Guest post by Isuru Seneviratne, Founder & Portfolio Manager, Radiant Value Management. Isuru has specialized in energy sector analysis and investing since 2004. Visit www.radiantval.com for more information on the author and firm.
“Geopolitical risk is a transmission mechanism by which low oil prices are a cure to low oil prices.” – BCA Research
Oil prices incorporate no geopolitical risk premium today. This is an anomaly. From mid-2000s through 2014 (excluding the Global Financial Crisis), oil traded $10-30/bbl above the cost of production, partially as insurance against supply disruptions. Despite oil price recovery this year, it still trades more than $10/bbl below ‘shale breakeven’ levels. Under $60/bbl, North American shale production will continue to decline. Iran’s nuclear accord has taken the specter of atomic warfare off the table. However, in many other respects, the world has become substantially more unstable. During the 2000s, oil-rich governments saw dual windfalls of higher taxes and investment capital inflows. In several producers, this boon has laid the foundations of collapse, not prosperity. Low oil prices have accelerated the dysfunction in petrostates, increasing the frequency of supply disruption (see OPEC outages in Exhibit 1). Countries that used commodity wealth to mitigate domestic instability face the highest risk. Within OPEC, the produces outside the Persian Gulf are suffering the most from the present downturn. This subgroup’s production is down 9% from average 2014 levels. Oil prices will have to either rise to help mitigate geopolitical risks or will spike due to major disruptions. We are excited to pursue investment opportunities before markets acknowledge geopolitics.
Unprecedented capital expenditure cuts over the last 2 years are taking a toll on supply, especially outside OPEC. Low prices are accelerating consumption – growth is at the fastest rate in a decade. During 2015, demand grew 1.9 million barrels per day (mnb/d) over 2014 (2.0%), and has averaged 1.6 mnb/d for the first 5 months of 2016 (1.7%). After the 1986 oil crash, consumption grew at 2.1% per annum for 7 years.
In January, the International Energy Agency (IEA) estimated a 1H16 supply surplus of 1.5 mnb/d. By June, the IEA cut this figure by nearly half, to 0.8 mnb/d. The energy watchdog now expects inventory drawdowns starting 3Q16, with demand growth of 1.3 mnb/d for 2016 and 2017. The IEA anticipates a balanced market in 2017 if OPEC increases production by 0.8 mnb/d over May levels. Ironically, OPEC’s June market report projected non-OPEC production to grow by 0.9 mnb/d from 2Q16 to 4Q16. Spare productive capacity is at historical lows. With Iranian production almost back to pre-sanction levels, further sources of near-term, low-cost barrels are minimal. Below we explore three countries with elevated risk: Venezuela, Nigeria and Iraq. Together these produces account for ¼ of OPEC supply.
Venezuela on the Brink of Collapse
“Ten years from now, twenty years from now, you will see, oil will bring us ruin… I call petroleum the devil’s excrement.” – Former Venezuelan Oil Minister and OPEC co-founder Juan Pablo Pérez Alfonzo, 1975
Venezuelan oil production hit 2.2 mnb/d in May, the lowest sustained level since the early 1990s. Beyond the ongoing slow decline, rising social unrest has elevated the risk of sharp disruptions. The state oil company PDVSA has fallen behind on payments with its counterparties. International service providers like Halliburton and Schlumberger have diminished activity levels and are threatening to leave the country. PDVSA is contemplating $2.5 bn promissory notes to settle unpaid bills, on the books at $21 bn. With $4.4 bn of debt and interest due over 2016, PDVSA’s reinvestments will continue to decline as will production.
Oil accounts for 95% of Venezuela’s export revenue. After the formation of OPEC in 1960 and the nationalization of the oil industry came Hugo Chávez in 1998. The Bolivarian socialist regime’s largesse ate into PDVSA’s reinvestment plans. When oil workers went on strike in 2002, Chávez cleansed the leadership en masse and put technically inept but politically loyal Chávistas in place. PDVSA became the cash cow for the government, sprawling into all aspects of the welfare state. The company has ignored maintenance of energy infrastructure and safety for decades. The consequences are presently being felt across all aspects of its operations, from the time it takes to drill a well to port availability to deadly explosions at facilities.
Presently Venezuela satiates 2.3% of global oil demand. Any prolonged outage will have consequences, as was demonstrated during the oil lockout of 2002-2003. PDVSA’s strike against Chávez caused one of the largest global supply losses since the First Gulf War.
Political risks in Venezuela have been rising since Chávez’s death in 2013. His anointed successor, Nicolas Maduro, has neither the force of personality nor the oil wealth that kept the wheels turning. The state is crumbling under decades of mismanagement, institutional destruction and corruption. The government is trying to stave off looming debt default. Price controls have caused scarcity of everything from essential medicines to toilet paper. Food riots and violent looting have become a daily occurrence. In May 2016, there were 641 protests recorded in the country, up 37% year-over-year (Exhibits 2 and 3).
The dire economic situation and runaway inflation, estimated at 500%, propelled the opposition to a decisive win at the December 2015 parliamentary elections. The opposition wants to force a presidential recall election despite vehement opposition by Chávistas in the bureaucracy, the courts, the national election council, etc. Fearing a coup d’état, the Maduro administration has mobilized the largest military exercise in Venezuela’s history. However, due to the cash crunch, Maduro’s ability to pander to the military has diminished. Any coup attempt will target PDVSA facilities, the country’s sole economic asset. Instability could result in labor shortages, strikes or shut-ins as competing factions attempt to gain negotiating power.
Nigerian Production under Siege
Nigerian oil production fell to a 28-year low of 1.5 mnb/d in May. Sabotage by militants has skyrocketed, raising outages and dimming the probability of a quick recovery. The oil and gas sector accounts for about 35% of gross domestic product, and petroleum exports represent over 90% of total export revenue. Low oil prices has put the government in a bind and has raised risks of prolonged outages.
Niger River Delta has been a textbook example of the ‘natural resource curse.’ Most of Nigeria’s oil lies underneath this densely populated region and in the adjacent Gulf of Guinea. The Kaiama Declaration in 1998 demanded an end to 40 years of environmental damage and underdevelopment in the region. Since then, indigenous activities against commercial oil refineries and pipelines have increased in frequency and militancy. Pipeline damage from oil theft and spills from illegal refineries has degraded the health and the livelihoods of Delta inhabitants. The Movement for the Emancipation of the Niger Delta led a violent rebellion from 2006 that disrupted oil production, yet annual volumes never fell below the 2008 level of 2.1 mnb/d.
In August 2009, under Goodluck Jonathan – the first Nigerian president from the Delta – the government offered amnesty to the militants. Lucrative petroleum pipeline protection contracts appeased ex-militant leaders, creating a semblance of stability. This temporary arrangement enabled oil production to return to pre-insurgency levels. The government, however, failed to address the root causes of the insurgency – inadequate infrastructure, environmental pollution, local demands for a bigger share of oil economics and youth unemployment (recently estimated at 42%). Corruption, theft, political rivalries and poor leadership in a culture of impunity have stalled development plans and environmental restoration of the Delta.
Muhammadu Buhari, a retired major general, won the presidential election in 2015 on an anti-corruption platform. Buhari restructured the amnesty program, which used to cost $500 mn per year, and discontinued the security contracts with ex-militants. In 2016, a new militant group, the Niger Delta Avengers (NDA) launched sophisticated attacks upon onshore and offshore oil infrastructure. NDA demands control over most oil revenues, an impossible concession for the government. NDA vows to curtail all production, ignoring the government’s call for a cease-fire. Buhari deploying more military in the Delta and threatening an unmitigated crackdown risks increasing local dissent. The quandary for the administration is how to appease the Avengers without encouraging other groups to similar tactics.
Iraqi Infrastructure vs. Guerilla Insurgency
Unlike in Venezuela and Nigeria, Iraq’s oil production is up. The May 2016 output of 4.3 mnb/d (4.6% of global demand) was 31% higher than average 2014 level. Surprisingly, this growth coincided with rise of the Islamic State (IS) Caliphate along the Iraqi-Syrian border. In mid-2014, after the IS seized some Iraqi cities, fear of production losses helped push oil prices above $110/bbl. Today, the caliphate is shrinking under a U.S.-led coalition using a combination of air strikes plus training and outfitting local partners.
Upon closer inspection, oil infrastructure was probably safer due to the caliphate. It forced the militants to attend to domestic security and governance. When the IS harbored hopes of conquering Iraq, it made little sense to destroy productive infrastructure. However, with the caliphate falling, fighters will return to being guerillas. Attacks on infrastructure will likely rise in a bid to cripple the weak government (Exhibit 4).
Iraq, OPEC’s second-largest producer, has plans to reach 5.5-6 mn b/d by 2020. However, international oil companies that delivered recent growth may be tiring of Baghdad’s delayed payments. Oil majors received only $43 bn of payments from the oil ministry between 2009-2015 when $62 bn was due.
Other aspects of Iraqi stability are also at risk. In May, the Minister of Industry and Minerals disclosed that Iraq needs $65/bbl to balance budgets. The peshmerga forces of Iraqi Kurdistan have been leading the fight against the IS. However, disagreements with Baghdad on oil revenue share have left the regional government in the lurch. Growth of patronage networks and political infighting have frozen structural reforms, limiting investment flows and increasing discontent in this oil-rich region.
Geopolitical risk premium will return to oil, the most geopolitical of major commodities. Beyond the areas identified here, low oil prices are increasing producer instability in an increasingly multipolar world. Saudi Arabia, which has fought for market share against rivals Iran, seems to have reached its limits. Thus any supply disruption will eat into inventories. Prices will have to rise high enough curtail demand growth. In the meantime, we continue to identify undervalued oil producers best suited to survive the downturn and thrive in recovery.
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