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Oil Energy Me

A long time ago, in a market far far away, oil was a hot commodity.  Investors expected prices to reach $200 without breaking a sweat.  Unfortunately there wasn’t a happy ending, but fans of that story should read this article closely.  

Following the Fed’s announcement on Wednesday to buy $300bn of US Government debt, traders rushed to commodities to protect themselves from inflation.  In doing so, they pushed NYMEX crude above $50 for the first time since December.  Could this signal A New Hope for oil investors or should they beware the Return of the Bear?

The rally is fuelled principally by economics 101:  Publishing money in huge amounts will lead to rampant inflation and a devalued dollar.  When the American Treasury buys treasury bills and bonds, it is exchanging cold hard USD for dollar denominated securities.  If we consider dollar supply and demand, the treasury has effectively shifted the supply curve rightwards and created a lower ture (equilibrium) price for dollars.  With dollars worth less, we need to pay more to buy imported goods and materials.  To afford these prices, workers demand wage increases, leading to more dollars in the system, which leads to an even lower exchange rate, which leads to even higher prices and soon we’re locked in to serious inflation.

Traders, to prevent getting caught in the inflation trap, have recently started moving out of dollars and in to commodities.  This week saw the fifth consecutive increase in oil prices, gold has increased 8% since Wednesday and the Reuters/Jefferies CRB Index, which tracks a basket of 19 commodities, is up 11%.

Clearly, Wednesday’s announcement caused bullish sentiment, and even looking beyond monetary policy we see greater confidence in oil.  OPEC’s December 17th cuts were initially disregarded by the markets, but are finally being taken seriously due to OPEC countries like Nigeria working together to stick to their quotas.  Venezuela’s Hugo Chavez nationalized the local unit of Spanish banking conglomerate Group Santander, and governmental power plays usually put oil traders on edge.  Further, as the April contract reaches expiry we may see traders caught in a short squeeze pushing up prices, much like we reported in October of 2008.

Looking at next week, can we expect the bulls to keep charging? Two considerations: First, demand.  We mentioned earlier that a rightward shift in the supply curve of dollars would lead to a weaker dollar.  Similarly, a leftward shift in the demand curve for oil would lead to cheaper oil.  And we’re seeing very very weak demand for both crude and finished products like gasoline.  Unless the economic condition picks up, metals stand to gain more from the commodity boom than energy.  

Secondly, and in the longer term, a weak dollar hurts OPEC because of dollar denominated barrels.  So we may see an announced increase in production or, more likely, individual countries will start ignoring their quotas and increasing output to make up for lost revenue.

It’s a pleasant change to see investors converging on oil after almost a year of bearish sentiment.  If you know what you’re doing, you could pick upon increased arbitrage opportunities as retail investors often ignore the fundamentals.  But remember, the market can stay irrational longer than you can stay solvent, and although Oil Energy Money is feeling bearish, the force is definitely with the bulls this week.

With most  talking heads discussing executive pay limits and pork barrel spending in the latest and biggest Stimulus plan, no one’s paying attention to the changes planned for America’s stagant energy policy.

 Theoretically, President Obama and Vice President Biden want to save the environment, remove dependance on foreign oil and create jobs.  To do this, they’ve set out five major goals:

1. Help create five million new jobs by strategically investing $150 billion over the next ten years to catalyze private efforts to build a clean energy future.
2. Within 10 years save more oil than we currently import from the Middle East and Venezuela combined.
3. Put 1 million Plug-In Hybrid cars — cars that can get up to 150 miles per gallon — on the road by 2015, cars that we will work to make sure are built here in America.
4. Ensure 10 percent of our electricity comes from renewable sources by 2012, and 25 percent by 2025.
5. Implement an economy-wide cap-and-trade program to reduce greenhouse gas emissions 80 percent by 2050.

Source: The White House Energy Agenda

Let’s break this down point by point.

1. ‘Strategic investment’ otherwise called infrastructure development.  Basically,   there’s a difference between fixing bridges and creating industries.  The former creates short term jobs, the latter provides long term job opportunities.  Of course, the latter is much harder to implement.  After the recession of the 1930’s, FDR’s New Deal worked because it created opportunities: The Securities Act of 1933 created the SEC, thus opening the door for new investment and finance operations.  The Agricultural Adjustment Act of the same year raised prices for farm products, supporting and encouraging the national farming industry.  Today, such programs would be shot down as big government meddling, and the alternatives, such as giving tax breaks to companies developing energy products or buying products for use by the government, are far less likely to produce long term results.  Five million new jobs may not mean much when these jobs are unsustainable.

2. This point is tantamount to completely stopping imports of oil from the Middle East or Venezuela.  Within in ten years? Impossible, but also pointless.  Why don’t we stop importing North Sea oil, Scotland is just as likely as Saudi Arabia to become a rogue nation security threat (read: not very likely).  As OPEC’s failure to stop falling wholesale prices demonstrates, oil is a truly global commodity no longer at the whim of certain Middle Eastern nations.  Instead, the international movement of products is natural and beneficial, it improves diplomatic ties, creates importing jobs and provides a wider variety of product.  We should all use less oil, sure, but picking  on these two countries seems an odd way to phrase that.

3.  Two concerns: 150mpg?! and, made in the USA?! Hybrids are nowhere near the 150mpg mark, Toyota’s hybrid superstar the 2010 Prius only manages 60mpg.  This is unlikely to almost triple within six years.  Other than the Prius there are two talked about Hybrid cars: the Honda Insight, which should steal the limelight from Toyota when it’s released later this year, and the Chevy Volt, which has been an automotive laughing stock for the last decade.  American companies have focused too long on the gas guzzling SUV and may never catch up to their foreign counterparts in terms of ingenuity or ideas.  But foreign companies can be convinced to build factories in America.  Unfortunately though, restrictive labour laws and strong union power makes these jobs inefficient for global companies.  Again, it may be too late to change as public opinion will quickly sour at the dismantling of worker priveliges.  

4.  Al Gore won’t like us for saying this, but 10% of total American energy from renewable sources within 3 years is a pipe dream.  Currently, technologies like geothermal, wind, solar, and marine energy together produce less than 1% of energy consumed by Americans.  In this shaky economy, the private equity and IPO support for renewable energy companies has practically disappeared.  The closest we’ll come is clean energy, and that will only happen through the construction and development of nuclear plants. 

5.  As our friends in the European union have shown, putting ‘by 2050’ at the end of any sentence is tantamount to saying ‘Let’s not worry about it now and let someone else worry about later’.

These plans are theoretically brilliant, but probably too difficult to meaningfully put in practice.  As more details leak out, we’ll keep you updated.

A flight to safety has recently seen a boom in commodity prices.  Last week gold hit its highest price in three months, timber has become a haven for long term investment and wholesale chocolate prices jumped above £2,000 a tonne level for the first time in almost 24 years.  NYMEX contracts seem to follow this trend, at $45 today after a four year low of $34, but don’t be fooled – this is closer to a dead cat bounce than a real bull market.

The fundamental weakness is an overabundant supply compared to consumer demand.  Due to the contango on market prices, where the spot price is significantly less than the futures price, institutions are buying oil at the low spot price and storing it for delivery in the future.  This has led to record stockpiles which far outnumber expected consumer demand.

Some analysts expect American President Barack Obama’s stimulus package to boost the economy and thus oil demand, but this is tenuous at best, probably long term and not a valid reason for high prices today.  

Many financial news outlets suggested the prices were due to OPEC strictly following the production cuts it announced last month.   But this should conversely be a bearish indicator, OPEC is cutting supply because it expects demand to remain weak, if OPEC believed oil really was seeing a return to high prices, it would delay or simply ignore the production cuts.  

The commodities mentioned above are either demand independent, self supporting safe havens (in the case of gold and timber) or demand for them genuinely outweighs supply (harsh weather has led to weak crops of chocolate and orange juice).  

Oil is currently neither a safe haven or a scarce commodity.  Oil Energy Money will go on a limb and predict traders will come to their senses (and sense is a relative term when discussing commodity investors) around Wednesday, when the American Department of Energy releases its weekly status report. If crude stockpiles increase again, and there are few indications otherwise, the bears will make a killing.

On Thursday, the state energy company of Russia (Gazprom) cut off Natural Gas supplies to Ukraine (Naftogaz).  Why this happened, and how it can be resolved is discussed below.

There are two contracts in dispute, historical and prospective.  Historically, Gazprom claims Naftogaz owes $2.1 bn in back payments.  Prospectively, the countries need to agree on contracts for future gas supplies, which Gazprom is pricing at $418 per thousand cubic metres of gas, while Ukraine has offered $201.  

Of course, the details are endlessly more complicated.  Last week Ukraine paid around $1.6bn against the debt but Gazprom claims $600 mn of late fees must be paid.  The contract for $418/tcf is paid by most Western countries, but it will probably decrease due to the falling market prices, thus it seems unfair to make Ukraine agree to pay it.  However, Russian officials accuse Ukraine of stealing gas from the pipelines which travel through it.  These pipelines are a major source of contention since 80% of Russia’s gas passes through Ukraine on its way to Europe.

Cutting off heating gas in the middle of winter may seem harsh, but Ukraine has at least seven weeks worth of reserves.  The United Kingdom, however, has less than 15 days worth of reserves, so the European union is anxious to resolve the dispute before Ukraine takes drastic measures such as closing the thoroughfare pipelines.

Oil Energy Money is always the first to question Gazprom’s strong-arm tactics, but for once, this is not a case of Russia’s Goliath attempting to crush David.   Political bickering between Ukraine’s President Viktor Yushchenko and Prime Minister Yulia Tymoshenko is making negotiations difficult and the Ukranian siphoning of other countries’ gas deliveries is a serious concern.   According to a BBC report on the 2006 crisis, where Russia cut gas supplies to Ukraine for two days, many European countries suffered:

• Austria – supplies down by around 33%
• Croatia – supplies down by around 33%
• France – supplies down by 25–30%
• Poland – supply down by 14%
• Romania – supplies down by around 20%
• Slovakia – supplies down by around 33%

To prevent similar shortfalls this year, Gazprom has offered to reduce Ukraine’s contract prices to $250/tcf but Ukraine refused.   In fairness, Ukraine has been badly hit by the global financial turmoil and sees little hope of a quick recovery.

Both parties are aiming for a resolution by January 7th, and with good reason.  Without Ukranian demand, Gazprom may have to reduce production and shut down factories, a costly and time consuming process.  Ukraine needs to negotiate before its reserves falter, but what’s the solution?

Oil Energy Money predicts supplies will resume by January 7th, though negotiations will continue long after.  The final agreements will probably involve a delay in repayment of the debt and late fees as well as a renogotiated supply contract with variable or staggered prices.  

Despite the mainstream press hinting at tearjerker scenes of freezing Ukranians, there’s very very little chance of the dispute escalating that far.  Ukranians, and the rest of Europe won’t feel serious supply disruptions over some state fuelled corporate bickering.  There may even be a small silver lining for the bulls amongst us- the potential for disruptions coupled with the invasion in Gaza have seriously boosted energy prices, oil is at a 4 week high and Natural gas is up 6% at $5.97/MMBtu.

The FT has an interesting article considering the oil price at which alternative fuels become feasible.   At $140+ it seemed all alternative energy sources were go, but how many of them still are?

According to the FT, Middle East fields (like Saudi and Bahrain) and Venezuela’s Orinoco Belt have 940bn barrels of reserves in total, which are worth exploiting when oil is above ~$30.  That’s in line with analyst considerations, Saudi can certainly survive at $30 but countries like Kuwait have a high initial capital cost, so prices may need to be higher before investment there is comfortably efficient. 

Next up is Brazilian sugar cane ethanol and conventional oil from the rest of the world, at $45.   Brazil is leaps and bounds beyond everyone else when it comes to the Ethanol as fuel market.  Due to heavy government support and well maintained infrastructure, Ethanol accounts for 50% of Brazilian gasoline use.  This government support and experience explains why Brazilian Ethanol is feasible at such low prices.

U.S. corn ethanol becomes efficient at ~$65, as does deep water drilling, which could produce between 160-300bn barrels.  When oil prices hit $70, traditional coal can be used to efficently generate electricity, and at a few dollars higher the first ‘clean’ sources become viable, with on-shore wind farms  priced at $75.  That’s good news for T. Boone Pickens, whose planned world’s-largest-wind-farm in Texas is depending on cost efficiency.

 AT $90, the Canadian Oil sands open up roughly 174bn barrels, but those projects have so much capital invested already that they’ll come on-line in the next few years regardless of oil prices.  

At $110 coal to oil conversion and the Bakken shale becomes feasible.  One of America’s latest and most important oil finds, the Bakken shale in North Dakota could hold anywhere between $167 and $300bn barrels of recoverable oil.   Given the benefits of job creation and improved national security, the American government should consider subsidising development, and commence building even if prices are lower than $110.

Lastly, at $140+, nuclear energy, carbon capture storage and offshore windfarms become feasiable.  That’s bad news for the London Array, Europe’s largest planned wind farm which is already losing uncertain investors.  The FT gives a considerable range for nuclear though, suggesting development could work between $90 and $140.  Oil Energy Money would err closer to $90 given the huge government support from countries like France.  

All told, the graphic is an interesting representative of when, and if, alternative fuels should be considered.  If prices are below $30 though, we may need Reindeer to pull us across the country.  Oil Energy Money would like to wish its readers Happy Hoildays, and many sound investments for the new year.

On Friday the Chinese government unveiled plans to drastically increase taxes on transportation fuel at the pump.  What effect, if any, should this have on global crude prices? 

First the tentative plans: Road tolls, water management tariffs and other fees will be abolished, but the consumption tax on gasoline will increase fivefold from 0.2 yuan (roughly 3 cents) to 1 yuan per liter, while the tax on diesel will rise eightfold (!) from 0.1 yuan to 0.8 yuan per liter.  However, prices at the pump  will not increase and the extra tax will be charged not to consumers but to producers.  Before our Chinese readers wipe their brows in relief, they should question why prices aren’t falling at the pump like they are across the globe.

Oil Energy Money readers should remember that the Chinese government sets pump prices at will, unlike most markets where wholesale prices dictate the numbers.  Thus, while prices spiralled at the start of 2008, pump prices in China didn’t increase until June.  This put considerable pressure on Chinese refiners who claimed to be losing money when prices were above $65 a barrel.  Now that prices are back down, the refiners are making much larger profits on pump transactions.  So instead of reducing retail prices, to benefit motorists, the government has chosen to keep retail prices the same and increase taxes, which it intends to use for infrastructure development and support for farmers who are losing out because of aforementioned tariff reform.

How does this relate to global prices? Well, some analysts consider Chinese demand the last barrier between us and $25 prices on NYMEX.  If Chinese motorists reduce consumption due to prices at the pump, the knock on effect could be severe.  Fortunately, the International Energy Agency forecasts a 4% growth in Chinese oil products demand over the next five years, so no fall in retail prices shouldn’t dent demand, on a national and thus global level.

To further mitigate the risk of a demand drop, the Chinese Government intends to impose a ceiling on prices.   The reforms are open to public feedback until December 12th, after which they will be finalised with the aim of putting them into practice by January 2009.

All told, the tax reforms could encourage drivers with the removal of road tolls and support farmers with the increased tax revenues.  While not exactly bullish, by maintaining demand the reforms will be one less bearish force on prices in the new year.

Short Answer: Not very much.

Long Answer: OPEC’s thirteen members are meeting in Cairo this Saturday to discuss a further cut in production.  Energy prices have been mixed in response-they’re higher than earlier this week, but that’s due more to China’s 1.08% interest rate cut accouncement.   Anyone expecting OPEC to cut production and finally pull up crude oil prices is surely drunk on Thanksgiving punch.

This weekend’s meeting was supposed to be a low-key event for OPEC’s Arab members.  With the price crisis, invitations were extended to OPEC’s other members, but  the meeting will serve as a stepping stone to a meeting in Algeria on December 17th, when a cut, if necessary, will be announced.  OPEC have made surprise announcements before but the benefits of a cut, either now or in December, are not guaranteed.

Last month’s 1.5MMbbls/d cut did little to stem falling prices.  The price of oil now depends very little on physical volumes, investors buy and sell on NYMEX in lieu of a market index or as a hedge against currency or as a purely specualtive investment.  Fundamental supply considerations are simply not in play.  So a production cut won’t automatically raise prices and gild OPEC’s coffers with gold.  In fact, some OPEC members are strongly against a cut.

Nigeria is already suffering production disruptions from militant attacks, producting only 1.95 MMBbls/d of its 2.05 MMbbls/d quota.   A Nigerian oil official has spoken out against a further cut as a fall in oil revenues will severely damage budgets.  Ecuador’s Oil Minister Derlis Palacios is attempting to negotiate exemptions for Ecuador from any further OPEC cuts in production.

Oil Energy Money may be wrong on this count, but the world and OPEC are beginning to realise that the cartel no longer wields the power and influence it once did.  A weaker OPEC is probably better for everyone in the long run, but with a global recession on the way and soaring unemployment, that’s only good news for people who love bad news.

Question: What happens when you combine a ruthless former superpower with one of the Axis of Evil’s most dangerous members and the world’s largest producer of LNG? Good news is not the answer.

According to the BP Statistical Review of World Energy 2008, Russia Iran and Qatar control 60% of the world’s gas reserves.  An OPEC-like cartel may not have the same influence on gas as on oil, due to reasons explained below, but the implications remain distressing.

Gazprom Deputy Chairman Alexei Miller said yesterday, “We are united by the world’s largest gas reserves, [and] common strategic interests”.  Those strategic interests in full:

• Gazprom supplies 25% of Europe’s natural gas through pipelines running West.
• Qatar sends megashipments of LNG to China via tankers.
• Iran has a prime location in the Middle East and substantial reserves but a lack of infrastructure.

Separately, each country has weaknesses.  Europe wants to decrease its independence on Gazprom by attracting other suppliers, countries are hesitant to deal with Iran due to disapproval by America, and Qatar’s shipping partners require long term contracts to justify the high costs of LNG processing facilities.

Together, though!

With dwindling North Sea reserves, Europe will have few alternatives to importing from the big three.  The Nabucco pipeline was considered the last alternative to Gazprom’s South Stream pipeline providing gas to Germany and Italy.  Who was going to build Nabucco? Iran.  Now the ‘G3’ may control both.  Iran will have the influence and supply to override American ill will and Qatar will find more buyers as the costs of LNG facilities decrease from economies of scale.   Combined, the G3 become a global supergroup with large supplies and the logistics to exploit them.

 The European Commission has spoken out against the group, spokesman Ferran Tarradellas Espuny said “The European commission feels that energy supplies have to be sold in a free market,”.  The statement, though will intentioned, reeks of hypocrisy.  The Common Agricultural Policy (CAP) takes up 62% of the European Union’s budget and serves to impose price protection, import tariffs and force quota’s on imported goods.  Why energy must be sold in a free market while food is not is a question better left to bureaucrats.

However, hope is not lost.  Even if G3 formed a cartel, their ability to influence prices globally would be limited due to transportation.  Unlike oil, which can be shipped anywhere by tanker, Steve Mufson at the Washington Post explains that when large LNG facilities are built they’re done with long term contracts locked in.   Thus prices are not as easily affected.

The pressure is on European and global leaders to prevent creation of an oligopoly.  Negotiations should begin with G3 while oil and gas prices are low, giving producers less influence.  Failing that, Mufson puts it best when he says: diversify, diversify, diversify.

 

With significant falls in the market value of many energy companies, market leaders are buying up their now undervalued competitors.  Warren Buffet acquired Constellation Energy after a 60% drop in Constellation’s share price and now America’s largest nuclear power generating company Exelon has launched a share-for-share tender offer for NRG energy.

NRG has lost over 50% of its value in the last two months, it was worth $38 at the end of August but traded at $15.17 ten days ago.  The acquisition by Exelon is offering a fixed ratio of 0.485 Exelon shares for each share of NRG outstanding, valuing NRG shares at $26.43.  The combined company would be the largest power company in the U.S., with a market capitalization of $40 billion

NRG’s board has yet to accept or deny support for the offer but Oil Energy Money predicts the offer as it stands is simply too low to succeed.

NRG is trading today at $23.21, implying that speculators are rushing in with expectations of a higher bid.  NRG’s power plants alone are worth $63 a share based on transactions over the past two years, says Gordon Howald, an analyst at Calyon Securities USA.  “The upside potential for NRG as a standalone company is much higher, assuming they can get through this credit crisis.” said Howald, “I think they have enough strength to say, ‘This is not good enough.'”

As well as the low price, the fixed ratio of Exelon-to-NRG shares means that if Exelon shares fall, NRG is paid less.  Given the unstable markets and length of merger approval in utility companies, a collar, or range of prices, should be agreed upon before accepting.  That way, if Exelon shares lose value, NRG should be free to walk away or renegotiate better terms.

Exelon stands to gain an inexpensive nuclear power plant and regional diversification outside its Illinois and Pennsylvania operating bases.   The combined company would be America’s largest power company, generating enough power for 14.4 million U.S. homes.  Exelon claims the deal would immediately boost earnings and cash flow and be earnings accretive within the first calendar year. 

“Exelon couldn’t build the plants for the same price it would buy NRG for,” said Nathan Judge, an analyst at Atlantic Equities.  With all the benefits for Exelon, a higher, better offer for NRG shareholders should be on the cards.