Oil & Gas Overview

Queen’s Capital

Evan Burns, Senior Analyst

Kelvin Li, Analyst

Hans Shen, Junior Analyst

Stephen Peng, Junior Analyst

Queen’s Capital

Our mission here at Queen’s Capital is to increase the value of our portfolio of securities by outperforming various indexes on a risk-adjusted basis; to help students develop practical investment skills and test them in the markets; and to create superior access to career opportunities in the investment and financial industry.

Queen’s Capital achieves this by giving bi-weekly educational presentations, reports on industry news, and by managing a portfolio of equities with investor capital. Queen’s Capital currently manages an $80,000 diversified portfolio of American and Canadian equities focusing on several investment strategies including fundamental, technical and value investing.

Queen’s Capital creates initiatives to bring in speakers from an array of firms to educate students about the Capital Markets and investing. We regularly send out emails with opportunities that are not otherwise advertised on campus. These career-related activities in coordination with one another give Investment Club members a definite advantage in the investment management career search.

At Investment Club meetings, you will begin to see familiar faces – these are the people who share your interest and passion in investing. We coordinate regular mixers to help in getting to know one another. Eventually, you will notice that many of these faces will become friendships, which we aspire to have you carry on with you past your time here at Queen’s University.

Jehan GhandhyJehan Ghandhy

Queen’s Capital, Chair

02 04 08Message from the executive

Recent industry trends

Oil and gas basics

The upstream stage of oil and gas industry involves the exploration and production (E&P) of resources. The upstream sector includes the searching for potential underground or underwater crude oil and natural gas fields, drilling of exploratory wells, and subsequently drilling and operating the wells that recover and bring the crude oil and/or raw natural gas to the surface.

Rising Cost and Project Delays Reduced Demand for EU Oil SharesThe price of European stocks and stocks with exposure to Russia have underperformed the Stoxx600. This reflects the increased amount of time spent by firms looking for potential reserves, and thus increasing cost and cutting into firm profits. The increased amount of delays was due to a growing share of developments in regions that were difficult to explore, such as in offshore deep water. However, shares in integrated oil companies outperformed E&P companies after management raised dividends.

U.K. Shale and Iran Are Important Year-End Themes for Europe Oil • IGAS, Total May Seek to Expand in U.K. Shale at Licensing RoundU.K. is granting onshore share licensing, hoping to spur a widespread exploration effort hoping to accelerate the initiation of shale and gas production in Britain to rival increased productions from the U.S. Companies interested include GDF, Suez, Total, IGas Energy, and Cuadrilla Resources. • Total May be First to Resume in Iran If Sanctions LiftedOn the other hand, Iran has opened up itself to international oil companies and developments in BP’s reorganization of U.S. shale operations. E.U. sanctions against Iran may be lifted within months as talks on nuclear curbs on the country are under way. Total may be the first to enter and resume its construction of a 2 billion cubic feet per day Liquefied Natural Gas export facility. The facility will be fed from the world’s largest natural gas field, South Pars, jointly owned by Iran and Qatar. Long term themes include Europe’s quest to reduce reliance on Russian gas and firms cutting investment budgets.

Russia-Ukraine Row Shows Europe Needs to Diversify Energy Supply • EU Sanctions on Russia Set to Transform Energy SupplyCiting recent conflicts in Eastern Europe, Eastern European countries are looking to diversify sources and to increase storage capacity. However, this has been delayed due to a lack of funds. EU looks to diversify energy supplies via new pipelines, increased liquefied natural gas imports, a higher share of renewables and greater indigenous production via shale gas.

UPSTREAM

RECENT TRENDS

Education, Network, DevelopmentHowever, EU sanctions on Russia may hurt EU companies’ prospects of exploiting Russia’s resources. Hampering Russia’s oil and gas production may also raise oil prices and force the EU to diversify its sources of supply at a higher cost.

Bull Case: Sanctions to Cap Russia E&P Access Boost Oil Price 1. Barring Russian companies from access to the latest U.S. and EU E&P technology may reduce Russian oil exports and raise prices. Especially hurtful to older oil fields in Russia. 2. Forecasts reveal that additions to LNG fell by 34% due to many planned liquefaction plants never open because of their complexity and expense. Hopefully, the reduced supply with underpin the LNG price.

Bear Case: High Execution Risk Ensures LNG Supply Remains Tight 1. Sanctions against Russia risk restricting western companies’ access to the latest oil-field service technologies and other E&P projects being pursued. 2. The discovery of new European natural gas resources creates a bearish scenario for liquefied natural gas imports, while also representing a threat to the commercial viability of planned and existing EU re-gasification terminals.

Libya Return, Strong Dollar Ease EU Oil Price WoesEU oil companies are cushioned from the recent oil price decline due to most of their revenues being in dollars while a large part of costs are billed in local currencies. In addition, the return of Libyan oil is helping the region’s oil majors in terms of more output and lower feedstock supply costs from refineries.

OMV Production Rebounds, Augurs Well for Libya Oil ProducersOMV (an integrated international O&G company) recorded a rebound in O&G output in 3rd Quarter partly due to resumed oil production in Libya. OMV’S competitors also benefited from Libya.

Weakening Euro Eases 3Q Price Slump Scare for EU Oil CompaniesThe euro’s 7.5% depreciation vs the dollar during 3Q means Brent crude’s drop will have less of an impact on Total, Eni, Repsol, OMV and other oil companies reporting in the currency. While the Brent price fell more than 16% in dollar terms, the decline was only 9.4% in euro terms.

Russian Baltic, Black-Sea Crude Loading Extends Decline in 3QLoading schedules for two major Russian ports accelerated their decline in July and August, despite having started to drop two years ago.

MIDSTREAM

Overview

Midstream O&G describes one of the three major stages of oil and gas industry operations. Midstream activities include the processing, storing, transporting and marketing of oil, natural gas and natural gas liquids.

Midstream activities are commonly included as part of downstream operations for much of the oil and gas industry. The midstream and downstream activities take place after the initial produc-tion phase and through to the point of sale.

The midstream industry processes, stores, markets and transports commodities such as crude oil, natural gas, natural gas liquids (NGLs, mainly ethane, propane and butane) and sulphur. The midstream provides the vital link between often remote petroleum producing areas and the population centres where most consumers are located. In Canada, transmission pipeline com-panies are a major part of the midstream petroleum industry. Most of these companies are also based in Calgary, although their activities extend across the country, into the United States and sometimes abroad.

Recent High Profile Transactions

1. Kinder Morgan Consolidation

Kinder Morgan plans to combine its disparate partnerships into a single company that will enable the biggest pipeline operator in North America to continue growing.

The deal, for $44 billion in cash and stock and the assumption of $27 billion in debt, will be the biggest energy industry merger since Exxon bought Mobil in 1999, according to Bloomberg. Houston-based Kinder Morgan operates the largest pipeline and storage network in the U.S., with 80,000 miles of pipelines and 180 storage facilities.

The deal underscores the massive demand for oil and gas infrastructure, especially in the north-eastern U.S. Producers have tapped huge new oil and natural gas reserves in shale plays, yet they need pipelines that can transport surging oil and gas production from shale plays to refineries. Kinder, which has in the past favored acquisitions over new construction, will have more flexibility with its simplified corporate structure.

Kinder Morgan employs a Master Limited Partnership (MLP) Corporate structure, which allows the firm to pay taxes as it makes distributions to its unit holders, rather than paying taxes from its profit. In order to be legally classified as an MLP, the partnership must derive ~90% of its cash flows from real estate, natural resources and commodities.

Kinder Morgan Inc. Corporate Structure: El Paso Pipeline Partners, Kinder Morgan Management, Kinder Morgan Energy Partners

2. Western Sanctions on Russian Pipelines

In response to hostilities occurring along the Russian-Ukrainian Border, economic sanctions

imposed by the United States and its Allies have limited Russian oil pipelines ability to operate in the regions surrounding Russia’s western border. In response, Russian pipeline operators including, Gazprom and Transneft, have pushed to secure new business with their eastern neighbors, namely China.

Reuters recently reported that Western sanctions are expected to delay Transneft’s Zapolyarye-Purpe and Kuyumba-Taishet pipelines by two to three years. Further, Gazprom’s Nord Stream pipeline plan, which was being developed to deliver Russian gas to Britain, has been scrapped due to worsening relations between the two governments.

These sanctions, combined with suppressed oil prices are pushing Russia towards its second recession in five years. A recent statement by the Bank of Russia in Moscow further hinted at this possibility. Over the past three months, the Ruble has plunged 21% against a composite of its peers.

DOWNSTREAM

The downstream portion of oil and gas involves refining petroleum crude oil and the processing and purifying of natural gas. The products derived from oil and natural gas must also be marketed and it is the downstream portion’s responsibility to do so. Examples of products generated from refineries include gasoline or petrol, kerosene, jet fuel, diesel oil, heating oil, fuel oils, lubricants, waxes, asphalt, natural gas, and liquefied petro-leum. Hundreds of other petrochemicals may also be formed.

Dividend and Buybacks Strengthen Support for Refiner EquitiesThere is a common presence of free cash flow amongst refiner companies. This can be capitalized and used to increase or sustain dividend yields or potentially for purchasing share buybacks. This will strengthen support of refiner equities in the market. The increased volatility of the Brent Crude bench has caused shares to be affected. This is further enhanced by an increasing uncertainty of regulatory issues within the industry. Re-finer operations have been given stability due to increasing export opportunities. Potential markets in Europe and Latin America support this.

1st Quarter Leaders in Refining IndustryNorth American Mining and its marketing peer group is up 0.4% ytd. Refineries have been underperforming as energy peers have been up 15% ytd. The group’s total returns has been overall flat as Brent to World Texas Intermediate differentials have come closer. The two refineries that stood out since first quarter earnings are PBF Energy and Northern Tier. The only companies gaining positive returns of 1.74% and 1.16% respec-tively. All companies have outperformed the S&P within the last 3 months.

EV/EBITDA of Refiner Equities Below Average Signaling ValueEV/EBITDA is commonly the multiple used to value refiner equities. BI U.S. refining peer group’s 2014 EV/EBITDA multiple is trading at 5.6x. This is below the average and is rebounding from a low of 4.9x after crude differentials began to improve. This is signaling value in refineries. The S&P Energy Sector Index is trading 6.5x above its historical trading range at a 16% premium to refineries. The potential for future oil exports outside of the United States has caused excitement over refiner equities to lower due to the potential of less future domestic production.

Export Opportunities and Flexible Transportation Options are Positive Outlooks for RefineriesGrowth in exports for gasoline and distilled products is causing refineries to have a strengthened demand. This is further increased by the revival of domestic oil production and its increased demand. Emerging construction of rail allows companies to take advantage of greater flexibility. This leads to a potential decrease in transportation costs that can inevitably increase the bottom-line of North American refiner equities.

Crude Export Bans Could be liftedIn the United States it is illegal to export crude oil, but the tight shale oil being produced domestically does not match the capacity of the refiner-

ies. US refineries are better suited to process heavy crude. This light oil is not connected by infrastructure to refineries that can process this crude. Therefore there is a strong consideration to overturn the ban on exports to deal with this problem. The increased international trade of crude from lifting this ban will allow refineries to have greater capacity allocate their activity therefore resulting in more gasoline production.

INTEGRATED

Integrated Oil & Gas CompaniesIntegrated Oil & Gas Companies engage in all four functions of oil & gas business operations: extraction, production, refinement, and distribution. Due to huge capital requirements necessary to sustain multiple business parts, and difficulties involved in vertical chain management, integrated O&G companies happen to be the largest companies in the business. Exxon Mobil, Royal Dutch Shell plc, and BP plc are the world’s largest inte-grated O&G companies by barrels of production per day (b/d) while Suncor Energy is Canada’s largest integrated O&G company.

2014 Q3, Q4 Brent and Crude Oil DipWest Texas Intermediate crude, the U.S. benchmark, is trading down more than 19% this year while the European benchmark – Brent Crude – is down nearly 24%. This vertical decline amid an already volatile market is an unexpected economic stimulus for consumers, but the effect is far from positive for the integrated oil and gas companies. ConocoPhillips, the third largest integrated O&G company in the U.S., became the first supermajor to announce plans of scaling back drilling. The price drop of oil can be attributed to the resurgence of the U.S. dollar, slower economic growth in emerging countries, and decreased global regulation on oil produciton. Saudi Arabia, the world’s largest producer of oil – a capacity greater than 11.6 million bbl/d of total petroleum, announced that it had no plans on slowing down production to sustain price levels. Further-more, the U.S. is importing 35% less crude due to domestic hydrolic fracturing capabilities, a move which lowers global demand, and consequen-tially price.

Pruning Assets and Capex Reductions may Increase EarningsIn response to falling brent and crude oil prices, North American Integrated O&G companies such as Exxon Mobil have looked at reductions in capital expenditure to improve earnings and increase free cash flow. Integrated companies will increase profitability by pruning assets that have shown weak performance relative to extraction costs; and instead, focus on maximizing refinary margins as raw material costs are at a multi-year low. Companies such as Shell have also sold subsidiary units to smaller, more specialized peers and private equity funds to raise capital for dividends and share repurchases.

ANALYST TEAM

www.queenscapital.ca

Kelvin Li Evan BurnsKelvin Li Evan Burns

Hans Shen Stephen PengHans Shen Stephen Peng

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PUBLICATION LEAD COORDINATORJung-Yung J. Chang