Competition for control of the oil market

Rajinder Dhesi

OPEC’s policy of lowering output to use up excess oil inventories has resulted in a small revival of crude future prices. Brent crude is trading at approximately $64 a barrel, up from $45 a barrel in the summer. Talks were held this week between OPEC and Russia to continue production cuts of 1.8m barrels per day for a further nine months in an aim to raise oil prices further. Before the talks, Wall Street analysts suggested the tense relationship between the oil cartel, who account for 40% of world production, and Russia, the world’s single largest oil producing state, could result in a stalemate. Concurrently, there has been enormous recent growth of the US shale sector, which by 2025 is predicted to match the record Saudi Arabian growth at the height of their oil expansion. The outcome of this is uncertainty in the direction of oil prices in both the short and long term, with analysts seemingly unable to agree on estimates in this volatile market.

OPEC member states, with a few small exceptions, have been lowering output for the last 18 months. Net production is down 669,000 bpd. Spearheading this move is Saudi Arabia, who have cut production by 541,000 bpd alone. Without Russian support these measures would only be punitive, offering no real effect. OPEC requires a commitment from Russia to back an extension of cuts throughout 2018. From a Russian perspective, an end to cuts would be welcomed, given the close link between the Kremlin, Gazprom (who are majority owned by the Russian government) and large private firms such as Lukoil who recorded a profit 78% higher in the last quarter compared to the previous year. These firms it seems would like to continue an expansion of production, reaffirming their dominance in the sector. Complicating the situation further, is the Ruble’s floating exchange rate that fluctuates with oil price. Currently, the low value of the Ruble is benefitting Russian exports in the minerals and agriculture industries. As a result, OPEC and Russia will have to agree on compromises at the upcoming negotiations which are likely to result in the market remaining bearish.

Another possible outcome of negotiations which succeed in raising oil value is a negative rebound as US shale firms are incentivised to continue their dramatic rise in extraction. The USA is currently producing 9.48 million bpd of crude oil, the fourth highest monthly average since the early 1970s. If the rebound was to occur, analysts suggest that Brent Crude prices could fall as low as $45 in 2018. This reflects shale oil’s increased influence over prices in years to come. However, in-house reports by OPEC, which may have to be considered with a degree of scepticism, estimate that peak shale oil will occur as early as 2025, because producers are already focusing on drilling their best fields, where oil and gas can be extracted at the lowest cost. After this, shale will become harder to extract and consequently less profitable. After 2025, OPEC according to their own predictions, are likely to increase in market share again until at least 2040.

To conclude, there are a number of competing factors and parties involved in determining the price of crude oil. It appears that control of the oil market and the accompanied benefit of being able to dictate oil prices is what each actor would like, though recent trends suggest that is unlikely to happen. Furthermore, the nature of developments in crude oil technology and production is unknown; very few would have predicted the shale oil boom ten years ago.

Fracking & the UK: A question of security?

Nicholas Ogilvie

It was the last Parliament day before Christmas, but there was plenty stirring. Fracking was back on the agenda. New legislation was passed permitting the fracking of National Parks and other sites of special interest. This is provided that drilling takes place at more than 1,200m below the surface, with the wellhead outside the National Park. The Oil & Gas Authority granted 14 companies permission to explore in 124 new areas last week. Andrea Leadsom, the UK’s Energy Minister, is on a mission to get the fracking industry in the UK underway. The new legislation solely permits exploratory work; local councils must be sought for planning permission to build drill rigs.

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Fracking, or hydraulic fracturing, is the process of pumping high pressure fracking fluid, predominately water, sand and chemicals, into a rock structure in order to fracture the rock. The sand, or proppant, is used in order to keep the fractures open to allow the gas to flow out of the rock. Much of the environmental concerns surrounding fracking relate to the chemicals used in the fracturing process and their potential to pollute drinking-water aquifers. Hydrochloric acid is a commonly used to dissolve limestone rocks. Emulsifiers, like 2-butoxyethanol, are often used to lower the surface tension of the high pressure fracking fluid. Other concerns surround the large volume of water required in the fracking process and the miniature earthquakes, or tremors, occurring from the fracturing the rocks.

Hydraulic fracturing is used in 9 out of 10 wells in the US. Despite documentaries and protests regarding the detrimental effects of fracking, from both a social and environmental standpoint, the US has reaped the economic benefits. Between 2007 and 2013, gas bills dropped $13 billion per year, equating to a drop of roughly $200 per household as a result of increased fracking activity. The industry generated 725,000 jobs during its boom between 2005 and 2012.

Looking back towards the UK, the statistics of the US’s shale revolution make fracking a very appealing exploit to pursue. The British Geological Society estimates that the North of England holds 1,300 trillion cubic feet of shale gas. Cuadrilla Resources, who have faced plenty of protest since their deployment in the UK, announced that they were sat upon 200 trillion cubic feet of gas in the Bowland shale of Lancashire.

The argument for shale’s development revolves around five key points. These are: improved local employment rates, increased local per capita GDP, increased local house prices, increased government revenue and a decrease in nationwide natural gas prices resulting in lower bills for consumers.

Specifically, for the UK, the question of energy security is an important one. The UK imports 477GWh of natural gas, around 62% of the total supply, with 57% coming via pipeline from Norway, the rest via LNG vessels from Qatar and pipeline from the Netherlands. Over half of this supplied gas is used in the production of electricity in gas fired power stations. The UK has announced plans to close all coal-fired power plants by 2025. They are to be replaced by natural-gas and nuclear plants. These changes come as increased scrutiny is placed on heavily polluting coal plants. Burnt natural gas produces half the amount of CO2 when compared to coal. But Norway’s natural gas production is shrinking. Some estimates see the Norwegian delivery potential to decline by 40-50% by 2025. So how will the UK keep the lights on?

Fracking seems to be the obvious answer. However, there are plenty who oppose the idea and plenty of uncertainties within the industry itself. There is much scrutiny over the estimates of potential reserves scattered across the UK. Regulators of the industry have also been exceptionally fierce. Exploration may have been permitted, but extraction will require even more hoops to be jumped through. Environmental permits look to be the toughest obstacle. It is important to remember that no fracking has taken place in the UK since 2011. This was after Cuadrilla’s operations near Blackpool caused tremors throughout the area. The resulting public outcry sent the industry back to the drawing board. But now that the government’s energy fears for the future are mounting, it looks as if fracking companies might be about to get the full go-ahead. Their biggest obstacle will most likely be public uproar, but that hasn’t stopped the government before.

Shale’s future: Existing but bleak

Nicholas Ogilvie

As OPEC announces that it is to forgo an output reduction, the oil market looked out towards a bleak future with persistant low oil prices on the menu. On Friday 4th December, OPEC announced that it would not be changing its stance on output and, put simply by OPEC President Emmanuel Ibe Kachikwu, also Nigeria’s oil minister, “watching to see for future market fluctuations”. OPEC has shale-oil in a chokehold and it is not going anywhere.

For the US shale-oil pioneers, visions of $100 dollar barrels of oils are now most definitely a thing of `the past. Futures trading seems to indicate July 2017 as the date for when oil will surpass $50 dollars per barrel again. This spells serious trouble for operations in the shale industry that have been propped up with huge investments based upon much higher priced oil. Shale-oil’s bust period has been extended again and its chance of redemption does not look promising.

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Shares across the major players in the US, including Marathon Oil, Hess Corp, Occidental Petroleum Corp all dropped by 1-2%. These drops were all dwarfed by North Dakota’s smaller oil players including Whiting Petroleum Corp, Continental Resources Inc and Oasis Petroleum Inc all whom saw their share prices drop by over 5%.

The process of hydraulic fracturing is very complex and expensive. Technological advancments led to the rapid expansion of the industry across the US as far more complex rock structures could be drilled and have their oil and gas extracted. The costly process was feasible when the price of oil was over $100 a barrel and still, to an extent, as it passed below $75, now not so much. With capital expenditure shrinking, spending on exploration and research – the factor that kick-started the shale revolution – is dramatically falling. For many, reducing capital expenditure in order to focus on their profitable wells, of which few companies are lucky enough to still be in possesion, is the best plan to see out this period of low oil prices.

This is evident from the dramatic reduction of the rig count in the US. The US rig count is currently at 545, having fallen for 28 straight weeks until the end of June this year. Capital expenditure has dropped, jobs are being lost and oil rigs are being taken offline. Let shale’s hibernation period begin, well, not just yet.

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The resilience of the shale industry has been exceptional. OPEC’s relentless production has put both parties under immense strain and yet, US output still stands at 4.9 million barrels per day. The global appetite for oil is still rising and, although there is still an exceptional surplus, countries such as China and India, along with other emerging economies will still require significant quantities of oil.

OPEC’s member nations are putting a serious strain on their financial positions through their orchestrated surplus in order to cave-in US shale operations. Only time will tell whose finances stand the ultimate test.

Uh-OPEC: Iran’s return, “Is now a bad time?”

Nicholas Ogilvie

OPEC stated this week that surplus inventories of crude oil are at their highest in ten years. The IEA announced that a record of 3 billion barrels filled inventories across the globe. Yet despite the record glut, 2015 has still had a very strong oil demand growth, which is expected to stay high in 2016. Lower oil prices are benefitting consumers, developing countries and petrochemical companies, who have seen huge surges in profits, one of the key reasons why many integrated oil companies have faired reasonably well since the price plunge.

On the supply side, the Saudi’s flooding of oil in an attempt to regain market share from the continuing output of the US shale oil efforts is beginning to falter. Even though US production has dropped by 500,000 barrels-per-day (bpd) since the middle of the year, for the past 3 weeks that production rate has been rising. So does OPEC have any other tricks up its sleeve for regaining market share?

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Well, it’s a little bit more complicated than that. To start with, the question is not being addressed to the correct entity. OPEC has been diminishing in power ever since Saudi Arabia, the ring-leader of OPEC, began its plan to regain market share, predominately from the US, with its supply glut. OPEC was setup as a method of ensuring market stability and maintaining fair oil prices. With West Texas Intermediate trading at $40.74, as of 13th November, some would say that this goal was not being adhered to. OPEC has effectively been dissolved. So what’s next for Saudi Arabia?

The Saudi Arabian budget is bolstered by its oil revenues accounting for roughly 90%, any further reduction in price could have a disastrous impact on the stability of the nation. Even with the largest conventional oil field, Saudi Arabia is constrained in its response to plunging oil prices. One of the main reasons for this is the lifting of sanctions on Iran which is expected to occur early 2016 after inspections of its nuclear facilities. As one of the earliest oil powers, Iran has announced that its post sanction oil production levels will rise immediately to 500,00bpd, which, much to the Saudi’s irritation, roughly equates to the reduction in oil that the US shale industry has experienced. It expects to be operating at pre-sanction level outputs of roughly 3.4mbpd within 12 months – enough to cover for the global reduction due to the price collapse caused by the Saudi glut.

So where does this leave oil prices? Economists believe that the oil market is currently operating under the supply-demand principle. Indicators suggest an increase in supply, predominately coming from Iran, the maintained resilience of US shale output and from new gas and, potentially, oil discoveries off the coast of Egypt by ENI. It is important not to forget Libya, where any form of settlement could see further increases on the supply side. Unfortunately for the increased supply, the demand side doesn’t look quite as promising. The recent economic slowdown in China and the potential for a developing economy bust make the prospect of increased oil prices look bleak. Saudi Arabia and the remnants of OPEC meet in Vienna on the 4th December, expect hostility.

BASF: An Update

Zach Chadwick

BASF is a German chemicals company; the largest in the world based on sales volume. As a company, few analysts would disagree that BASF has performed impressively over the last 5 years. Since 2006 it has seen a surge in its capex, accompanied by a rise in share price. And its recovery post 2008 was exceedingly strong, demonstrating the robust core of the company.

BASF has historically been a cheap option in chemicals due to the conglomerate discount that the market applies to it. Conversely, the hugely diverse range of chemicals businesses that it runs, means that it is somewhat protected if one of them underperforms. Taken from Lincoln Jim’s note for DUIFG on BASF 2014: ‘BASF’s sales revenues is split amongst its five business segments: Chemicals (23%), Performance Products (21%), Functional Materials and Solutions (23%), Agricultural Solutions (7%) and Oil & Gas (21%)’. Its status as a ‘reliable giant’ is exemplified by its outperformance of the Stoxx 600 index by 5% YTD and 7% over the past 12 months. Despite its impressive track record as a consistently reliable investment, it is beginning to show some chinks in its armour. BASF’s historic corporate performance has bought about an air of exuberance arguably unjustified given the companies more recent performance.

Alongside the reporting of third quarter results, BASF issued a profit warning stating that expected future profits will come in below previous forecast. They had hoped profits would stand in the region of 14 billion euros EBIT which it now expects to be between 10 and 12 billion euros; a significant downgrade. They cited slack demand in Europe, backlashes from sanctions against Russia and the slowing growth in Asia (discussed below). With this has come some criticism of the senior management. During their surging recovery, post 2008, management were extremely proactive, acquiring big names such as Ciba and Cognis, to stimulate growth. These amounted to around $9[i] billion. However, Bock only made one significant takeover of the seed-treatment supplier Becker Underwood in 2012, for $1 billion. This lack of eagerness to spend the big bucks has been questioned by several analysts and may correlate to a decrease in growth and share price.

BASF’s inability to exploit areas with significantly lower raw material costs has been a major downfall; its competitors Dow and Dupont were more astute. Dow for example, invested $4 billion in shale gas in the US back in 2011, whereas BASF is only just getting in on the scene. It was announced in May of this year that they are considering spending $1.4 billion dollars on targeting cheaper shale gas in the US. Bock said in an interview with Bloomberg that he expects the US to become the ‘earnings powerhouse’ but their failure to deliver must be viewed as concerning. Even though BASF operates in an industry where developments often take many years to bear fruit (Dow’s investments aiming to be fully functional by 2017) this does not represent the sort of pioneering conviction you would expect. This is especially prevalent when we consider this is BASF serving as a market leader in the region that they expect to be their spearhead.

The company is also hindered geographically by its dependence on the European market, which accounts for around 56% of its revenue. Europe is still predicted to slowly progress in recovery, but it is not doing so at anywhere near the rate BASF would like. With Germany on the brink of recession and the continual murmur of Eurozone deflation, things do not bode well for a company so reliant upon Europe. One line of business which has been particularly impacted is BASF’s agricultural unit. The effects of lack of demand has been exemplified by the movement of crop growth to cheaper economies. This has tightened up profit margins and stunted growth.

BASF’s CEO, Kurt Bock, has said that over the next five years they will reduce the portions of their investments allocated to Germany from a third to about a quarter, due to energy prices. The question is; where are they going to shift their investments to? BASF has pumped capital into an Asian market which has already been seen to be flailing due to oversupply, and offers structurally lower returns as a result. It was late to the party in North America – whether this is salvageable remains to be seen. BASF must find the next big opportunity early and cash in if it’s going to remain at the top of the chemicals industry.

Oil prices: possible implications for consumer spending

Peter Elkin

The question often raised in recent months is how will the combination of massively reduced oil prices and stagnant inflation effect consumer spending patterns? Chancellor George Osborne took to twitter in early January stating; the ‘Oil price was $53 pbl last night – lowest in 5yrs, vital this is passed on to families at petrol pumps, through utility bills and air fares’. Mark Carney aired similar sentiments to MP’s stating that the drop in oil prices is putting more disposable income into people’s pockets. Gas companies have hwever been under criticism for the small reductions they have made to their prices and the delay of price reductions until after the winter season.

Different reports from the BBC, the Independent and the Telegraph report that the average household will see a benefit of between £35-£100 a year. Furthermore, both diesel and premium unleaded petrol have fallen by over a fifth in recent months and this will provide consumers with bigger and more regular savings as they fill their cars either weekly or bi-weekly. Routine drivers can spend anything between £1000 – £5000 on fuel every year so there is the potential for a £200- £1000 yearly saving. When this is added to the reduction in utility bills the saving only further increases.

The focus of this article is how will these circumstances affect consumer spending; more specifically which consumers groups will benefit most from the reduction in oil price and which companies will these consumers choose to spend their increased disposable incomes on. One preliminary point to note is that the additional funds will not come in a lump sum and consumers will save money every week on their petrol costs. Therefore, they are less likely to put the money into savings as it will not always be evident a saving has been made. The likelihood is that consumers will find a little more money in their wallets or accounts at the end of the week and not view it as a massive reduction in a life cost.

There are two main groups of people who will benefit in greater proportion: those who own cars and houses that use more gas/petrol, and those who have jobs where driving is a necessity or particularly regular occurrence. The first group are logically those with bigger cars and homes and therefore more likely to have higher incomes. The second group will be those who drive a lot and pay for their own petrol such as tradesman, taxi drivers, low paid entertainers and travelling salesman. These consumers are more likely to have lower incomes. Another couple of distinctions must be made between the two groups; the second are more likely to be paid with cash and are less likely to funnel all their transactions (wages and spending) through a bank account. They are also more likely to be male. This may effect their spending, as will be considered below.

Now the question is where will the consumers put this extra cash?

Group one. Here we have those with higher incomes. It is harder to ascertain and stereotype what types of jobs these people will have, but inferences can be made that their tastes are perhaps more “middle class” in nature and that they are less likely to overview their finances on a weekly basis. This opens up the potential that they will be ignorant of the savings and find themselves with more cash in the bank at the end of the month, to spend on more expensive one off products. Given that people with higher incomes are more likely to be older, buying new clothes from retailers they trust is a reasonable deduction in how they may spend the money. Companies like Next, Ted Baker and French Connection could benefit from increasing sales as well as lower delivery costs. Furthermore, technological companies such as Apple and even Vodafone could see sales increases with consumers deciding to treat themselves with impulse purchases.

Group two. Here we have a male, lower income demographic, who deal more frequently in cash. Bookies for example, may stand to benefit from said demographics extra fund. The extra £20 at the end of the week is not going to allow them to buy anything extravagant but gambling with the money gives them a chance to change this fact. This is further supported by the fact that the saving on petrol is seen as free money as they have done nothing to earn their reduced petrol bill. The gambling companies listed on the London Stock Exchange include 32 red, 888, Betfair, Ladbrokes and Paddy Power. The latter two could be benefit especially given their recent advertisement campaigns targeting relatively young single men.

Admittedly this article has made many assumptions and logical jumps but its intentions were to provide some interesting thoughts on which specific companies may benefit from the oil price drop, rather than provide systematic analysis of all variables and possible outcomes.