The current wave of unrest blowing across the Middle East, North Africa (MENA) region and the associated uptick in crude oil prices have raised concerns about another (and possibly sustained) global crude oil price shock — the region currently holds about 60% and 45% of global crude oil and natural gas reserves respectively and accounted for about 45% of global oil exports in 2009. Current estimates of potential peak oil prices for the year range from US$130 per barrel to US$300 per barrel; recent investment considerations have therefore dwelt on the merits (or otherwise) of buying oil stocks at such times. Three points are noteworthy:
1. Oil Prices and Corporate Earnings
This may sound counterintuitive but rising crude oil prices do not always translate to higher corporate earnings for oil and gas operators and oversupply does not always bring about falling prices. In 2009 for example, crude oil prices doubled between early Q1 and end Q4 but major oil and gas companies recorded steep decline in earnings (for some, as much as 70%); this doubling of prices was in spite of massive, global crude oil inventories — even floating and other storages were fully oil-laden.
According to a recent report by the energy research firm Evaluate Energy, the six largest IOCs by market capitalization to wit, BP (NYSE:BP), Chevron (NYSE:CVX), ConocoPhillips (NYSE:COP), ExxonMobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A) and Total (NYSE:TOT), have, in spite of massive capital expenditure “failed to materially expand either their production or their proved reserve base over the past decade”; acquisitions alone accounted for 28% of their ten-year reserves replacement. The implication then, if these conditions persist, is that rising discovery costs per barrel of oil — which would probably become even steeper given the increasing geological complexities of available acreages — may test the profitability of these companies in due course, even in spite of rising oil prices.
2. Policies of State – royalties and windfall profits taxes
Among major petroleum exporting countries, the steep royalty and tax rates on oil proceeds have been more than an emperor’s ransom to the operating IOCs. In addition to reserves constraints, these have brought them under comparative disadvantages with their state-controlled counterparts, National Oil Companies or NOCs, especially those that have re-organized and have become partially-listed (see Figure 1 below for example).
That said, for some of these countries, these rates are tenured — and therefore stable even if unpalatable — and that significantly reduces investors’ worries about uncertainty. In Nigeria, Africa’s largest crude oil producer, IOCs have decried an “asphyxiating” government take on oil proceeds and some have even threatened to quit the country altogether. The country’s Petroleum Industry Bill however, has been languishing, trophied in the legislature’s dust even as accusations of bribery have been rife.
Surprising and destabilizing however, was the announcement last week by the British Chancellor of the Exchequer in his new budget reading, of a substantial tax hike for oil companies operating in the North Sea; surprising, not just because it was unforeseen, but also because it was made by a Conservative (and presumably more business-friendly) government. The announcement saw dips in the shares of some mid-cap companies. While many companies are currently re-evaluating their North Sea operations, some mature field operators have warned that the hike would amount to an effective tax rate of as much as 81%, possibly a death knell. The government’s response was that higher oil prices would still make them profitable. A windfall profits tax by any other name?
While there may be strident opposition to high taxes in some political quarters of the United States, one can never discount the degree of shrewd bargaining in those political back rooms. For example, though they may not want to admit it publicly, some oil and gas operators would not mind a little hike in tax if that would mean less restrictive regulatory regimes (such as much faster and more flexible permitting for drilling and exploitation) than are currently in place.
Oil and gas majors such as Royal Dutch Shell and BP have been divesting North Sea assets for some time but this tax hike may dilute the value of both divested and retained assets, making such assets unattractive and even reconfiguring planned capital expenditure by reducing estimated divestment proceeds. Financial Times reports that companies with the biggest exposure in North Sea include BG Group, Premier Oil and Enquest.
NOCs in comparison, when operating in their domestic acreages are not subject to such asphyxiating operational regimes as IOCs and some have put such advantage to good use. Brazil’s Petrobras (NYSE:PBR) for example, has made what is arguably one of the largest ultra deepwater oil discoveries in recent times. Its market capitalization, grew by a 27% compound annual rate between 1999 and 2010 according to PFC Energy, the energy research group and its public offering in 2010 returned a record US$70 billion; also, Columbia’s Ecopetrol which had impressive 2010 results has attracted the investment attention of billionaire investor Carlos Slim.
When rising crude oil prices are sustained, investment windows inevitably open for alternative energy or oil sources such as oil sands. Early investors in Canada’s oil sands for example were on better footing than much later ones which had to grapple with spiraling project costs requiring crude oil prices of between US85 per barrel and US$95 per barrel for breakeven. Many of the latter projects were subsequently suspended after oil prices plummeted. Following project reconfigurations however, this breakeven point is now estimated at between US$60 per barrel and US$70 per barrel; and with current crude oil prices at about US$30 above the top of that range, there is a seemingly comfortable operational window.
Cenovus (NYSE:CVE), Enbridge (NYSE:ENB) and Total SA have all signed exploitation agreements with Canada’s First Nations to scale the second oil sands operational hurdle; now, just environmental considerations remain, which in the light of Japan’s recent nuclear reactor problems, may seem middling. Suncor and Husky Energy also have joint venture projects coming on-stream.
According to IHS Cera, three quarters of the projects which were previously set to bring about 2 million barrels of oil per day on-stream have already been restarted. Some may even start coming on-stream by next year.
The impact of technological breakthrough on resource production can be enormous. Hydraulic fracturing and horizontal drilling for example were crucial to the shale gas explosion in the United States and which explosion may be replicated in parts of Europe and Africa. While research into production of renewable petroleum fuels (such as diesel, gasoline and jet fuel among others) from bacteria is not new, a recent process — for which patents are being filed — celebrated a further step towards its actualization. Such a breakthrough if commercialized, could dramatically alter not just the global energy mix, but also the fortunes and even the very structure of oil companies involved in mostly conventional plays.
All said then, while buying oil stocks in times of rising oil prices may not be ill-advised, it makes a difference however, what type of oil stocks one buys.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.