Market Overview - Lundin Petroleum

Whilst financial markets have recovered from the lows of 2009, the high levels of volatility currently being experienced shows that investors still lack confidence in the underlying principles of the recovery. This lack of confidence is due not only to the uncertainty around the pace of recovery and political instability, but the exposure of banks and investors to European debt, particularly in countries in risk of default such as Greece and Ireland.

The lending market showed a cautious recovery in 2010, although liquidity could tighten as banks are required to sustain higher levels of equity to support debt. European banks are taking a more long-term view to funding, accessing funding from the US market and fixing interest rates for long-term funds, attempting to avoid the reliance on short term funds which led to problems in the credit crunch of 2008.

The oil market continued to recover from the financial crisis, with prices moving past the USD100 per barrel mark in early 2011. Although part of this is due to short term disruption such as the unrest in the Middle East, the oil price has also undergone a sustained underlying increase post 9/11, driven by a narrowing gap between supply and demand for oil and oil products.

Demand dynamics
Demand for oil and gas products increased in 2010, past even 2007 levels, and is forecast to grow again in 2011.

This demand increase has mainly been sustained by increasing demand from developing economies such as China. An indication of this growth phenomenon is that from 2008-2009, when western economies underwent a demand decrease of more than five percent, China showed an increase in demand for oil of six percent.

In long-term demand to 2035, the International Energy Agency Statistics database shows an increase in forecast consumption in all geopolitical areas. However, of most significance is the projected doubling of consumption from 17 MMboepd (2007) to 32 MMboepd in 2035 in the Non-OECD Asia region. This large increase in consumption must be filled by supply from hydrocarbon or non conventional sources, despite the increasing difficulty in finding conventional reserves, and the cost of developing non conventional sources.

Supply dynamics
The supply of oil has increased from the economic crisis of 2008, but the underlying dynamic is uncertainty in the quantity and the type of supply. Short term supply can be heavily influenced by current political and economic events, but long-term supply is dependent on the oil price and long-term infrastructure investment.

Oil stocks
The ability to absorb short term supply shocks is dependent on the availability of inventory and stocks. OPEC stated in 2010 that they were withholding 5-6 MMboepd of production, which can be used to relieve supply constrictions and hold the oil price within the range of USD 70–90 per barrel. However, as can be seen by the recent Libyan crisis, this ability does not relieve the situation where refineries are geared towards processing a particular type of oil (Libyan sweet oil – OPEC produces mainly a sourer crude), and critically there are no indications of how long it would take to get this additional production onstream.

Long-term supply mix
Much attention has been paid to the introduction of gas as an alternative in power generation and heating, however the infrastructure for gas is distinctly different to oil. As a consequence the gas market is increasingly 'delinking', or separating from the oil market particularly in relation to price.

One of the reasons for this is a significant number of discoveries of gas now coming onstream and a development in pipeline and LNG infrastructure, particularly from countries such as Russia into Europe. This has led to an adequate level of gas for the current infrastructure and a drop in the price. At the same time, the oil price has not experienced a drop – oil is particularly important and not easily substitutable in transportation, and has not experienced the same level of reserves replacement and infrastructure development.

Replacing reserves
As reserves are less and less available in stable political areas with good economic terms, replacement of reserves can require development of more expensive assets in frontier areas (often with a high level of risk). Some alternatives to these frontier areas have been found through the advent of new technology which allows the development of alternative sources such as shale oil and gas, which has had notable success in the United States and has a growing focus in Europe.

Acquisition vs. Organic Growth
There are two main focuses for oil and gas companies trying to replace reserves or to increase their resource base. In high oil price regimes, the appetite for acquisitions tends to decrease as companies hesitate to pay high prices for assets and move towards organic growth as a methodology for reserve replacement – either through exploration drilling or reworking existing development assets.

A notable exception to this is the Chinese National Oil companies who appear strongly in the mergers and acquisitions market, where in 2010 they accounted for USD 26 billion of an estimated USD 183 billion of upstream deals, an 85 percent increase on the estimated figure of USD 14 billion in 2009 (Petroleum Economist/Woodmac). Chinese dominance in the M&A market is expected to increase in 2011 as the Chinese budget surplus continues to grow and the national oil companies seek to secure long-term supply.

Future growth
2010 has been an interesting year for petroleum companies, with a slowly recovering economy and short term political and economic events influencing a sharp increase in the oil price. The fundamentals of the oil markets remain the same however – there is an increasing disparity between increasing demand and the difficulty in replenishing long-term supply of oil and oil products, which will continue the upward pressure on the oil price.