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Life On The Plateau

 

By Credit Suisse’s Global Equity Research, Oil & Gas

We think the next phase of the energy cycle will resemble a Plateau, after the Upcycle of 2003-05 and the Resolution of 2006. During this Plateau period, which could last until the end of the decade, oil prices will need to stay high in order to keep demand growth under control and in order to encourage new sources of non-OPEC hydrocarbon supply. Access to Resources (the title of our Energy in 2005 report) is not getting any easier for non-OPEC, at least not for traditional black oil resources. One consequence of this is an increasing share of investment going into nonconventional hydrocarbons: everything from oil sands to biofuels. These hydrocarbon sources all share a common characteristic – a higher break-even oil price than their conventional counterparts.

The world’s largest oil and gas companies now appear more willing to invest further up the cost curve and this should eventually lead to a looser market. However, the lack of easy and/or traditional investment options is lengthening the overall cycle, and keeping oil prices higher: this is the Plateau.

Oil prices have risen to current levels not through any gradual increase in the marginal cost of supply but via a much faster-acting mechanism: the marginal price of demand. The perceived deliverability or availability of refined oil products hit an inflection point in 2003, and much of the price action since then has been generated by the market searching for the price at which global oil demand would demonstrably inflect downward. It seems that we found that point over the summer of 2006. However, while the upcycle has been Resolved this does not mean that we will now inevitably enter a downcycle.

We are calling for a Plateau period mainly due to the lack of any convincing supply response from non-OPEC to the last three or four years of high and rising prices. With little sustainable supply growth from non-OPEC (though with a temporary supply bulge coming in 2007), oil prices will have to stay close to the marginal price of demand in order to keep global oil demand growth subdued. The world’s biggest oil companies are still comprehensively failing to grow their conventional oil production at anything like their own target rates, and in many cases they are failing to replace their existing oil reserves organically.

OPEC Market Management

During the demand upcycle of the last four years, OPEC could afford to remain passive while the demand side of the pricing equation took the strain and set the tone. This is no longer true. Like it or not, OPEC is being thrust back into its market-management role. OPEC must try to keep markets adequately supplied while preventing any dangerous inventory builds and while preventing the perception that spare capacity will inevitably rise as OPEC invests in its own capacity. This is a tricky balancing act.

OPEC also needs to keep a close eye on market share threats from both traditional (the Super Majors) and nontraditional (biofuels) competitors. OPEC’s market management requirements are substantial, particularly in 2007, but we think the cartel should be able to pull it off and oil prices should stay high and volatile as OPEC likely stumbles several times in the coming 18-24 months but does not fall down.

Consuming nations’ policy responses to the Plateau phase of the cycle are likely to be more resolute than in the past. The US administration may change tack a little given the result of recent Congressional elections where conservation and emergency dependency were notable themes. Energy Independence is certainly a laudable aim but is beyond the reach of all but a handful of countries worldwide, and “freedom from foreign oil” in the US (a recent rallying cry by both major political parties) is nothing short of fanciful.

Nevertheless, the US government has several energy levers it could pull in the next few years, including an expansion of the US biofuels mandate and/or a more coercive approach to raising vehicle mileage standards. Whatever the political outcome, higher fuel prices are already having a meaningful impact on the sales of larger, less fuel-efficient vehicles in the US, and this is not likely to change anytime soon, we think.

We are already seeing a more extensive series of US mandates for renewable fuels in electricity generation. We look at four different scenarios for the adoption of renewable portfolio standards (RPSs), from meeting current existing proposals up to something much more radical. We conclude that any move to a serious RPS in the US will cost anywhere from $180-850bn between 2006 and 2025; the new renewable generation capacity to be added would be 100-450gw; and increased renewable generation output, and a reduced need for incremental output from conventional plants, will slow the growth in utility coal and natural gas consumption to around 1.0% annually from 1.5% without renewables. Seems it’s not that easy being green.

US Gasoline Demand

US consumers already appear to have made their own decision with regard to one part of future energy consumption patterns: US gasoline demand. Total miles driven in the US flattened out over 2005 and 2006, for the first time in many years, but the meaningful longer-term adjustment implied by multiple years of higher gasoline prices will likely be made within the vehicle mix, ie, a compounding preference for smaller-engined vehicles. The evidence for this trend is already clear, we think. Europe is still progressing through a decade-long dieselization of the private automotive fleet, and while this option is unlikely to be the answer for the US (nowhere near enough diesel production capacity), a continued drift away from larger engines and toward more fuel efficiency is both possible and likely.

Non-oil energy markets also remain very active. The market is still searching for the new equilibrium price of North American natural gas: higher-cost but higher-decline shale and other unconventional gas sources have filled in for lower Gulf of Mexico gas volumes, while the price elasticity of demand for US gas is proving difficult to pin down. We still expect a meaningful amount of LNG to make it into the US market in the next ten years, but the near-term impact looks limited: US natural gas may need another few short cycles to reveal its new clearing price. Over time, more LNG in the Atlantic Basin should start the much-discussed globalization of natural gas markets, though the process will remain slow we think.

During the next few years, it looks like North America will need to add a significant amount of new energy infrastructure capital to transport and refine with new oil supply from Canada’s oil sands and to remove potentially severe natural gas supply bottlenecks in the Rockies and Mid-Continent. While not all infrastructure proposals will be commissioned, many will, and in total, we anticipate about $17bn of North American infrastructure projects moving forward in the next couple of years: $9bn on the oil side and $8bn on the natural gas side.

Finally, while oil prices should stabilize and North American natural gas prices stay cyclical, costs are continuing to rise, for now at least. Tightness in global construction markets is pushing up the price of new hydrocarbon developments, while a shortage of deep water drillships is still making itself felt in rig rates now over $500,000 per day for the most advanced equipment. Finding and developments costs are continuing to rise in consequence while higher operating costs are also squeezing margins.

During the Plateau period, we think investors will likely pay a premium for above average cost control (preferably alongside volume growth). In the end the oil companies will likely revert to historical rates of reinvestment, one way or another, and we are likely to see more cash spent in the upstream during the Plateau, before a downturn at the end of the decade or whenever marginal supply pricing reasserts itself.

Plateau For The Integrated Oils

As expected in Energy in 2006, the integrated oils mainly outperformed the more commodity-levered energy sectors during 2006. The break in the oil price upcycle over the summer led to a scramble for safety, which benefited the larger stocks. During 2007, we think it will become incrementally more difficult for the integrated oils to post meaningful outperformance against the wider equity market unless there is a general return to oil and gas production volume growth.

We are expecting a bounce in non-OPEC volume contributions in 2007, though much of this is due to timing accidents (delays, etc) rather than the beginning of a multiyear supply response to upcycle oil prices. A convincing supply response is not yet in place, we believe. Therefore, much will depend on how investors interpret the volume growth they see in the larger oil companies in 2007. Interpreting growth will be a company-specific task, we think, and consequently we are less inclined to generalize about the integrated oils going into 2007, since the spread of outcomes in volume growth and share price performance is likely to be quite wide.

The year 2007 is also likely to include a partial reversal the unusual 2006 trans-Atlantic performance gap. During 2006, the US integrateds convincingly outperformed the S&P 500 by an unweighted average of 18%; the weighted average was about 2% lower. By contrast, the European integrateds only managed an unweighted average of 1% outperformance against the S&P 500 while the weighted average was well into negative territory, and performance in local currencies against local markets was even worse.

The weakness of the US dollar was mainly to blame for the significant performance differences, we believe, although some company-specific issues (at BP, for example) were also a factor. As we are expecting the US dollar to stop depreciating in 2007, and even rebound somewhat, we are recommending an Overweight on the European integrated oils versus the European market while we are moving the US integrated sector down to Market Weight versus the US market.

Plateau For The Independent E&Ps

After rising around 45% in 2005, the US Independent E&Ps rose just 6% in 2006 as natural gas prices eased back down to the $7/mn BTU range from $10-plus in January, and global crude prices backed off the mid-summer highs of $75/B. Adding further pressure, E&Ps suffered persistent cost inflation in 2006 given heightened competition for services as producers scrambled for growth. E&P margins were squeezed as commodity prices began to turn, while costs continued to rise.

Despite this, most producers held onto their original volume growth targets and raised capex budgets (+20%) throughout the year to meet these targets. This trend quickly eroded industry free cash flows, with the average E&P now set to spend about 120% of internal cash flow in 2006. With recent producer announcements suggesting bigger budgets in 2007, we believe the E&Ps will once again be spending beyond cash flow for volume growth. During the Plateau period, we believe the independent E&Ps will continue to face capital productivity challenges. F&D costs in 2006 are likely to cross above $3.00 per Mcfe and a dwindling pool of lower-cost, flush resources. US E&Ps have spent much of the last two years accumulating acreage positions prospective for unconventional gas (tight gas sands, shale, and coalbed methane), where higher-cost techniques are generally required to extract the resources.

This trend is likely to bring a structural lift to North American natural gas production costs and supports the recent increase to Credit Suisse’s natural gas price outlook. Meanwhile, under our forecast for a channeling of commodity prices during the Plateau period, unconventional resource play economics should still be strong enough to attract capital dollars.

We expect future production growth from unconventional plays to help stem some of the declines within the maturing conventional asset base and bridge the gap to LNG. Consolidation could also accelerate during the Plateau phase as companies compete for the few remaining choice assets: drill-bit F&D costs for the industry could possibly surpass the cost of acquiring reserves.

Plateau For The Independent Refiners

The year 2006 was one of two halves for the Independent Refiners, which could do nothing wrong in the first six months, and then could do nothing right after August. The disruption engendered by the removal of MTBE from the US refining system generated a severe shortage of gasoline finishing agents, a shortage that was on the way to being solved by the time the season fell apart in early August. We will likely see another US margin run-up in 2007 between the winter and summer periods, and this could generate another period outperformance for the independent refiners. However, the same forces driving the plateau in crude prices will likely apply to the refining market as well, suggesting that the best period for refining margins is already behind us.

With no OPEC to manage the refining market (unless we count the run-cuts seen when margins collapse) refining is always likely to be the more volatile part of the energy pricing chain. The big question for 2007 will be whether or not the US can actually supply itself with enough finished summer-grade gasoline without resorting to expensive imports of alkyl late, etc, from Europe. The picture looks more balanced for 2008, for US gasoline at least. Later in the decade it is possible that the US will experience a diesel shortage, keeping margins in that fuel higher than gasoline margins.

In Europe the picture is more mixed. The already tight diesel market should get some relief from new secondary (hydrocracking) refining capacity additions in 2007 and 2008, although the outlook is still for continued shortage. Meanwhile European gasoline demand continues to fall, freeing up more gasoline for export to the US and helping diffuse margin tensions across the Atlantic Basin.

In the medium term Europe requires more capital investment in diesel (or biodiesel) capacity and margins in that fuel will need to remain high enough to attract this capital. Most European refining stocks feel expensive to us for this part of the refining cycle, and we see better value in selected US names.

In Asia the refining outlook is highly dependent on the likely direction of Chinese net product imports, specifically imports of residual fuel oil. The Asian gasoline market remains sloppy, and while distillate is a little better, simple refining margins ended 2006 in negative territory. Over time we believe Asian refiners will add more conversion capacity and capture more of the upgrading margin, but new capacity is still several years away, except for one or two large Indian additions. One bright spot may be the Australian market where recent new clean fuels standards have isolated the country somewhat from a looser surrounding regional market, and this should benefit margins.

Plateau For The Oilfield Services And Equipment Stocks

We think the Oilfield Services and Equipment sector offers one of the more interesting energy investment opportunities during the early phases of the Plateau period. OFS companies should continue to grow earnings through higher pricing and increasing volumes (rising upstream activity). A sustained period of high commodity prices will likely encourage higher upstream investment and will boost demand for oilfield equipment and services as producers struggle to grow supply.

We expect OFS pricing and returns to remain strong as capacity constraints, and the repeated industry pattern of most producers trying to increase spending at the same time, keep pricing power in the hands of the service companies and offshore equipment and rig suppliers. An added boost to OFS returns will come from National Oil Company spending, which is increasing rapidly for the first time in decades, and is less price-sensitive given NOC access to lower-cost reserves. We expect the industry to eventually settle back into its cyclical pattern of rising and falling spending, but at a much higher level than we saw in the 1990s.

Rising capital intensity should drive a steady increase in drilling and completion spending over the long term. The largest and easiest to produce hydrocarbons are normally discovered and produced first, creating continued declining marginal productivity interrupted by periods of technological innovation. Drilling and completion spending should continue increasing over time in order to maintain production volumes, and further increases will be required if supply is to grow at the same rate as demand for the first time since the late 1970s.

OFS returns will eventually fall as more capital investment creates more capacity and eventually evaporates both pricing power and returns. This could start happening for commodity assets such as US land rigs over the next few quarters, depending on natural gas prices. However, we expect capital discipline, industry consolation, and a tightly stretched industrial manufacturing supply chain to keep returns high for several more years for value-added, technology-based services and offshore rigs and equipment.

The year 2007 could be the one of consolidation in the drilling industry. The industry fundamentals remain strong and valuations are not stretched versus history. With a shortage of skilled labor likely to emerge more strongly in 2007 and 2008, consolidation may bring expansion synergies to this part of the energy industry.

Plateau For The Global Emerging Market Oils

After three years of strong performance with emerging market energy rising 179% and outperforming both underlying markets and the global energy sector, life on the plateau for the GEM oils is about to get more difficult. Emerging markets are growth markets and over the last 36 months, rising oil prices have allowed emerging market oil stocks to mimic the typical earnings growth pattern of more “secular” emerging market stocks. As oil prices plateau, earnings growth will slow very significantly.

We see GEM energy earnings mostly trailing their underlying markets in 2007, generating significant headwinds for GEM oil stocks. Higher volume growth is now the main lever to drive further performance, as is cash flow generation commensurate with that growth, ie, the growth needs to be profitable. This combination is beyond the ability of most GEM oils, we think. We are therefore Market Weight the GEM oil stocks for 2007.

Among the gloom is one bright spot in Brazil where Petrobras should be able to generate profitable volume growth from its advantaged asset base and see this accrue into the equity value. Russia, in general, looks pricey, although our above consensus earnings forecasts suggest that sector earnings have a chance of closing some of the gap with the local market, supporting some relative performance. Lukoil is our pick in Russia, given valuations and its longer-term strategic plan that promises to deliver strong volume growth. China’s oil producers all look expensive and we would avoid them for 2007. COSL, the China offshore service provider, is more attractive, we think.

Plateau For North American Infrastructure

The natural gas infrastructure group encompasses a broad combination of integrated pipelines (both in US and Canada) held in traditional C-corporations as well as assets increasingly migrating to the expanding master limited partnership (MLP) space. In either case, stock performance in 2006 for these names has been relatively robust (+19% year to date for our US gas diversifieds, +9% for the Canadian pipelines, and +13% for the CS MLP universe).

The outlook for infrastructure stocks on the Plateau appears positive, albeit highly competitive. With commodity prices now likely to trade sideways for an extended period, improving netbacks will be a key dynamic for producers, and this means de-bottlenecking the pipeline grid to reach premium markets, particularly in “supply-push” areas such as the Canadian oil sands, US Rockies, and Mid-Continent, where new supply threatens to compete against itself creating potential pockets of severe price pressure.

This in turn is leading to a new boom in infrastructure projects, for which we estimate approximately $17bn in crude oil pipelines and $15bn in natural gas pipelines are proposed to be built in North America through 2010. Moreover, we also track an additional $2bn in storage projects under regulatory review and over $20bn worth of proposed LNG terminals.

Competitive positioning is now key, and competition for the same sources of supply means that only half of the pipeline projects will likely proceed (only those that receive long-term commitments) and less than 30% of the LNG terminals will eventually see the light of day. Given the strength of project demand, financing this large capital outlay has if anything eased over the last few years with the continued rise of the MLP asset class (and its lower cost of capital), private equity interest (especially in storage), and more recently greater direct participation from pension funds (particularly in Canada).

From a stock standpoint, the combination infrastructure boom and interest from nontraditional investors has led to an upward creep in pipeline EBITDA multiples, which are now tending toward the 9-10x range for a US corporation versus the 10-year average closer to 8x. While nearly every major gas pipeline has at least one (if not three) proposed pipelines in the works, those most levered to new infrastructure include Enbridge, Enbridge Energy Partners, Kinder Morgan Energy Partners, EI Paso, Sempra, and Williams.

This article is the opening chapter of Energy In 2007, produced by Credit Suisse’s Global Equity Research, Oil & Gas, with the theme of “Plateau”.Its views are not necessarily those of PETROLEUMWORLD.

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Petroleumworld News 01/28 /06

Copyright©2006 Credit Suisse’s Global Equity Research. All rights reserved

 

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