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Cash the new king of the oil sector

High commodity prices put resource-rich countries in command and left IOCs scrambling for a strategy. How will falling oil prices and tighter credit affect them and their rivals? Derek Brower reports

WHAT BEGAN as a problem with bad debts in the US housing market could shift the geopolitical landscape of the last eight years. The oil sector needs cash. Some national oil companies (NOCs) have it and so do the supermajors – and their secure financial footing is putting them in the driving seat of the industry, just as the resource nationalists are running into trouble.

The global economic slow-down has brought with it two different forces that are bearing down on the sector: falling oil prices and a shortage of credit.

For some countries, the falling price of oil, which last month was trading at almost a third of its peak value earlier this year, is disastrous. The confidence of Russia, Venezuela, Iran and other countries in the vanguard of the petro-nationalism movement was, to a great extent, based on the bull run in energy markets.

Russia's stock exchange has now lost almost two thirds of its value since August and the rapid economic growth that characterised the presidency of Vladimir Putin is no longer being taken for granted.

Hugo Chávez's Bolivarian revolution is facing a reality check: according to Chávez himself, Venezuela's spending programmes could be under threat if the price of oil stays under $80 a barrel (see p13). Other countries in Latin America that followed Venezuela's nationalistic lead are watching their credit ratings fall – hampering future funding.

Iran's finances are looking brittle; Deutsche Bank says the country needs $97/b just to break even – bad news for its leader, Mahmoud Ahmadinejad, as he begins to prepare for next year's presidential election.

Begging for finance

In Russia, the fall in value of Gazprom, paragon of the country's energy strategy, is galling for the Kremlin, as was the spectacle of the country's largest companies, including Gazprom, Rosneft, Lukoil and TNK-BP, lining up to beg for preferential financing to help steady their battered ships. The Kremlin has already spent $10bn of the $50bn it recently set aside for the purpose of bailing out some of the country's largest firms, many of them belonging to Russia's richest citizens.

Russia has, so far, proved resilient, having wisely built up foreign-currency reserves of around $0.6 trillion and a $200bn stabilisation fund during the oil bonanza. But in its efforts to control the rouble's fall and staunch the collapse of the stock exchange, the finance ministry has – according to some media reports – been drawing down by $15bn a week on its currency reserves since the financial tsunami flooded into Russia, draining 20% of the total. A sustained oil price beneath $65/b would mean that by 2010 Russia would also be forced to begin draining its stabilisation fund, the Kremlin admits.

How will this affect the Russian oil sector? Although in September oil production reached a year-to-date high of 10.05m barrels a day (b/d), Russian output is stagnating: average production this year will be lower than 2007's 9.9m b/d, analysts say.

High oil prices would normally result in higher production, but high taxes on exports have had the effect of capping output. Export duty was about $50/b until last month; with the country's Urals blend trading at around $60/b in October, that made the real price of the country's benchmark crude just $10/b. The duty has already come down (by virtue of a mechanism that adjusts the levy to account for fluctuations in the price of crude), to just under $40/b, and there are proposals to lower other taxes. However, the combination of weaker prices and punitive taxation will further discourage upstream investment.

Meanwhile, companies such as Rosneft – which borrowed heavily to complete its spending spree of the last two years – find themselves exposed to the tightening of bank credit. Even after the Kremlin's assistance, some of the state-controlled firm's debt will need to be rolled over again in 2009, say analysts.

The response of the companies has been to scale back their projects – maintenance on existing developments as well as new ventures – says Chris Weafer, an analyst at UralSib, a Russian finance house.

This will prolong the stagnation of Russian production and hit the state's revenue from output, in turn making the Kremlin more reluctant to offer the industry the tax cuts it wants. "Kudrin's scissors", as the punitive excise duty is known in honour of finance minister Alexei Kudrin, are unlikely to disappear soon.

That dilemma epitomises the power battle within the government, between the hawks in the oil lobby, represented by Igor Sechin, and more liberal-minded ministers close to President Dmitry Medvedev.

The oil lobby wants to stimulate industry investment by cutting taxes and to ensure the sector remains the engine room of the Russian economy. In addition, it appears to favour closer ties with Opec – Sechin recently met senior officials from the group in Moscow and Vienna. The liberal lobby wants to avoid alignment with Opec, retain a tough tax regime on the oil industry, preferring instead to diversify the economy away from the oil sector. The outcome of this latest confrontation will shape the direction of Russia's economy, says Weafer.

However, one effect of the oil sector's stagnation is that the government is likely to adopt a more pragmatic approach to foreign investment. Weafer points out that the rhetoric from the Kremlin has softened since May, when the oil price was heading towards $150/b. Notwithstanding Medvedev's bizarre decision last month to use the occasion of Barack Obama's election in the US to announce plans to station new military surveillance equipment in Kaliningrad, the Russian enclave within the EU, the Kremlin is keen to patch up relations with its neighbours, say analysts. Foreign investment in Russia has fallen by 80% since the war with Georgia in August.

Easing the pressure

There are ways that foreign partnerships can help ease some of the financial problems, too. Rosneft and Transneft, another of the firms understood to have liquidity problems, last month signed a "cash-for-oil" swap with China National Petroleum Corporation. The two Russian companies will build a pipeline to export 300,000 b/d of oil to China and, in the meantime, will receive loans of $20bn-25bn to help to cover combined debts of $29bn.

Indeed, the large Asian NOCs are increasingly targeting the Russian sector, says Marc Hammerson, an energy lawyer at Stephenson Harwood. That follows a trend that many Chinese and Indian firms have established in other producer countries in need of capital, especially in Africa. Russia will not much like the comparison, but China's NOCs remain well funded and that country's need for oil has not gone away, even if Chinese demand growth has slowed recently (see p4).

The Kremlin may even adopt a more welcoming attitude towards the supermajors. Although the law now requires state-owned firms to retain majority control of oil projects, there are likely to be more investment opportunities in the future – even if the terms will be no more generous than they are now. While international oil companies' (IOCs) collective experience in the country during the Putin era will make them wary, petro-nationalism may have run its course in Russia.

However, it may not have done so elsewhere. Robert Ebel, an analyst at the Washington-based Center for Strategic and International Studies, says the rebalancing of power away from the supermajors is irreversible. And around the world, many NOCs still have strong balance sheets – and deep-pocketed state backing. Algeria's Sonatrach, Brazil's Petrobras, Malaysia's Petronas, and Norway's StatoilHydro, says Hammerson, remain as well placed to cope with the global financial crisis as the majors.

Petrobras: cash flow strong

Petrobras, for example, might struggle under present market conditions to finance the heavy investment its pre-salt discoveries will need (see p13). But much of its funding is sourced through the state-controlled development bank, BNDES, and its cash flow remains strong. Compared with those companies, which have large domestic upstream portfolios to tap, it is the supermajors that have the running to make.

Hammerson suggests that one outcome could be a polarisation of the sector, as the NOCs concentrate on their core domestic resource base and the IOCs compete for the remaining large oil plays around the world.

If access to upstream resources remains difficult, IOCs are likely to try to expand through acquisitions, taking advantage of lower equity values (PE 11/08 p6). Some analysts even compare the landscape now with the feeding frenzy of mergers and take-overs of the late 1990s, when oil prices bottomed out at $10/b and the majors morphed into supermajors.

The lack of liquidity also favours the IOCs, which can continue to operate while smaller private-sector companies and weaker NOCs may struggle to fund projects. "The advantage of the supermajors is that they are cash-rich," says Keith Myers, of Richmond Energy Partners. "They all carry debt, but they could pay it off tomorrow, if they wanted to. They are self-financing."

In September, for example, Eni bought First Calgary Petroleums for $0.866bn. First Calgary struggled to find creditors earlier this year, despite developing a large gasfield in Algeria, says IHS Global Insight, a consultancy.

Canada's EnCana, meanwhile, postponed a plan to split the company into two units because it was concerned that two smaller firms would face more expensive credit than the single entity. Tullow Oil and Cairn Energy, two other mid-cap companies with attractive assets, are now also in the sights of larger firms.

The lesson is that size matters again in the industry – which should benefit both the IOCs and the larger NOCs. India's Oil and Natural Gas Corporation's cash reserves amount to some $5bn; last month it won approval from Russian authorities for its proposed $2.2bn take-over of UK independent Imperial Energy, which has assets in the country. The UAE's Taqa is also still in expansion mode, notes Hammerson, targeting assets in the North Sea as the supermajors retreat from the province.

And Chinese companies remain particularly well positioned to keep buying. PetroChina, notes IHS Global Insight, has an asset-to-liability ratio of just 30% – even lower than Shell (53%) and BP (41%). A sustained drop in the oil price, the consultancy says, would affect Chinese companies more than many large IOCs, but with financial backing sourced in Beijing, that risk is low.

However, Russian firms are notably absent from the list of companies that analysts expect to continue expanding abroad. Just a few months ago, the TNK-BP shareholder dispute centred on the charge that BP was preventing its Russian joint venture from expanding overseas. The company's credit wobbles – exacerbated by its low reinvestment rate as BP stripped it of cash, says one analyst – mean that debate is now academic. The company, like others in Russia's energy sector, needs to shore up its domestic position before thinking of foreign ventures again.

Plus ca change ...

More consolidation in the sector will not, however, increase the world's oil supply – a threat linked to underinvestment that the International Energy Agency voiced again last month (p25). Indeed, IHS Global Insight says that while credit retrenchment in the sector will not affect project financing for developments under way in the next spending cycle, between 2008 and 2012, it could undermine plans further ahead, up to 2015.

Between now and then, low oil prices present an opportunity for cash-rich companies to increase their portfolios and capitalise on the sudden humility of some of the resource-holding countries. The window to consolidate their strategic positions again before the next upswing in the oil price and its related surge in producer power may be shorter this time than it was the last. Resource-rich countries are down, but by no means out.

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