon is now armed and ready. It has already placed a bid, rumoured at $ 4 billion for the assets of Kosmos in the Jubilee field in Ghana and continues to pursue attractive assets. As Rex Tillerson said, the company does not pursue crazy acquisitions, does not invest in political occurrences or areas that do not generate superior returns. And history shows it in their focus on the core business, a return on capital employed of 35%, share buyback of "only" $ 55 billion between 2008 and 2009 ($ 2 billion this fourth quarter!) And no debt, $2.9 billion net cash.

As Warren Buffett, Exxon knows that investing in cyclical assets with high debt clouds the ability to create long term value. And that's what Warren Buffett has bought: a dirt-cheap stock, as he pays the total resources (72 billion barrels) at $4/bbl and pays zero for the chemical and refining businesses … but especially with the option to grow and buy without destroying the balance sheet.

In 2010 the figure of mergers and acquisitions, according to several companies and analysts, will reach $35 billion and may exceed $50 billion. Between PetroChina and Exxon they already have more reserves than all European listed companies together. The large integrated oil companies from France’s Total to Russia’s Rosneft, are unable to replace their reserves. 80% of global proven reserves are held by the producing countries. The little, very little that is left available, the independent companies with high exploration potential, will gradually fall inexorably. Those companies that lose this opportunity should not complain afterwards.

Happy Birthday, Oil

(published on August 28)
The modern oil industry began as a result of the search for inexpensive lighting. Until 1859, most people obtained artificial light by burning animal fats in the form of beeswax candles or whale oil.
In order to take advantage of the high prices of illumination, a group of investors hired a railroad conductor named Edwin Drake to head to a location close to where traces of crude oil had been observed on the surface. After a nervous few weeks in rural Pennsylvania, Drake struck oil on August 27, 1859. The 69 foot deep well on a salt dome rock formation yielded around 15 barrels a day.
The petroleum that flowed from this well in what became known as Oil Creek, near Titusville, Pennsylvania, started the modern oil industry we know today (oil had been produced in other parts of the world, but the Titusville well kicked off industry on a large scale).
The new industry was gradually consolidated and monopolized by the Standard Oil Company. In 1911, Standard Oil was split by anti-monopoly legislation into several competing firms. Esso (“S. O.” for Standard Oil), which later became Exxon and then ExxonMobil, remains the most well known of the Standard Oil children and the largest company in the S&P 500.
A few statistics:
Global oil production reached its highest figure in 2006.
Two companies, Exxon and Petrochina, control more oil and gas reserves than the entire rest of the quoted oil and utility companies.
OPEC and Russia control 77% of global oil reserves (including oil sands).
In 1991 global years of demand covered by proven reserves was 15 years. In 2009 it is roughly 12.
In 2009, c$198 billion will be invested in E&P to produce c81,820kbpd (oil). The highest figure (inflation adjusted) ever spent.
In 2008 global proven reserves fell 0.2% despite the addition of Tupi to proven status. Global reserve replacement ratio has been below 100% since 2004.
Global oil discoveries have declined steadily since the early 1960s despite periods of high prices and advances in exploration and production technology. The deficit has grown such that around the world we are now consuming roughly three times the amount of oil we are discovering each year.
The discovery deficit is now so large that the IEA estimates an equivalent of six additional Saudi Arabias need to be found and developed, requiring cumulative investments of US$26 trillion, to meet its expected 2030 global oil demand.

Before we start worrying about US Oil demand again... Non-OECD is the key

DOE data trading is starting to be both irrelevant and more importantly, dangerous. We are seeing oil price swings on a weekly basis worried about US demand. That should not be the focus. US demand peaked, according to Rex Tillerson in 2005 and OECD demand in 2006. This is also very logical given that oil production from OECD countries has been declining since 1997 and is now way below 23% of the world production. Therefore, it is normal that OECD demand tops out and declines as we see the effects of efficiency, maturity, saturation of the credit bubble model and Obama's beloved electric car (the one we will all be forced to buy at $60k a piece).

Meanwhile, Non-OECD consumption grew from 40% of the world demand in 2004 to 45% in 2009. No wonder we are seeing reduced exports to the US.

How low can the OECD consumption go? At the moment, demand for the OECD excluding the US is around 12 barrels per capita per year (US is 25 barrels per capita per year). The IEA is predicting by 2015 a further consumption decrease toward 10 barrels/capita/year for the OECD excluding the US and toward 20 b/c/year for the US.

The key thing is that (unlike what we believe in US-EU financial markets), non-OECD countries are much less price sensitive than OECD ones, as their growth requirements and modernisation are much more "essential" and energy intensive, so the swings to price from demand drops depends on OECD. Therefore, oil prices will have to be high but not too high to keep the demand growth steady. Right now everyone, including the figures I saw recently, assume an impact of $20 per 1 mbpd of excess demand (and similar on the way down), from a "sustainable" $65/bbl break-even.

The elephant in the room: Producing countries demand growth. Many expect something close to an "export extinction" with a decline in exports (below the 2006 level) of between -33-46% by 2011.

The second elephant in the room: Energy intensity of "infrastructure plans to move away from evil foreign oil". According to Chevron, the stimulus packages and infrastructure plans are adding 2mmbpd of oil demand while supplyis slipping 5%. Hard to argue when, in Spain, the example of renewable overbuild, with demand down 7% and renewables blowing out all technologies, oil imports have not fallen significantly (1.2mmbpd).

The third elephant in the room: Oil investments peaked in 2008. All energy agencies estimate that capex required to maintain production is slipping. Below $220bn a year, decline (currently at 5%) accelerates.

The fourth elephant in the room: non-OPEC growth is overestimated. See today Lukoil. Interfax reports Lukoil’s strategic development plan for 2010-2019 with a drastic slash on previous 10-year growth targets (only 0.3% average growth versus previous of 2.2%). Wait for Rosneft to do the same.

Bye bye Yen?

Just a thought, only marginally out of the energy sector, but given the surprise change of government in Japan, and what appears to be a growing sense in the market that this government is more focused, finally, on fiscal restraint (or least this threat of massive debt overhang to deal with) and less concerned about maintaining the weak-policy on JPY and even stating their ability to intermediate has declined, it looks like the JPY is keeping its bid. The market—big vocal guys like Jim O’Neil at GS for example—have been pounding the table that the JPY would decline back to 120 eventually on failing demographics and a larger global recovery, and it's on its way, but slower. Maybe it’s because the US has usurped Japan as the ultimate source of funding and itself is now in a fiscal death spiral; maybe it’s these demographics and the start of deleveraging a bit, I’m not sure, it’s complicated. But whatever the root cause(s), the implication of a stronger than expected JPY (particularly against the $) absolutely HAS to be a weaker domestic industrial and manufacturing economy in Japan. Until China de-pegs, Japan’s opportunities for exports (at least market share risk) seem to be declining; in fact, what we are seeing are Japanese companies setting up shop in China (or elsewhere) instead, similar to the US. Therefore, the Japanese ‘equity market’ might be able to do ok, particularly if this increased JPY leads to a bit of insulation on domestic consumption, but the Japanese economy could be fairly troubled. Utilities would be in the cross hairs of declining consumption.

The key to figure out is: is this a currency issue primarily, or is it something else structural? We know that Japanese energy companies are short Yen in revenues and long Yen in expenses, eg, their costs fall when the JPY is strong, but now perhaps the JPY relative strength is enough to have structurally interrupted volumes and we know what slack does to prices on top of that!...

Weekly commodity outlook

Oil continues to drive the commodity complex. Why is oil more buoyant than other commodities? Probably more to do with funds flows and consistently positive macro-economic datapoints (up to the end of week US unemployment data) rather than any specifics relating to the oil market. Could this change near-term: we think not. Next week will see the three main forecasting agencies publish monthly updates; their demand estimates have started to move up (and look to have further to go) but more importantly supply estimates still look too optimistic.

Why is gas not following oil? In the US, the weight of evidence that is pointing to improved productivity means that the US will be self-sufficient even allowing for a reasonable demand recovery in 2010. Outside the US, gas’ recent weakness relates more to higher Qatari and Nigerian LNG exports (maybe 1.5bcf/d), but this is still small in relation to the issue of Gazprom releasing the gas buyers from pipeline deliveries (potentially 6bcf/d). So need to watch those Gazprom negotiations, but we’d stay positive on gas outside the US.

Why is coal no longer following oil? Much of the positive demand trends (eg South Korea) and supply restrictions (Australia and Colombia) remain. However, for once there was a big pick-up in South African exports. Newsflow is scant but we suspect that this could signal the expanded port capacity is becoming operational; which if confirmed could see coal prices give up their sharp contango.

In short, retain a bull view on energy, but recognize that this is becoming confined to oil and gas outside the US. And the risk of higher coal supply out of South Africa, if confirmed, could push us to a bearish stance on thermal coal.

ECONOMIC BACKDROP:

Bull news:

. Chinese October PMI rises to 55.2 v 54.3 prior, and the State Council Research Centre predicts 9.5% Q4 GDP growth

. US October ISM rises to 55.7 v 52.9 prior, while Sept factory orders up 0.9% mom versus -0.8% in August.

. UK Sept Industrial Production up 1.2% mom.

Bear news:

. US October unemployment rate hits 10.2% against an expectation of a rise to 9.9% from September’s 9.8%.

OIL OUTLOOK: POSITIVE

Bull news:

. Chinese apparent crude oil demand lifted to 3.3% in H1 after declining 1% in H1. Car sales up 76% YoY.

. Yemeni based terrorist activity aimed at Saudi Arabia is increasing, although yet to get much media attention.

Bear news:

. OPEC October output rises, although concentrated in Nigeria. Shell indictes it still has 0.8mbpd shut-in in Nigeria (the lull in rebel activity is unlikely to be permanent but should last beyond the turn of the year).

. Russian oil output tops 10mbpd in October.

GAS OUTLOOK: NEUTRAL

Bulls on US gas are receding rapidly with the weight of evidence about the resilience of US domestic gas production. Bearish gas pricing could spread outside the US but only if Gazprom forces its pipeline gas into Europe, as then surplus LNG would push UK pricing closer to Henry Hub. Gazprom will allow gas buyers to lift less than contract commitments.

US depressed by domestic supply, Europe heading for balance thanks to Gazprom

Bull news:

. Russian Sakhalin LNG is taking one of its two trains down till the year end, taking 0.6bcf/d.

. Ukraine negotiating a postponement in its payment for October gas (from 7th November to 20th November) doesn’t bode well for Gazprom’s ability to push its volumes into Europe, although October itself saw European exports up 3.1bcf/d (19%) mom.

Bear news:

. US official August gas production data showed a 0.5bcf/d increase mom even though this is more than six months after the gas rig rate was in freefall (it declined by over one-third from its September 2008 peak by the end of February 2009). Moreover, Chesapeake’s Q3 beat estimates in part thanks to lower costs.

. Qataris reveal that all three of its new megatrains are at full capacity (totaling 3.2bcfpd and adding 1.5-2.0bcf/d over expectations).

COAL OUTLOOK: Neutral

Bull news:

. Monthly Australian thermal coal exports drop to 10.7mt in September, the lowest since April, as met coal crowds out limited export routes. Exports through Newcastle port though have moved up to 102mt annualised but the assumption must be that this growth continues to be driven by met coal.

. Data from Colombia confirms exports down 4.2mt ytd despite commissioning of new mines.

. South Korean generators take 6.6mt of coal in September, up 19% yoy.

Bear news:

. South African exports jump to 81mt annualized rate in October. Over the summer exports have been way below expectations since the port’s expansion from 72mt annual capacity to 92mt annual capacity was supposed to have been ready in July. This may signal the expanded facilities are now operational.

. Indian inventories continue to build while buyers said to be out of market for 2009 deliveries..

What do you buy into market weakness? Big Oil... Big Cash

The market has been using Big Oil and utilities (specially large caps) as sources of funds for their beta trades, especially financials and miners. I hear that short interest in BP is 12% of free float, for example.

As the mood in the market turns bearish and the concerns on balance sheets return to a market that forgot what net debt was, the focus, like in the past November, turns to real cash monsters.

If we add to this that most of the market went short Big Oil after the 3Q results showed that growth was not appearing, and especially after lacklustre earnings from RDS and Total, we have a perfect storm. Last November, with oil going from $70 to $50 and the market disappearing downhill Big Oil outperformed the market by 12% into December.

Big Oil trades at 10x PE, 0.6x to the broad market (almost 15% from historical levels), generated 15% free cash flow yield last quarter (!!), delivers dividend yields that range from 6 to 7% and more importantly, has virtually no debt (Statoil 26% ND/Equity, BP 23%).

Into Megacap utilities, these have underperformed but now, ahead of 3Q in E.On and GSZ, the focus will turn back to free cash flow generation and balance sheet. Here the issue is that Enel, Iberdrola are massively debt constrained so the market opportunity is not as wide as in Big Oil (as utilities balance sheets are quite different, unlike in supermajors), so we are likely to see a move to real defensives, ie regulateds and megacaps.

The chart shows what BP did against the FTSE from Sept 08 to Dec 08 with oil falling and the market down.