The new and tighter financial regulation that has been introduced gradually since the banking crisis, such as Dodd frank and EMIR, is having the well-publicised consequence that US and European banks are withdrawing from providing market-making and financing services in the independent E&P and refining sectors. Independent oil companies (IOCs) are therefore seeing fewer competitors to provide them with hedging/financing services and are therefore paying more for these services.
The premiere league trading houses and major oil companies are apparently filling the gap left by the banks and continue to offer swaps and options in the 2-10 year forward period, to help the independents manage risk and raise finance. There has been little apparent change in the bid-offer spread in the 2-10 year forward oil curve, so who cares if the independents are paying a bit more?
There are three problems with this thinking:
- The independents are not paying a bit more for hedging/financing services; they are paying a lot more. We are not talking $1/bbl more, in some cases we are talking $5-10/bbl more. But this not a number that is attracting much publicity because a large proportion of it takes the form of opportunity cost, not a clearly visible line in the P&L account.
- The liquidity and prices we are seeing on the 2-10 year forward oil curve often represent non-arm’s length transactions. The non-arm’s length nature of the prices arises because the remaining market makers that are offering the over-the-counter (OTC) swaps, options and finance are often taking a share in the project they are financing or hedging, are tying up the output of the asset in long term contracts with considerable operational flexibility for themselves and often charge a high marketing fee on top. So whatever the forward oil curve prices transacted in the OTC market represent, they are not an arm’s length price between a willing seller and a willing buyer in international trade, which does not involve barter or swap arrangements and where price is the only consideration of the deal.
- The non-arm’s length prices in the OTC find their way onto the regulated exchanges because the service providers eventually lay off the easily-manageable proportion of this risk on the regulated exchanges. The unmanageable part of the risk they take on their own book or lay off by the physical and proprietary trading of oil in a manner that is now denied to the banks. That is why the banks have withdrawn from the field and why the traders and the majors can continue to play.
The IOCs are not up in arms about this because, so long as someone is providing finance and hedges, they have a project. Without the trading houses and majors they would have no project at all. In any event the actual opportunity cost, which they find difficult to quantify, is not reportable, so does not loom large in their thinking. Even if they could measure accurately the opportunity cost of giving away the operational flexibility that provides the traders and majors with a margin, they would not be in a position to exploit that flexibility themselves because trading is not their core business.
The biggest losers are the tax authorities/NOCs in Production Sharing Contract regimes, because if the trading flexibility given away to trading houses/major oil companies were to be valued accurately the prices and refining margins that are reported to them by the IOCs would be higher. The non-arm’s length nature of the eventual trade of cargoes between the IOCs and the traders/majors is not obvious because the oil sale or purchase contract is usually written as an arm’s length one. But the IOC does not get the hedging/financing services of the market maker if it does not sign the oil trading contract. Is that an arm’s length deal? I suspect not.
In general, no-one is doing anything wrong here. We are simply seeing market forces at work. If you suddenly remove a large swathe of service providers from the market, i.e. the banks, the price of that service goes up. In theory, the next development in a healthy market is that new service providers will be attracted to the high margins being made by the remaining service providers, i.e. the oil majors and the large trading houses. New competitors ought to enter the market and that would eventually relieve price pressure.
Of course it is not that simple. It takes more than deep pockets to be a market maker or service provider in the oil sector, although that is a fundamental prerequisite of taking part. It takes an ability to trade physical crude oil and refined products, often non-standard grades with difficult quality characteristics or in inaccessible locations, to manage the IOCs’ highly-tailored basis risks.
So where are the new competitors going to come from? Who knows? But here are some guesses:
- Second tier trading companies, such as Sempra and Mercuria, may well try to catch up with the trading “Royalty”, such as Glencore, Trafigura and Vitol. The purchase of JP Morgan’s trading book by Mercuria may be an indication that this is what it has in mind.
- It is unlikely we will see wholesale entry by national oil companies (NOCs) into financing IOCs’ projects in exchange for trading rights and marketing fees. It is just not in the nature of the beast, but it is not completely unheard of either. SOCAR of Azerbaijan appears to have ambitions in that direction, particularly in Africa.
- Unsurprisingly Chinese companies are beginning to make their mark by providing finance in exchange for access to barrels of crude or tonnes of product. Unipec is one example of this phenomenon.
- Non-US and non-European banks, such as Standard Bank and VTB, are still offering financing and risk management services. In my opinion this category of bank does not have the physical oil trading capability that is necessary to take on the trading houses or oil majors. They need to partner up with either a second tier trading house or one of the larger IOCs, who have the physical oil trading capability, but who may lack the finance to provide financial services. The IOCs that do have good balance sheets are likely to prefer to deploy their financing power in their own core business, rather than in offering financing or risk management services to potential competitors in the physical oil business. Nevertheless a partner with money would provide such IOCs with an opportunity to provide trading services to other E&Ps or refiners. Management may be more willing to grant authority to do this if it does not encroach on the borrowing base of the core company activities.
- A company to watch in this genre is Tullow. In my opinion, it is not in a position to take on the majors or trading houses in the oil trading arena, because it does not have the spread of physical producing assets or refineries into which problem cargoes can be aggregated or dumped and blended away. It also, arguably, does not have the corporate culture to even want to enter the race. But irrespective of whether it chooses to compete, on its own or with a partner providing a separate source of finance, it is at least unlikely to be a victim of the lack of competition in market-making services. This is because it has the capability to trade its own oil and manage its own risk, or those of its minority partners in the same fields, without having to go cap in hand to the oil majors or trading houses.
- Tullow’s acquisition of Nuon’s oil portfolio in 2011 was almost certainly done for reasons other than beefing up Tullow’s trading clout. But if a company with the financial profile to compete in providing financing and risk management services to the IOCs was to be looking for a partner to handle the physical trading aspect of laying off the risk, Tullow would certainly be on the list of companies with whom it might be worth having a conversation. Talisman and Maersk are other potential candidates on paper, but in practice management conservatism may get in the way.
- Other potential new entrants to more active market- making for finance/hedging purposes in the oil sector might be the well-capitalised utilities who are used to trading in related sectors, such as gas, coal and power, and who have some oil interests of their own. These are companies like Centrica, Eon, EDF, GDF, RWE etc. Surprisingly these companies have been ultra conservative when it comes to oil trading and oil risk management. So they may be more likely to sell their own oil portfolio or outsource their trading risk. This outsourcing might be to the second tier trading companies or non-major oil companies that may be looking to staff up to share in the hidden bonanza created by the departure of the banks from the sector. But the size of the prize that is emerging may be enough to make the utilities think again about what they can offer in the oil trading arena.
This situation is evolving rapidly and, as the extent of profits to be earned in providing financing and risk management services to IOCs emerges, the pace of change is likely to gather speed. In the meantime beware of the prices you see on the 2-10 year forward oil curve, either on regulated exchanges or in the OTC market. I do not know what those numbers represent, but they are almost certainly not arm’s length prices between willing buyers and willing sellers involving no consideration other than price.