Oil and Gas: Taking a Peek at the Pump Well

Oil & Gas
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Wednesday, January 13, 2021   /05:25 AM / By Proshare Research/ Header Image Credit: EcoGraphics

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"To change the current paradigm, the industry will need to dig deep and tap its proud history of bold structural moves, innovation, and safe and profitable operations in the toughest conditions. The winners will be those that use this crisis to boldly reposition their portfolios and transform their operating models. Companies that don't will restructure or inevitably atrophy.-  by Filipe Barbosa, Giorgio Bresciani, Pat Graham, Scott Nyquist, and Kassia Yanosek. McKinsey & Company 2020


The opinion of the McKinsey writers above underscores the need for Nigerian oil and gas companies to rub out the original chalk marks laying the perimeters of their businesses and redraw new outlines for their activities with an eye on the future rather than the past.


In their foray into new activities, oil and gas companies will need to build models that feed into the contemporary emphasis on environmental, social, and corporate governance (ESG) issues. The greener economic models would provide the basis for stronger, more resilient, and farsighted businesses of the future as communities insist on friendlier mining and drilling environments.


Yesterday's tomorrow is here today and so oil and gas (O&G) firms will need to prepare for the future now. This would mean the following:

  • Corporate visioning that integrates local communities into the business architecture of the firm in such a way that guarantees stable community relations and business solutions that create win-win outcomes for all parties. For example, in the upstream sector, local Nigerian oil companies may be required to support massive agricultural ventures that power Agro-allied processing factories that use gas as a critical energy input. Also, the ammonia and nitrate output of domestic refineries could supply fertilizer to local farmers and improve farm crop yields. The symbiosis between farming and oil drilling may create the platforms for establishing the basis for smart agrarian communities.
  • Strengthened corporate governance standards.  With tougher internal governance regimes, oil and gas companies would likely see higher operating efficiency with flatter profitability. As efficiency improves corporate top and bottom lines will get better. The chief problems here would be reworking the business architecture to take into account new priorities, upscaling worker competence and learning, unlearning, and relearning new skills. Processes and procedures may create better operational templates but execution will rest on new skills and mindsets. The oil and gas industry can be demanding with high skill requirements in narrow work bands. 
  • The downstream operational margin squeeze and upstream output uncertainty will continue well over the next decade. The margins on white oil retailing will whittle down in a slow burn decline (margins are less than 5% in the domestic Nigerian market) hence requiring business alliances including mergers and acquisitions (M&As) amongst large and perhaps marginal players as economies of scale become a critical factor in business survival. At the upstream end of the market, analysts see a 9% fall in global demand for oil in 2020 and a 7% rebound in 2021. Companies like Seplat and OandO in the local upstream business will likely see gross revenues slide a few notches.


Forecasts from the International Energy Agency (IEA), the Energy Information Administration (EIA) of the US Department of Energy, projects that a strong global supply response to a demand rebound would lead to sharp reductions in oil output. EIA estimates the current supply deficit (stock draw) is approximately 3.4m b/d, while oil inventories may be expected to normalize in July 2021 (see chart 1 below).


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Chart 1: Oil Market Supply; Waiting for A Reprieve

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Source: EIA, Bloomberg Finance LP


In the interim as the international oil market tries to rebalance itself, Nigerian upstream companies may still have to struggle with sales and profit margins. The major challenges to be faced by upstream local oil majors would be the slowdown of global economic growth on the back of the Coronavirus pandemic in Q4 2020 which may likely see a reduction in supply to the end of Q2 2021. Also, slow growth could see a drop in global oil demand with a subsequent fall in oil prices.


Analysts observe that Brent oil price tends to rise when demand exceeds non-OPEC supply which also drags up the price of Nigeria's Bonny light crude. The outlook for the market in Q4 2020 till Q2 2021 is that demand may not exceed non-OPEC supply anytime soon as China remains the world's principal buyer of oil and has already stocked up heavily on reserves when oil prices plunged below US$40 per barrel in 2020. Thereby enabling it to average down its cost of crude oil purchase over the next few quarters right into 2021 (see chart 2 below).


Chart 2: When Demand Growth Takes on Brent Oil Price

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Source: EIA, Bloomberg Finance LP, Renaissance Capital


  • Upstream businesses have seen revenues put under pressure as international oil market imbalances in April 2020 nudged prices downwards (Brent price dipped below US$ 20 per barrel) as Nigeria saw quick storage fill-ups and large discount requests on official selling price (OSP). Nigeria is believed to have offered steep discounts to offload inventories in Q2 and Q3 2020. Nigeria's sweet crude has often been sold at a premium to Brent but has tracked Brent in movement from 2012. The country's upstream majors have had a torrid time in 2020 as COVID-19-induced output and demand disruptions were worsened by Q2 2020 disagreements and market turf disputes between Russia and Saudi Arabia. Nigeria's Bonny light crude just under US$ 4 per barrel premium over Brent between 2012 and 2014 but this slumped to under US$1 per barrel between 2015 and 2017 before rising to US$3 per barrel in 2019 before tumbling to a massive discount of US$4 per barrel in 2020. October saw a noticeable recovery with a premium of slightly under US$1 per barrel (see chart 3 below).


Chart 3: Bonny Light Oil Pricing; Dated Brent Anchor, US$ per barrel

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Source: Bloomberg, NNPC


  • Midstream activities have been less uncertain as pipeline and transportation activities have been steady with no sharp domestic price changes. But the midstream market is not without challenges. Pipeline vandalization has majorly declined in the Niger Delta but fuel distribution is still fairly inefficient using surface road transportation by way of tankers. COVID-19 did not adversely affect the transportation of white products but the downturn in demand reduced the level of domestic consumption.  Furthermore, another midstream activity, storage, suffered problems of inadequate capacity as international sales volumes fell and inventories rose to lead to deep sale discounts. Not much will change in Q4 2020 and Q1 and Q2 2021.


The midstream segment of the oil business has been poorly managed. Domestic refineries have become moribund, oil tankers distressed with unsold crude cargo, and gas throughputs stumbling through falling futures market prices. The midstream market requires massive new investments in refineries (Dangote's 600.000 barrels per day mega plant will prove pivotal), pipelines, gas tankers, and gas processing plants.


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Illustration 1: Nigeria's Missing Midstream O&G Business

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  • The downstream industry has in recent times been very lucrative as subsidy payments, nebulous import accounting, and dodgy foreign exchange translation arbitrage more than compensated for the low fixed margins on white oil products, especially premium motor spirit (PMS). With the removal of subsidies and the depreciation of the exchange value of the naira, the distributors of white oil products have found the sale of petrol, diesel, and kerosene significantly less profitable than in the past. This, in part, explains why the Nigerian National Petroleum Corporation (NNPC) remains a monopoly importer of refined oil products. Given the moribund state of all local refineries, the NNPC has become the principal supplier of refined petroleum products with downstream operators serving as distributional channels operating on agreed off-take margins.


The downstream market structure yields very modest commercial economic value with operators barely able to scrape up operating margins of 5%. The government-influenced industry pricing arrangement when adjusted for costs leaves operators with wafer-thin margins that barely cover initial capital outlays beyond the regular operating cash flows that emanate from the business. This explains why most retail pumps are intermittently "tweaked" to provide wider margins per liter sold. Even with the underhand pump meter adjustments margins remain uninspiring. So why do companies stay in the business?


Behavioral economists suggest that individuals and corporations dread the consequences of loss more than they take joy in success, therefore, companies that have invested heavily in the downstream oil and gas (O&G) sector behave very similar to a gambler; they believe that their immediate business losses are only temporary and therefore, on the balance of probabilities, operating success is primed to appear around the corner. Of course, most often than not they are wrong (see O&G ecosystem below).


Illustration 2: Oil & Gas Sector: An Ecosystem Under Pressure

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Most companies in the O&G downstream business simply want to find a way back from their sub-optimal business margins to recover earlier capital outlays and perhaps pay off bank borrowings. The average fuel station requires a maximum of two days of the sale of 33,000 liters of PMS to breakeven, anything longer than this tilts the fuel purchase and sale into an operating loss. The cost-of-carry wipes away already thin margins.

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The Banking Connection 

The tough nature of the oil and gas business in Nigeria has required companies to rely heavily on short-term credit offered by local deposit money banks (DMBs). Tier 1 banks have about a fifth of their credit exposures locked in O&G related transactions.


Of course, this has led to some problems for financial groups such as the FBNH group which saw non-performing loans (NPLs) rise steadily in 2016 as the international economy slowed and the oil and gas sector felt the pinch.  In 2018 the trend reversed as a recovery from the 2016/2017 recession started to kick in. The sectoral concentration of bank loans to the O&G and Power sectors by financial groups such as FBNH was a gambit that threatened the group's fiscal stability when oil prices dipped in the year and COVID-19 increased the inventory period of downstream operators.


Some other tier 1 banks saw similar large O&G exposures disrupting the quality of their loan books in 2018, 2019, and H1 2020 with potentially high non-performing loans (NPLs).


Banks continue to lend to O&Gs because of their large intraday cashflows (in the case of downstream companies), sizable foreign currency inflows (in the case of up and midstream companies) and huge capital outlays. The O&G business is a drug most big banks find difficult to resist, including the most catholic.


The problem with the O&G business relying heavily on the domestic money rather than the capital market is that there is usually an evergreen mismatch between project duration and the possible lending horizon. If uncertainty and policy disruption is built into the financing model, then the recipe for chaos has been truly formulated. O&Gs should only rely on bank loans to cover short-dated working capital requirements and not long-term strategic growth plans. A reason for the relatively high incidence of NPLs relative to the total banking industry average has been the structure of oil sector financing.


True, falling oil and gas prices have taken a toll on revenues of upstream and midstream operators but their vulnerability to global market price and volume movements has been made worse by their high short-term debt-to-equity ratios. High short-term debt-to-equity numbers indicate a relatively high debt service ratio and a weaker ability of O&G companies to increasingly meet debt obligations sustainably.


The oil and gas business has typically seen a chiseling down of margins, high and rising capital outlays, and large and recurring cash flows; the character of the O&G business means that optimal financing positions require a careful mix of long and short-term funding. The uncertainty of the fiscal terms built into the industry's recent financing structure has made certain activities such as onshore exploration unattractive and offshore mining less appealing. The Petroleum Industry Bill (PIB) tries to address these problems but leaves yawning funding gaps. Indeed, dwindling prices and thinning margins continue to plague the business and discourage fresh capital inflows.


O&G: Moving the Needle Forward


To improve the O&G sector analysts have called for the adoption of a few initiatives:

  • The fiscal terms of the industry must be improved to make the sector more attractive and encourage a larger inflow of private investment.
  • Deepwater operations account for about 40% of Nigeria's oil production and many of the country's projects are within the "1993" PSCs and PSAs that expire in 2023-28. Oil majors are reluctant to invest more money in deep offshore exploration contracts, given prevailing fiscal uncertainty. The introduction of royalties to PSCs in 2019 worsened potential private sector investment returns and has thereby discouraged further investments in Nigeria's deep waters.  Experts have argued the need for a revision of the fiscal terms to reduce costs and improve operating margins. Renaissance Capital, an investment banking group, recently noted that it carried out modeling of the onshore oil operations of the country under different fiscal terms and observed that "...Nigerian onshore fiscal terms are some of the least attractive, with deepwater PSCs being more attractive." Oil economists have also noted that the sector's reconciliation losses and tariffs have driven down economic value. To make the sector more attractive for capital investments the fiscal authorities may need to cut down on taxes and royalties (see chart 4 below). 


Chart 4: O&G: A Comparative Look at Taxes, Royalties, and Depreciation

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Source: Renaissance Capital


  • The poor Q3 2020 result of Seplat Petroleum Development Company (SPDC) highlights the challenges of the upstream operations of local oil majors.  The company posted a loss of N33.7bn which rode on a -10.7% year-on-year (Y-o-Y) decline in gross revenues from N152bn in Q3 2019 to N136bn in Q3 2020. The company's net assets, however, grew by 15.5% from N554bn in Q3 2019 to N640bn in Q3 2020.  Visit Seplat Petroleum Development Company Plc IR Page in Proshare MARKETS.


Seplat's fortunes reflect the difficulties of turning a profit in a global market that has been squeezed by supply gluts and demand downturns. The situation has been worsened by a global health pandemic that could reduce global energy demands and create a fresh market imbalance in 2021 and beyond.


To worsen matters economists at McKinsey Global, recently noted that "the rise of shale made it more challenging for OPEC to maintain market share and price discipline. While OPEC cut oil and natural gas liquids production by 5.2m barrels per day (BPD) since 2016, shale added 7.7m BPD over this timeframe, taking share and limiting price increases. When the industry no longer needs a decade to find and develop new resources but can turn on ample supply in a matter of months, it will be hard to repeat the run-up in prices of 2000-2014."


The new market realities suggest that Nigeria's oil majors may have to wait a while longer before they start to see sustainable improvement in their fortunes. The folks at McKinsey observed that "Historically, price wars wipe out poor performers and lead to consolidation. But the capital markets were generous with the oil industry in 2009-2010 and again in 2014-2016. Many investors focused on volume growth funded by debt, rather than operating cash flows and capital discipline, in the belief that prices would continue to rise and an implied "OPEC put" set a floor. It hasn't worked out that way".


O&G companies in Nigeria may have two revisit their business models and reimagine their future. The global oil market and the rising cost of production in Nigeria will lay siege to operating profitability, thereby requiring companies in the business to step into new territories such as residential, automobile, and industrial piped gas, alternative power production such as wind, solar, and perhaps blue energy which takes power from the boundaries that separate seas from oceans.


The new realities of a shifting and uncertain global market for fossil fuel will call for greater mindfulness of a future without or with minimal carbon-based energy. 


The Gas Gambit 

With oil set to tumble and perhaps slide permanently over the next decade, the lowest hanging fruit alternative as a foreign exchange earner is gas. Indeed, Nigeria is more of a gas than an oil belt with 187trn cubic feet (Tcf) of proven reserves as of 2017. This represents 3% of the world's total gas reserves of 6,923Tcf. Nigeria's gas reserves are 306 times its annual consumption providing ample headroom for increased domestic consumption and export.


Nigeria has one of the lowest global net electricity generation capacity per capita, leading to, by some estimates, 20,000 MW of off-grid diesel-generated power, costing a few billion dollars of imported generator fuel annually. Increased gas production will be crucial to Nigeria's prosperity as it may reduce FX outflows and upscale domestic household electricity consumption.


Both the upstream and downstream gas sector have difficulties that need to be overcome if the sector is to drive economywide growth and development. The upstream challenges of supply can be more easily handled than the circular debt problems and infrastructural challenges of midstream operations. Part of the domestic problems relates to below cost recovery pricing that makes the domestic supply of gas inefficient and untenable as a business proposition. Gas price is as volatile as oil price and forward contracts to a certain extent temper down the variability of gas contract terms, but demand and supply factors are just as finicky as an oil market (see chart 5 below).


Chart 5: The Bumpy Gas Ride; International Gas Price Movement 2016-2020

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Source: NASDAQ


An upward review of the supply price would lead to a rise in domestic quantities and engineer an improvement in industry economics. With the local price of gas trading lower than its international equivalent, the opportunity cost of investing in domestic gas operations, especially upstream would be high.


In other words, to draw a higher supply of gas to the domestic retail market, retail gas prices must rise. This would choke off demand in the short-run but it would also increase supply, creating a more sustainable market equilibrium (see illustration 3 below).

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Illustration 3: Getting the Market to Speak

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Downloadable Version of Oil and Gas: Working the New Normal in the Time of a Pandemic Report (PDF)

1.    Full ReportOil and Gas: Working the New Normal in the Time of a Pandemic - Jan 11, 2021

2. Executive Summary: Oil and Gas: Working the New Normal in the Time of a Pandemic  - Jan 11, 2021

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