The price of oil has been a dominant theme for 2004, with WTI passing $55 per barrel. The sector is continuing to plan for huge capital expenditure outlays to ensure reserve replacement. Russia has grabbed many headlines and we believe this will continue to be a hotspot in the coming future. We will also comment on the growing LNG sector and the dynamics facing investors looking to finance this growth.

During 2004, energy bankers have been busy, with activity picking up from 2003. There have been some notable deals in M&A, capital markets, and lending parts of the business, and the outlook is favourable. Particularly, energy lending activities should remain robust.

High oil prices, massive capital expenditure budgets, portfolio re-alignment, and consolidation should provide banks with ample opportunities to continue to support the industry and provide a further dynamic to investment in the sector for the years to come.

Oil prices
Oil prices have dominated discussion in 2004, both within the industry and the media. Strong demand, which began to build in 2003, has caused a shift in global fundamentals that we expect to remain tight, barring an unforeseen global recession. OPEC responded by increasing its production by 2.6 millioin bbl/d, which has left little room for spare capacity and caused a degree of anxiety in the markets. With a backdrop of terrorism fears, concerns over supply disruptions were amplified and led to a record nominal WTI price of $55.17.

Strong demand, which began to build in 2003, has caused a shift in global fundamentals

Looking forward, we expect the current fundamentals to remain in place, albeit leading to a lower absolute oil price. The key assumption here is that the burden on OPEC will be alleviated by growing production from Russia and Africa. However, key risks remain such as Russian export capacity constraints, project delays and potentially higher decline rates from mature areas.

Capital expenditure
Looking forward, capital expenditure is likely to increase substantially as companies continue the push to replace reserves. This is being driven by Big Oil’s investment into “mega-projects” such as Karachaganak, Kashagan and the several Sakhalin projects, plus the move into mature fields by independents that are committed to adding value through enhanced recovery techniques.

We have also observed increasing inflationary pressures within the E&P sector, which is linked to the increasing capital expenditure levels. The market prices of capital goods are being increased as the spare capacity of suppliers becomes absorbed and rising steel prices have caused service companies to pass on inflated costs to the E&P sector. To the extent that E&P companies cannot mitigate these increasing costs through technology advances and supply chain management, capital expenditure budgets will need to be revised. It will also be interesting to see if continued weakness in the dollar puts further pressure on capital expenditure budgets.

However, these cost increases must be put in the perspective of the massive windfall gains that companies are currently enjoying from the oil price. Most companies have recorded substantial, if not record, increases in profit over 2003, which has forced the focus onto returning cash surpluses to shareholders. Many of the larger companies have used share buy backs as the preferred vehicle. We expect this trend to continue.

Russia
The other big theme for 2004, which we expect to continue into 2005, is the high level of activity in the energy sector in Russia. Gazprom announced its merger with Rosneft, Total acquired a 25 percent stake in gas company Novatek, and ConocoPhillips successfully acquired the 7.59 percent stake in Lukoil. However, the debate continues on how to participate in deals given the backdrop of the Yukos affair. Given the willingness of the Government to ease restrictions on foreign ownership in Gazprom, it appears that there is still support for foreign players in the market and that Yukos does not represent “just the beginning”.

Domestic consolidation will continue to provide opportunities, as international oil companies continue to focus on the strategic importance of Russia’s vast reserves. Although some may argue that the cost advantage of investing in Russia has diminished in recent years, Russia remains strategically important given the Middle East’s continued instability and reluctance of the NOCs to open up their reserves.

Oil companies continue to focus on the strategic importance of Russia’s vast reserves

From a financing perspective, the appetite for Russian names has carried on from 2003 on the back of sovereign upgrades and improved sentiment. Increasing debt capacity for Russian energy names was demonstrated through several notable deals. For example, Gazprom’s $1.25 billion, 7.5 year structured export notes were the first investment grade deal issued in Russia, and their $400 million issue was the first unsecured deal taken to the market since the Russian crisis in 1998. Rosneft launched two pre-export deals raising $1.2b, and TNK-BP also received strong interest for its 5 year, $600 million loan, with the size likely to be increased by up to an additional $400 million. We expect the trend towards lengthening tenors in the bond market to continue.

LNG
LNG continues to dominate the energy finance landscape. The EIA forecasts that gas consumption will overtake coal in the mid-way through this decade, driven by factors such as the increasing use of CCGTs in power generation. Upstream players with stranded gas reserves are evaluating how their reserves can deliver LNG to markets far away from the gas source. LNG is currently estimated at 6.5 percent of the global gas market and is expected to grow to 10 percent within the next few years. The Majors are all pursuing LNG projects, and as there is a natural barrier to entry in terms of high capital costs, they are set to deliver the bulk of this increased production.

LNG is currently estimated at 6.5 percent of the global gas market and is expected to grow to 10 percent within the next few years

LNG production and import facilities are often financed off balance sheet due to the high capital costs, multiple sponsors, and utility returns. LNG projects are increasingly accepted by lenders who witness proven technologies and have a good track record working with experienced well capitalised sponsors. Indeed, recent deals have been over-subscribed and generally well received by the bank market and export credit agencies.

However questions remain whether the strong growth could lead to an over-capacity position in the medium term, with pressures on the cost of gas delivered to the market. The emergence of a spot market for gas is also changing the landscape, albeit in a small way for the time being. The banking market also needs to adapt to these market changes. For example, we are likely to see more challenging structures, which reflect the mix of long-term contracts and short- and medium-term sales, combining some degree of price and counter-party mix.