Pessimistic Investors Bet on Service Companies

The present standoff in Ukraine is rapidly changing the cards on the investors' table. Elizabeth Mitchell, Independent Advisor and Analyst, told Natural Gas Europe that investors have a long memory and that they are quite pessimistic about gas in general. According to the co-author of "What Next for the Oil and Gas Industry", recent write-downs and political interference are high hurdles for energy firms. But in this grim context, service companies could emerge as unexpected winners.

You worked on the report “What Next for the Oil and Gas Industry” more than one year ago. Which have been the gas industry’s major developments in the last months from the investors’ point of view?

I think that, specifically on the gas side, it’s been interesting to see the loosening of the Gazprom’s monopoly and the rise of Novatek. We also start to see the loosening up of LNG. I think it is very interesting the relationship between what you might call domestic, regional gas and LNG. I see a number of developments on that basis, one of which is the loosening of the Russian export restrictions. It's a structural change.

Do you see any problems for investors who bet on Russia?

One problem from an investor point of view is you never feel quite comfortable with what Russia does, because they can turn around and reverse it; investors do not like political risk.

In this context, do you think that the rise of Novatek could increase investor confidence?

I think that if it is allowed to do its business without interference, yes. The longer, I think, Novatek is allowed to act in a rational business like fashion the more comfort it does provide. At the same time, investors have long memories and remember Yukos. Investors don’t like to see expropriation. They are always really worried with countries like Russia.

Apart from Russian developments, do you see other relevant changes in the last months?

The other major thing since we finished the report is what has been happening with the US gas. One thing that has been interesting with the US is that, although the gas price has ticked up quite strongly across the winter because it has been so very cold, the gas prices have remained relatively low. So a lot of producers, where they had the option, have switched towards liquids. So when we look at some of the most aggressive forecast for gas demand from the United States, there is the need of more gas supply. But, in order to have more gas supply, the gas producers need a better price. But then if the gas price goes up too much, the gas becomes less competitive. That is the first very interesting thing. So, as we look forward, we would like to see if this is the bottoming out, or if this is just a blip in the price, because it has been a very very cold winter or does this show a trend change of the US gas price? And if it is then we can see a bit more confidence among dry gas producers.

You were mentioning other aspects, what were you referring to?

The degree to which coal, which is no longer needed in the US because they have got gas, is displacing more expensive gas in Europe. So you see a ripple effect outwards. The final thing is related to LNG. As we started to see more LNG export terminals permitted and going forwards from the US, you are starting to see delays of some of the most expensive LNG projects throughout the word, mainly in Australia. We have seen big write-downs from BG.

So if the LNG is the new card on the table, does it translate into renewed optimism among investors?

I think that it is difficult to see investors very excited about gas in general. There are two reasons. One is that everybody expects lower gas prices, not just in the US. The bottom line is gas prices are liable to be lower. It is normal that, in a period of more abundant gas, we have seen a lot of write-downs. The second problem investors have with gas is the political interference, especially given the fact that gas is mainly used in power generation. Political interference relating specifically to climate change, which is the new and wide-reaching and not entirely predictable or rational type of political interference that we see in the industry now, is making gas generation a very difficult thing to invest in. And that links back to what gas demand can be. If we look at the UK, I have seen estimates suggesting that gas could be 40% of the mix, and others saying that it could be 0% of the mix. I think that this is very destabilizing for investors.

So you are saying that investors are more pessimistic than the industry participants?

I think that they are more pessimistic. Some investors in specific US companies may be more optimistic in the short term because the gas prices have gone up over the winter.  But now, after the winter, how much of that optimism can be sustained will depend on what the price starts going forward.

In this context, do you think that the new projects (South Stream, TAP, LNG terminal in Cyprus, pipeline from Israel to Palestine and Jordan) might restore this kind of confidence that markets lack at the moment?

What concerns me is that a lot of these projects are projects with a very long life span. They were designed at completely different gas prices. On the other hand, if they do a better job at moving gas around, they also do a better job at equilibrating prices toward the lower level, rather than enabling local anomalously high areas of pricing to remain.

Among those projects, which is the most rational from your perspective?

I suppose the South Stream. However, I would like to see a lot of numbers, which they don’t ever show you, to show that it is anything other a political decision.

Which is the one convincing you less?

I am not entirely convinced by the LNG terminal in Cyprus. I think that the most interesting is the pipeline through Israel, Palestine and Jordan. I mean, who knows? The management is very professional, but it is a green field. Good luck with that.

What are you saying now is that political interference is the main obstacle for investors to take part to small and large projects.

I think you have to divide political interference into two types. One is the regional or project-specific type, which has always existed and will always exist. The political interference, which I think is new and very all-encompassing, is relating to emission targets, carbon targets – anything climate change related. That is doing a number of things. One is that it is moving value out of the carbon-based energy space into the more general energy space, including renewables. And two it is shifting value away from energy provision to energy efficiency. That is new, that is the new big threat for investors to worry about. We just don’t have any idea. It is like the Internet, the Internet has changed everything, everyway, every business. I think that climate change will be like that.

In this sense, the companies that will pass untouched will be the service companies, as their work is less affected by political decisions. Am I right? Do you think that investors will increasingly pour money into service companies?

Possibly. Service companies had a very good long-run, especially Saipem did very well for years and years. And then in 2012 and 2013 they had a number of profit warnings to do with cost overruns in contracts. That caused the shares to perform very badly. However, given that the share prices are so much lower and given that they all have a pretty good backlog, I think that investors will increasingly be looking at them, because they do have fewer restrictions in that they can work with IOC, NOC and small companies. So, yes. I think that the service companies are increasingly interesting, particularly because they have just had a terrible year.

Could service companies have any role in paving the way to fracking in France?

Possibly. I think that in Europe, in general the industry needs to explain fracking more clearly to the general public, because they are running the risk of losing the argument in the same way the food industry lost the Genetically Modified Food argument. That is the risk factor in Europe.

Do you think that shale gas projects run the risk of budget overruns?

Every project runs the risk of budget overruns.

More or less than other projects?

I suspect less, in the sense that the projects that tend to go really widely over budget are very large projects in very hostile environments. My understanding of fracking is that each drilling is a smaller unit. There are more variable costs involved in fracking and more fixed costs involved in very large oil projects.

In a sense, you are saying that companies that could benefit from the situation are smaller companies.

Yes.

What about investors’ attention with respect to small and medium companies?

Investors in general like a clear story. And sometimes a medium-size company that does one thing can give you a better theme that you understand. I think that especially in a situation where there is a lot of change, you can do much better by finding a niche company that does something that others don’t do, or companies doing it better. It is hard for the very large companies to change.

 Sergio Matalucci