On Friday 26th 5.00 PM London time, at the closing bell for European stocks, Brent was trading over $36 per barrel and WTI was over $33.50. Oil registered the biggest weekly gain since August amid signs of strengthening U.S. fuel demand and speculation that some producers will complete an agreement to freeze output. Nonetheless, Crude is still down about 11 percent this year on concerns that a worldwide surplus will be prolonged because of rising U.S. stockpiles, which have reached to the highest level in more than eight decades. Iran has pledged to increase shipments by as much as 1 million barrels a day after sanctions were lifted last month.

Few hours later, the “closing bell” of the CERA Week 2016 rang. CERA Week is an annual energy conference organized by the information and insights Company IHS in Houston, Texas. The conference provides a platform for discussion on a range of energy-related topics. This year more than any other before in the recent ones, all the media and traders were watching closely this meeting to find some insights from the main speakers, among the others Ali al-Naimi, Saudi Arabia’s influential oil minister.

But first of all let’s have a brief recap of what happened in the first two months of 2016 in the oil industry. The main fact is for sure the OPEC’s oil freeze agreement between Russia and Saudi Arabia. Talks between major oil producers about freezing output show how painful cheap crude has become, but it is not likely to bring an end to the world oil glut anytime soon. The accord reached on Feb. 16 in the Qatari capital marks the first sign of cooperation between OPEC and non-members, that Saudi Arabia has said is necessary before it agrees to curb production.

The problem with using a production freeze as the bedrock for deeper cooperation is that none of the parties involved have to make any effort to comply. In addition to this, the production freeze has been set at the highest level of oil production ever, therefore it does not help in solving the problem of an oversupplied market. Furthermore, in the next few months we are going to see the come back on the international market of countries like Iran and Iraq, that don’t seem to be intentioned to cut their production levels.

For what concerns the deal reached between Russia and Saudi Arabia, the view of Goldman Sachs seems pretty clear. “Freezing production does not really change our view on Russia supply for this year,” said Jeff Currie, Goldman Sachs’ New York-based head of commodities research. In fact, the nation’s output wouldn’t have grown any further after it reached 10.84 million barrels a day last month, the bank estimates.

Saudi Arabia on the other hand already boosted output by about 500,000 barrels a day in the past year to near-record levels of more than 10 million barrels a day. While the Middle Eastern country has at least 1 million barrels a day of spare capacity, it probably doesn’t intend to tap the reserve.

The effectiveness of this deal faces an imminent test. Even if oil production remains frozen at January levels, there’s no shortage of other factors putting pressure on prices. Seasonal demand typically peaks in February and keeps falling until May. Crude stockpiles in the U.S. are the highest in more than 80 years and are still rising, according to Energy Information Administration data.

For what concerns the CERA Week, the words of Naimi, Saudi Arabia’s oil minister, have been rough and unexpected. He told the executives in Houston that Saudi Arabia believed that freezing oil production, as it agreed with Russia, would be enough to eventually balance the market. Over time, high-cost producers will get out of the business, and rising demand will slowly eat up the oversupply, according to Naimi’s view. In addition, he underlined that freezing  output doesn’t mean in any way cutting it, adding later that Saudi Arabia won’t cut production because it doesn’t trust other countries to join.

The direction of oil prices matters greatly outside energy hubs such as Houston. Oil influences inflation and lately it seems to have guided equity markets. Stanley Fischer, vice-chair of the Federal Reserve, told the conference the price of oil has become a macroeconomic issue. Three factors are critical to any recovery: one would be a reversal in the accumulation of stocks that total more than 3bn barrels in western countries alone, according to the International Energy Agency. Another factor is the pace of demand growth; IEA forecasts world consumption will expand by about 1 per cent a year, reaching 100m b/d for the first time in 2019 or 2020. According to many chief executives at the Conference in Huston, it is clear that the days of oil above $120 were an “anomaly”, but $30 or $40 days won’t last long because strapped oil companies would soon fail to meet demand. The third factor, supply, is one over which oil producers have the most control. Mr Naimi made clear Saudi Arabia, the world’s biggest exporter, would not cut production and could “coexist” with $20 crude. That would necessitate supply cuts from higher-cost producers as they conserve cash to survive. With oil refineries in a seasonal slowdown, crude stocks could swell further and push prices even lower in the near future, according to the US Energy Information Administration.

How is the Oil & Gas industry reacting to the deep fall of oil prices?

Most of the oil majors, active both in upstream and downstream operations, recently released their fourth quarter or full year results. All these results are characterized by important losses both for European and US based companies, and most of the times these losses have been worse than expected if compared to general analysts’ consensus.

Just to briefly mention some numbers: the Board of Directors of Repsol, the Madrid based oil company, decided on Thursday to cut the dividend from €0.5 per share to €0.3 per share, after reporting a full year net loss for 2015 of €1.23bn.

In US, one of the most important players of the market, ConocoPhilips, took the same decision few weeks ago, cutting its dividend after reporting a fourth quarter net loss of $3.5bn compared to a $39mln one year earlier.

Other companies, such as BP and Chevron, are still trying to pay the dividend as they see it as a priority. These companies also declared they would be ready to ask for additional borrowings if needed, in order to reward their shareholders. This is a risky way to pay dividends, in fact, increasing the amount of debt in such an environment could really bring too much pressure on the balance sheet, compromising future performances.

On the other hand, it is also important to consider that there are no investments with positive NPV available given the actual level of oil prices, so paying out dividends may eventually end up being a controversial but good choice.

We would now like to move our focus on why the oil-related companies are reporting worse that expected losses.

The first reason is of course directly related to low oil prices: revenues ceteris paribus go down and so does the cash flow generation. But this is not the only reason.

The second reason is that the fall in prices came very fast, and these companies didn’t have the chance to cut at the same pace costs and investments, weakening their financial results.

The third reason has to be found in write-downs. The book value of the assets of these companies, in light of current oil prices, cannot be justified, and this must be reflected in the income statement as a loss. To quantify the entity of this phenomenon, it is sufficient to consider that the amount of write-downs made by oil & gas companies during 2015 has been higher than the overall write-downs during the entire history of this industry.1

The goal for oil companies, and for all the related counterparties such as oil services providers, is to find a way to be profitable even with oil traded within the $30-$40 range.

Even if this seems not to be an issue for Saudi Arabia, Iran, and other countries with very low break-even points, it is crucial for a big share of the producers in the market with break-evens well above $40 per barrel.

The only way these companies can manage to be profitable is through restructuring plans, which are mainly focused on reducing operating expenses and cutting expensive investments.

Following the reduction of operating expenses we are currently observing various job cuts and few drilling machines still working where extracting Oil is very expensive (e.g. North sea).

Due to the the cut of investments, instead, we are seeing a lot of projects being stopped or rescheduled and several orders for drilling machines cancelled, in order to get back to profitability in a lower and longer environment of low oil prices.

It still remains difficult to say whether these moves will be enough or the entire business model of the industry will have to change in the near future.

How is the global economy reacting to falling oil prices?

The impact of the persistent fall in oil prices has started not to be limited to the industry but, especially for highly exposed countries, it has affected also Central Banks balance sheets and citizens themselves.

Saudi Arabia, for which oil accounts for about 90% of its government revenues, ran a deficit of $98 billions in 2015 and has taken measures to drastically cut spending in key areas and increase revenues from other sources: education financing of Saudi Arabian students abroad will be cut by about 15%, subsidies on gasoline, electricity and water have been partially lifted thus leading to an increase in their own domestic prices, infrastructure and real estate projects have been frozen and more taxes are expected to come.

This inherently has an impact not only on the economic structure of Saudi Arabia, leading to a dramatic change on its forms of financing, but also on the equilibria governing a society whose inequality claims were on one hand smoothed by generous cash handouts and on the other hand reinforced by attractive tax relieves for magnates deciding to invest or settle down in the country; consequently oil price will force Saudi Arabia to reconsider the structure of its economy but also of his social tissue.

No less important is the impact of oil and more in general of commodities on countries in the African continent.

Most states in Subsaharan Africa are highly commodity dependent, meaning that imports or exports of minerals, metals or oil equal to a high percentage of their own GDP.

Angola and Nigeria are both oil exporters, Kenya is an oil importer, minerals (95% of which is gold) represent an important share of Ghana’s exports and finally Zambia is highly dependent on copper.

Among them, in the last year, the only winner has been Kenya, which on the back of lower oil prices has been able to dramatically reduce its current account deficit and obtain a quarterly budget surplus matched by positive expectations about economic growth.

However interesting trading opportunities arise when assessing the risk and return of these African currencies; independently from the size of their exposure to commodity prices, we can see here applied two different approaches to the FX market from the central Banks.

On one hand we have Ghana and Zambia that opted for a passive stance thus experiencing high levels of annualized volatility and obviously a negative return, on the other hand instead we find Kenya, Nigeria and Angola that adopted instead an interventionist policy.

The central banks active interventions were able to reduce the volatility of the currencies but at the expenses of FX reserves: since the end of 2013 Nigerian FX reserves shrank by 15 billion of dollars, while Angola’s by 10 billions.

Furthermore, in cases like Nigeria, where a black market rate exists, the FX regime is becoming increasingly similar to that of Venezuela, where the parallel exchange rate increasingly diverges from the official one. Last week the Naira parallel exchange rate touched an all-time low of 400N/$ leading to a difference of about 200N with the official exchange rate, while the CBN targets a 3N difference, thus suggesting that CBN might be forced soon to further depreciate its own currency if not to abandon its currency peg and opt for a fluctuating exchange rate regime as suggested by the IMF.

Consequently, even if Kenya, Nigeria and Angola show low levels of annualized volatility with respect to Ghana and Zambia, investors should be wary of “jump risks” of these currencies; in particular, when possible, looking at the historical and target levels of divergence with the parallel rates it would be possible to predict the size and timing of additional FX adjustments.

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