Per the Big Boys – No Quick Rebound of Oil and Gas Prices on the Horizon

14 November 2016

In this blog entry we take a look at the recent financial results of two of the key players in Trinidad and Tobago’s oil and gas sector – BP and Royal Dutch Shell.

We consider their future plans in Trinidad and Tobago, the outlook for oil prices in the short to medium term, and we consider whether a further sustained period of lower prices might strengthen the Minister of Finance’s hand in his attempts to negotiate a fairer more equitable oil and gas regime.


A recap of the 2017 National Budget – the Minister lays down his marker in the sand 

On the 30th September 2016, the Minister of Finance delivered his budget for financial year 2017. The 2017 budget is predicated on an oil price of US$48 per barrel and a gas price of US$2.25 per MMBtu. At the time the budget was presented the Minister stated that these figures were below IMF forecasts, World Bank forecasts, and USEIA forecasts.

At the time of writing this remains the case. The IMF currently forecasts 2017 oil prices at US$50.64 per barrel, the World Bank at US$55 per barrel, and the USEIA at US$51 per barrel.

On the 1st November 2016 both BP – who own 70% of BP Trinidad and Tobago, and Royal Dutch Shell – who own all of BG’s assets in Trinidad through Centrica announced their third quarter results. Both BP and Royal Dutch Shell make up their accounts annually to 31st December annually and both agree with the IMF, World Bank, and USEIA. Oil prices are likely to remain flat for the rest of 2016 and 2017.


The official BP position on oil and gas prices 

BP had a difficult third quarter for 2016 with its underlying Replacement Cost Profit of US$930 million being 49% lower than the amount recorded for the same period in 2015 (for a definition of Replacement Cost Profit please see the technical section below).

BP’s position on oil prices remains unchanged from the position it stated in its second quarter results. While BP believe that the oil market has moved into “balance”, with the amount of oil being produced each day broadly equating to the amount consumed each day, there is little impetus for prices to increase because the level of inventories held remain at record levels and will take some time to reduce.

BP expect inventory levels to decline gradually in 2017 supported by a rise in demand and sustained weakness in supply from the non-OPEC countries. The pace and timing of that reduction is dependent on the outcome of the next OPEC meeting carded for the end of November and discussed in further detail below.

In response to questions BP’s Chief Financial Officer Mr. Brian Galvery stated that “we see some firming in prices next year but nothing significantly north of what we see now.”


The official Royal Dutch Shell position on oil and gas prices

 Royal Dutch Shell also had a difficult third quarter for 2016. Using different terminology, but essentially the same metrics (for a definition of Current Cost Supply of Earnings see below), Royal Dutch Shell’s Current Cost of Supply Earnings for the third quarter of 2016 amounted to US$2.8 billion representing an 8% fall over the corresponding period in 2015.

Royal Dutch Shell made no prediction as to the future levels for oil and gas prices but the Chief Financial Officer Mr. Simon Henry did state that “lower oil prices continue to be a significant challenge across the business, and the outlook remains uncertain.”


Getting a little technical – How BP and Royal Dutch Shell Calculate Profit

 For those readers wondering what Replacement Cost Profit (RCP) and Current Cost of Supplies (CCS) Profits are they are types of accounting conventions used in the oil and gas industry to measure profitability. Despite the difference in terminology used by BP and Royal Dutch Shell RCP and CCS are essentially the same.

As stated above BP uses a system called RCP and Royal Dutch Shell uses CCS Profit to calculate and report their profitability to shareholders.

When any company calculates its profit one of the calculations that company performs is the deduction of the cost of the goods they have sold from revenue. The result of this calculation is referred to as gross profit. For oil companies the value of the cost of goods sold can vary dramatically depending on how much the company paid for the item being sold.

In the oil industry, the value of cost of goods sold varies significantly due to market variations in the price of oil. An oil company’s profit is effectively driven by the value of its cost of goods sold.  For example, if BP acquired some oil reserves when the price was $100 a barrel and sold those reserves when the price had fallen to $40 a barrel, BP would under normal circumstances report a loss of $60 per barrel.

RCP and CCS addresses the problem of volatility in oil prices (coupled with potentially long stock holding periods) by allowing oil companies like BP to base their cost of goods sold on the current oil price rather than the price at the time the reserves being sold were acquired (often referred to as the historic cost). This means that oil companies report profitability based on how much it would cost to replace the oil it sells at current prices.


The consensus on oil prices

 Looking at the IMF, the World Bank, the USEIA, BP and Royal Dutch Shell, the consensus on oil prices is that they will remain flat throughout what little remains of 2016 and the whole of 2017. That consensus could change if a meaningful agreement to cut output is agreed at the next meeting of OPEC to be held in Vienna on the 30th November 2016. 


Will OPEC save the day

OPEC pledged at its September meeting in Algiers to cut production by as much as 2% but left the final decision on which countries within OPEC would trim output and by how much to the November meeting.

Prospects for a significant improvement in oil prices depends on OPEC being able to reach an agreement on which of its members are to cut output. At the time of writing this blog entry, four countries have requested exemption from the cuts. Those countries are Iran, Iraq, Libya, and Nigeria. Iran has stated that it wants to increase production until it reaches a total of 4.2 million barrels a day. Iraq is in a different position. It needs to increase production to generate sufficient levels of revenue to fund its continuing fight with the Islamic State. OPEC has agreed to exemptions for Iran, Libya, and Nigeria, but not Iraq.

Even if an agreement is reached there is no guarantee that Russia (as a non-OPEC producer) or another non-OPEC oil producer won’t increase output to pick up the shortfall, and certainly no guarantee that it or they might cut back production to bolster prices.

In these circumstances the Minister of Finance must be looking at the OPEC meeting with some trepidation hoping for a meaningful cut in supply.


Implications for future investment by Royal Dutch Shell and BP in Trinidad and Tobago

 When Royal Dutch Shell completed its US$50 billion acquisition of the BG Group it effectively created a huge footprint in Brazil. As the largest foreign oil company in the country, Brazil is now its focus.

Although not specifically identified it is fair to assume that Royal Dutch Shell’s Trinidad assets are up for sale because the BG Group had been trying to sell those assets for two years prior to the company’s acquisition by Royal Dutch Shell. This is of course speculation but it would be a logical move for Royal Dutch Shell to complete full exit from Trinidad.

Royal Dutch Shell stated in their investor presentation that they are using asset sales as an important element of their strategy to reshape the company. Up to 10% of Royal Dutch Shell’s oil and gas production is earmarked for sale including several country positions. Although not disclosed in nature 16 separate asset sales of a material nature are now in various stages of progression towards completion.

It is unlikely that Royal Dutch Shell see Trinidad as a key investment opportunity moving forward, although that of course may not be the position of any potential purchaser of Royal Dutch Shell’s Trinidad assets. Royal Dutch Shell plan to spend around $25 billion on capital investment in 2017, with little (if any at all) being earmarked for Trinidad and Tobago.

BP, with less attractive results than Royal Dutch Shell, also plan to curtail capital expenditure. BP expect capital expenditure to be between $15-$17 billion in 2017 representing a 30-40% drop from the level of capital investment recorded at the zenith of its operations in 2013 before oil prices crashed.

While Royal Dutch Shell is looking for the exit, BP remains committed to its investments in Trinidad and Tobago. BP Trinidad and Tobago (owned 70% by BP and 30% by Repsol) currently operates in 904,000 acres of the east coast of Trinidad using 13 offshore platforms and two onshore processing facilities.

BP is also making (or considering making) additional investments in Trinidad and Tobago. On the 29th July 2016, BP announced the successful sanctioning of the Trinidad Onshore Compression (TROC) project. The TROC project is designed to increase production from low-pressure wells in BP’s existing acreage in the Columbus Basin using an additional inlet compressor to be operated by Atlantic LNG at Atlantic’s plant in Point Fortin. The TROC project has the potential to deliver 200 million cubic feet of gas per day when it comes into operation during 2017.

In addition, BP Trinidad and Tobago expects to make an investment decision in the final quarter of 2016 on whether to develop its Angelin gas field situated 40 km off the east coast of Trinidad. There were no indications of BP’s intent in respect of the Angelin field in the third quarter results.


Implications for tax collection

In the mid-year review of the economy of Trinidad and Tobago presented by the Minister of Finance on the 8th April 2016, the Minister noted that the policy of the previous administration to significantly increase allowances for capital investment by oil companies would result in the major oil companies paying little or no tax in Trinidad during 2016.

In the national budget presented on the 30th September 2016 the Minister of Finance stated that the government’s current position was that a rebalancing of the oil and gas regime was needed as a matter of urgency. The government’s position can be summarised in two bullets:

  • While the government will seek to promote investments on projects with low profitability forecasts it is of the view that it must also seek to assure the public that the extraction of the nation’s natural resources always results in at least the payment of some minimum royalty.
  • If a project generates a surplus over the total costs of production, including any profit necessary for initial and continuing investment, the government should, under a set of revised rules, share substantially in the surplus generated.

To assist in the rebalancing of the oil and gas regime the government engaged the IMF to provide it with technical assistance. The IMF has delivered an initial report. This report recommends:

  • A moderate fixed rate royalty in the region of 10-12% to ensure a minimum income stream.
  • A cash-flow tax that will replace the existing Supplemental Petroleum Tax (seen as a disincentive to smaller producers especially when the oil price is close to $50 per barrel).
  • A reformed Petroleum Profits Tax (PPT), where the PPT rate is reduced and harmonised across projects and capital allowances granted are streamlined.

As at 30th September 2016 the IMF proposals were, per the Minister of Finance, being studied by the major oil and gas companies. At the time of writing this blog entry it is not known what the view of those companies is to the IMF’s suggested reforms. A further sustained period of low oil prices may strengthen the government and the Ministers position.


Closing thoughts – time to consider your investing strategies 

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