The Effects of Global Recession The Effects of Global Recession and Credit Squeeze on the Oil & and Credit Squeeze on the Oil &

Gas Industry Gas Industry

OverviewOverview

• Special aspects of the economic and financial environment;

• Prognosis for oil and gas prices;

• Implications for commodity price volatility;

• Implications for investment and project evaluation

Current Status of the Economic and Current Status of the Economic and Financial EnvironmentFinancial Environment

• Deep freeze in the securitization markets: Issuance of asset-backed securities is down over 80% in the last year;

• Meltdown in the securitization market has effectively shut-down consumer debt options, leading to a sharp and possibly prolonged recession in the US and Europe;

• Corporate debt issue markets (including commercial paper ) severely affected following Lehmann’s bankruptcy --- only slow movement to life;

Current Status of the Economic and Current Status of the Economic and Financial EnvironmentFinancial Environment

• ‘Flight to Quality’: Effectively zero treasury yields imply very high borrowing costs for corporations (e.g., El Paso restructuring in December at 15% yield);

• Funding from institutions, such as pension funds and University endowments dried up because of drastic reductions in asset values;

• Even private equity investment shops only able to do all-equity investment deals;

Current Status of the Economic and Current Status of the Economic and Financial EnvironmentFinancial Environment

• Faced with frozen debt markets, corporations drawing down heavily on credit lines created during the boom: commercial and industrial loans grew at 25% annualized rate in last three months;

• But these loans stay on books, crowding out current and future lending to healthy new projects;

• Frozen securitization markets undermine any potential positive impact of “bailouts” for lending(new company loans down by 64% August-October)

Current Status of the Economic and Current Status of the Economic and Financial EnvironmentFinancial Environment

• Upshot: “Double Whammy’’

• US and European recession because debt-driven consumption engine of growth (for last three decades) is shut down;

• New external business financing is severely restricted: new investment-driven bank loans, longer-term debt issues and new equity financing are very costly ;

• Asian economies likely to recover faster than elsewhere (China and India, 6.5%+ growth rates)

Implications for Oil Prices: Demand Implications for Oil Prices: Demand FactorsFactors

• Dampened consumer demand because of prolonged recession in US and Europe;

• Historic high recent gasoline prices forced consumer behavior changes that are not immediately reversible;

• Economic recovery in Asia and Latin America may not lead to significant growth in automobile ownership because of strained consumer credit markets;

Implications for Oil Prices: Supply Implications for Oil Prices: Supply FactorsFactors

• Short-term oil inventory “overhang” due to increased production in response to high oil prices;

• National oil companies unlikely to pull-back production because of ambitious economic and political agendas;

• However, E&P hampered even in the boom period by scarcity of equipment and crowding out by national oil companies.

Implications for Oil PricesImplications for Oil Prices

• Benchmark case: competitive producers, predictable demand changes, and low production adjustment costs:

• Expected rate of growth of oil prices = risk-less rate of return (currently, Treasury YTM 0.05%);

• Reason: if prices rise at a lower rate, producers cut back production, restricting supply and raising prices (and vice-versa);

• Implies forward curve will exhibit weak backwardation at all times;

Implications for Oil PricesImplications for Oil Prices

• Demand uncertainty and real options imply rate of price growth higher than the riskless rate of return, but forward curve is still backwardated;

• But if there are high adjustment costs to demand shocks then the forward curve can be in contango;

• Costly to wind-down contracts when prices drop and national oil companies may not cut back --- adding to glut and sharpening drop in prices;

• Likely that the external financing squeeze will lag pickup in demand especially if it comes from Asia and Latin America (causes are very specific to US);

Implications for Natural Gas Prices Implications for Natural Gas Prices

• Direct demand somewhat less vulnerable to economic recession than oil (weather etc.);

• Recession will retard the growth of “clean energy” projects---shifts to gas-based power plants, CNG transportation systems;

• Demand projections will therefore have to be scaled back;

• Draw-downs from storage currently slower than expected;

Implications for Oil Price VolatilityImplications for Oil Price Volatility

• Suggestion that oil price sensitivity to the business cycle may be much higher in the current episode than has historically been the case;

• Therefore, expect much greater oil price volatility in the medium-run than is being predicted by forecast models calibrated on historical data;

• In particular, likely that we are entering an extended period of oil price surges and spikes.

• Why is price volatility important?

• There are substantial embedded or real options in the exploration and production process;

• The present value of these options depends critically on future oil and gas price volatility.

Importance of Price VolatilityImportance of Price Volatility

Negotiate AccessContractual Options

Wildcat Exploration Delay Option

Discovery DelineationAssessment

Information Development Option

Develop Field &Associated

Infrastructure

Production Sharing Option Investment Option to Reduce Development Costs

Produce Field Extendibility OptionsOptions for secondary/tertiaryDiscovery & Development

Shut-downDismantle &

Abandon

Contraction OptionAbandonment Option

Embedded Options and Price Embedded Options and Price Volatility: Examples Volatility: Examples

• Over-sizing the platform in a deep- sea exploration project:

• By investing more up-front, the company can choose a larger platform than is the industry practice for the expected reserve volume;

• Larger platform drastically reduces the marginal costs of additional drilling in case of exceptionally good field discovery;

Embedded Options and Price Embedded Options and Price Volatility: Examples Volatility: Examples

• This is an expansion option, because the company can decide later whether to go for additional drilling;

• Since the decision to invest in additional drilling will mostly depend on the future commodity price regimes, the value of this expansion option is driven by the upside of commodity prices, i.e., their volatility;

• Substantial investment flexibility options also exist at exploration and delineation stage

Implications for Strategy Implications for Strategy • Central message: Develop the ability to take advantage of price

surges or spikes;

• Pay special attention to projects with substantial embedded options or flexibility and invest up-front to reduce the marginal costs of supply responses later;

• Higher volatility in short- to medium-run suggests that the strategic NPV of medium-term projects may be higher than would be historically true at these levels of oil prices and at this stage in the business cycle;

• But NPV of longer-term projects with substantial embedded options will also be higher, and these projects may justify greater up-front investment to take advantage of the continued volatility

Price Volatility and Hurdle Rates Price Volatility and Hurdle Rates

Long-term volatility due to unexpected but permanent changes in demand and technology;

Short-term volatility due to cyclical demand fluctuations, temporary supply bottlenecks, OPEC adjustments etc.

With only permanent shocks, oil and gas prices would be random walks;

Short-term volatility makes oil and gas prices cyclical (or reverting to a mean);

Over-estimation of Discount Rates in Over-estimation of Discount Rates in Long-Term Projects Long-Term Projects

• Constant discount rate models assume that risk increases geometrically;

• That is, cash flow risks of E&P projects increase exponentially over time!

• However, permanent volatility shocks are unanticipated by definition and therefore can not be assumed to grow in any predictable way;

• Short-term volatility is largely self-correcting: cyclical changes, removal of supply bottlenecks, entry or exit of producers, etc.;

• Suggests discount rates for long-term E&P projects should be declining over time to the company cost of debt

Conclusions Conclusions • Oil and gas average or mean price levels likely to remain depressed relative to

recent levels in the next 18-24 months due to depressed demand and evaporation of “speculative” trading capital;

• But volatility likely to be significantly higher than in previous downturns due to supply constraints and this increase in volatility levels may be here for a long horizon;

• This, along with declining time-dependent discount rates, suggests that project cut backs should focus on very short-horizon projects (sparse embedded options and affected by the current downturn in prices);

• But focus should be on investing now to give greater flexibility and ability to take advantage of surges later;