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Global energy - the rapidly changing landscape
On the global equities stage, energy companies form the second largest sector with a combined market capitalisation over $3.5 trillion (US dollars). While plenty of opportunities remain, the global energy map is set to substantially change. David Whittall, Portfolio Manager of the Bennelong SGI Global Equities Fund, shares his outlook on what's in store for the global energy sector.
The energy sector can be broken down into several key sectors: integrated oil companies; exploration and production companies; oilfield service and equipment companies; refiners and marketers; and oil and gas pipeline companies. In this article, we explore the different industry groups within the energy sector and discuss where we see opportunities for investment over the next one to two years.
Integrated oil companies
Thirty of the large integrated oil companies, including Exxon Mobil, Petrochina, BP and Petrobras, account for 57% of the total market cap of the global energy sector. Whilst this sector is obviously dominated by the large players, collectively the industry faces two challenges: flat to falling production volumes and downward pressure on refining margins from a weak economy and new refining capacity from India, China and the Middle East.
One notable exception to the phenomenon of large integrated oil companies with falling production volumes is Brazil's Petrobras. Brazil's production of crude oil has nearly doubled since 2001 and continues to grow robustly. Petrobras is planning to spend a massive $474 billion in capital outlays from 2009 to 2013.
There are other integrated companies whose discoveries promise to change the energy landscape as we know it. Take, for example, BP and their recently announced Tiber discovery in the Gulf of Mexico (GoM) (Petrobras has a 20% stake in this project). Analysts have speculated that the Tiber discovery may hold between 3 - 5bn barrels of oil. To put that into perspective, as recently as 2005 the US Minerals Management Service (the Federal agency managing the nation's natural gas, oil and other mineral resources on the outer continental shelf), estimated the total cumulative production of the GoM to be 14.6bn barrels and the total remaining proved recoverable oil reserves to be 5.2bn barrels.
While the size of the find is historic, so are the challenges to removing the oil and gas. The well is one of the deepest wells ever drilled and carries technical and financial challenges that are analogous to space exploration. Only the integrated super-majors like BP have the capex budgets and R&D spending to pursue such opportunities.
These types of investments do not lead to insignificant results. A few more 3bn boe (barrel of oil equivalent)+ discoveries like BP's Tiber could help stem the decline in US oil production (see chart below).
Chart 1: US oil production, million barrels per day
Source: Factset, SGI
But what do such investments mean for the integrated oil companies' earnings? BP is, by any measure, one of the top exploration and production operators among the integrated majors. The company has replaced more reserves of oil and gas than it produced in each of the past 15 years and is now the largest producer and leaseholder in the GoM.
Even with this leading position, the future profitability of BP's deepwater exploration and production effort will depend to a high degree on the success of new, in some cases unproven, technologies and the management of very significant costs.
A more burdensome problem is the downstream businesses of the integrated oil companies which continue to be under enormous pressure from new refining capacity in Asia, the Middle East and Africa and from weak global refining demand.
BP's income statement tells the story: in the first half of 2009, their exploration and production activities generated $9.36bn out of $9.46bn in operating profit before taxes. Only 12 months prior, BP's exploration and production activities generated $20.84bn out of $21.09bn. With these economics, the super majors are actively trying to reduce their downstream exposure. The drag of the refining and marketing business is one of the major constraints we see for the integrated oil companies.
Exploration and production (E&P) companies
The relative success of the E&P segments at Petrobras and BP point directly to the opportunities in this industry. E&P companies are generally much smaller than integrated oil companies and enjoy higher production growth rates. For this reason, they have been and remain attractive acquisition targets for the much larger integrated oil companies that lack production volume growth. They can also be pure plays on exciting regional themes.
One case in point is China, who has been one of the most aggressive acquirers of assets and will change the global energy map if it continues buying energy assets at its present rate. SINOPEC (CNPC) and China National Offshore Oil Company (CNOOC) are reported to be preparing to purchase Repsol's stake in Argentina's YPF for some $17 billion. This acquisition would follow closely China Petrochemical's $7.7 billion acquisition of Addax Petroleum (reserves in Africa and Iraq) and $1.8bn acquisition of Tanganyika Oil (reserves in Syria). Earlier this month, PetroChina announced it will pay Exxon Mobil $41 billion over two decades for gas from Australia's Gorgon liquefied natural gas (LNG) project.
Another super major that has targeted LNG as one of its major future growth areas is France's Total SA. At the top of its major projects list is its Ichthys LNG project in Northwest Australia, expected to come on line in 2015 and have an initial production capacity of more than 8 million tons of LNG per annum, 1.6 million tons of liquefied petroleum gas (LPG) per annum and 100,000 barrels of condensate per day.
The massive flow of investment and capex money from the world's large integrated oil companies provides a floor under E&P company valuations, creating unique opportunities for regional E&P companies that have production growth, important resource claims contiguous to those of the major integrated oil companies, or unique assets like Australian LNG facilities.
The proliferation of LNG importing nations will be one of the most important developments in the energy sector over the next decade. Given its gas reserves, capex plans, investment environment and geographic proximity to importing nations, Australia is destined to become one of the largest exporters of LNG in the world.
Oil refining and marketing
A massive shift in comparative advantage in the refining industry is underway. The expansion of refinery capacity in Asia, the Middle East and Africa is forcing the shutdown of refinery capacity in the Atlantic Basin. Consider that India's Reliance Industries now accounts for a quarter of the market cap of all the world's listed oil refiners. After the March 2009 merger of Reliance Industries Ltd and Reliance Petroleum Ltd, the combined company's refining capacity at Jamnagar in Gujarat will be the largest single refinery location in the world.
The very size of new refinery capacity is one of the industry's main challenges. There is simply too much new capacity being built, especially at a time of global economic weakness. This environment of growing capacity amidst faltering demand is driving many refiners into loss and causing inventories of oil to rise. This can be seen in the tens of millions of barrels of oil being stored in super-tankers at sea or in US inventory numbers at critical refinery hubs like Cushing, Oklahoma, the nation's largest (see Chart 2). Meanwhile, recently rising oil prices are pressuring feedstock costs.
The only pure refinery companies that receive favourable ranks in our analysis are those with high rates of secular demand growth or favourable price controls and are in emerging markets including Thailand, Turkey and Israel.
Chart 2: Too much refined product!
Source: Factset, SGI
Oilfield services and equipment & contract drillers
The decline in oil prices from $140 in 2008 to below $40 in 2009 resulted in the freezing of many capex budgets in the energy sector. It may be years before the industry returns to the peak capex rates of 2008. One of the most tangible casualties of the drop in oil prices has been the decline in the number of rigs in operation and associated spending that accompanies each rig deployment each day. The Baker Hughes Rig Count has plummeted (see Chart 3 below).
Chart 3: Collapse in demand for rigs
Source: Factset, SGI
While Chart 3 hints at stabilisation in the rig count, the overall level of rig deployment may remain at depressed levels for some time. All oilfield services that vary with drilling, especially those that expanded operations in 2008, may face low capacity utilisation, margins and returns. We prefer the petroleum engineers who have exposure to the massive build-out of LNG infrastructure and the continued expansion of refinery capacity in the Middle East and Africa. We also like service companies that focus on the deep water offshore spending of the super majors.
The energy sector is broad so opportunities do exist, but sector knowledge will be critical in ensuring these opportunities are identified and capitalised on.
About Security Global Investors
US-based Security Global Investors (SGI) is a multi-disciplined asset management firm that seeks to deliver ‘Best-in-class' investment options for institutional investors and financial intermediaries. The firm manages approximately (US dollars) $19 billion in assets (as of 30 June, 2009), and offers a broad spectrum of investment strategies that span five distinct disciplines - actively-managed specialty fixed-income, value, growth and global equity strategies, as well as quantitative investment management solutions. Founded in 1962, SGI has 314 employees (including 51 investment professionals) with specialized investment teams in Topeka, KS; Irvington, NY; San Francisco, CA; and Rockville, MD.
Security Global Investors, LLC (SGI)does notguarantee the sequence, accuracy, completeness or timeliness of the data contained in this document. AlthoughSGI believes the information contained in this document is reliable, it cannot, and does not, guarantee or warrant its completeness or suitability for any purpose. This document is provided for information and illustration purposes only. The contents are neither designed nor intended and should not be considered as, or relied upon as, investment, legal, tax or accounting advice or as a recommendation of any specific security or strategy.
The opinions and forecasts expressed are those of David Whittall and may not actually come to pass. This information is subject to change at any time, based on market and other conditions and should not be construed as a recommendation of any specific security or strategy. The securities discussed may not reflect actual investments made by SGI.
SGI provides investment advisory services to the Bennelong SGI Global Equities Fund.