Do weak oil prices spell doom for Uganda's Oil?

By Jimmy Senteza (PhD)

Recent developments in global oil production continue have cast a dark cloud over the prospects and anticipated opportunity of Uganda’s oil sector. Brent crude oil the global benchmark slid to $48.56 a barrel (August 7) from a high of over $111 in June 2014, a decline of over 55%. Supply pressures continue unabated.

A determined OPEC cartel pumping 31 million barrels per day (mb/d) as well as the resilient production by US shale oil producers who have contained production costs much swifter than expected have resulted in what is now coined a global oversupply. Investment Banker Goldman Sachs puts the global oversupply at 2 mb/d, up from 1.8 mb/d during the first half of 2015. It warns that the impending crude oil storage shortages could push the price down further. Moreover, the potential lifting of sanctions on Iran could see another 0.5m to 1m barrels of oil on the market within a year “spelling a fresh oil glut”.

The consumption/demand picture is no better. US shale production has tampered much of the demand from the world’s largest crude oil consumer, and the anticipated growth of the world’s second largest oil consumer China, which was expected to generate additional demand, has been mooted as evident in its recent financial market turmoil. The US and China consume about 32% of global oil combined. On the back of this retreat, the International Energy Agency (IEA) forecast that global oil demand growth would slow to 1.2 mb/d in 2016, from around 1.4 mb/d this year. It is under this cloud of the global oil demand and supply games that our nation is finalizing the terms of the exploration, development, production of oil, the newfound national treasure.

true

Table 1: The five largest oil producers supply 46% while the five largest consumers demand 44% of the global crude oil. Given the star-studded status of China, Russia, and the US, a lot hinges on the dynamics of oil supply and demand by these  three nations. It is thus not surprising that OPEC has pushed its supplies above the 30 mb/d threshold in response to US shale production.

Uganda is one of handful sub-Saharan African nations for which recent discoveries of oil have been widely perceived to reign in the much needed economic prosperity. Indeed oil related disputes enabled Uganda to receive a capital gains tax settlement of $108m from Tullow PLC during the first half of 2015, an amount approximately equal to 10% of its exports over the same period. Three development and production companies; France’s Total SA., China’s CNOOC group and the London based Tullow PLC, will jointly develop the approximately 2.5 billion barrels of oil in the Albertine region. Further, following the recommendation of the 2010 Foster Wheeler feasibility report, the Government of Uganda recently committed to building a 60,000 bpd refinery, with the contract to build Uganda’s $2.5bn oil refinery and construct a 205 kilometer (127 mile) pipeline to Kenya’s coast won by the controversial RT Global Resources. With these measures in place, production is expected to commence in 2018 (Bloomberg & Reuters).

A scrutiny of the most recent reports and presentations of the three selected production companies underscores the strains resulting from the ongoing oil glut and dwindling global prices. All three have experienced significant declines in sales revenue to the tune of 30% since 2014 most especially from upstream (exploration to production) operations. Tullow PLC continues to report net losses. Further, all commit to cutting or have cut capital and operational expenditures in response to these uncertain times to the extent that some have imposed exploration caps. For instance Tullow PLC cut its 2015 exploration budget to $200m, 80% lower than its 2014 expenditure.


true

Table 2: Ten countries including two from Africa own the largest portion of proven global crude oil reserves (85%). Uganda’s proven reserves are barely one-fifth of a percent of the world proven crude oil reserves. The OPEC consortium controls 75%.

Total SA explicitly lists responses to mitigate losses. First, are two capital expenditure responses: the reduction in Greenfield investments (investments occurring when multinational corporations enter into developing countries to build new factories), and the cutting marginal brownfield spending (brownfield occurs when a company or government entity purchases or leases existing production facilities to launch a new production activity). Secondly, Total S.A. plans to cut operating expenditures two ways: first by doubling operating expenditure cuts through reducing staff and cutting logistics expenses. And second, by taking advantage of market conditions to renegotiate contracts, service costs, etc. It is not unlikely that there may be delays in our oil production as these firms try to reel the GOU back to the negotiating table to review the production sharing agreements (PSAs) and licensing contracts if not for anything else. Even recent efforts to grant production companies tax holidays may not stem their push to want to recoup investment costs sooner rather than later especially if such costs are to be derived from the balance of profits left over after royalties are awarded to government.

Moreover, Uganda’s position on this table is also undermined by one other challenge: the cost effectiveness of producing its oil. In a recent report by PricewaterhouseCoopers (PwC), Africa has one of the highest average finding costs in the world at $35.01 per barrel in 2009, lower only to the US’s offshore fields at $45.51 per barrel. Uganda’s oilfields are considered offshore and so the $35.01 per barrel is likely conservative. Further, Uganda’s oil is reported to be waxy. Regular paraffinic or waxy crudes are problematic, “and the major complex systems problems related to the production, processing, and transportation of these medium-gravity fluids is not just crystallization of their wax content at low temperatures, but the formation of deposits which do not disappear upon heating and will not be completely removed by pigging”.

This technically challenging hydrocarbon state makes waxy oil production expensive, a fact that was a bone of contention in discussions preceding the decision to build a refinery in Uganda. In recommending the construction of a refinery in Uganda, the Foster Wheeler report offered heat tracing as the most effective though not full proof method of facilitating the transportation of the waxy crude oil over such a stretch of a pipeline, effectively a costly process. By its estimates, this would add about $13 per barrel to transport the oil to the coast. It notes further that the pipeline could still choke the process “either as a result of the fluid cooling for example due to heat tracing failure or during pigging if the wax slug in front of the pig becomes too big to move.”

The same feasibility report also points out that Uganda’s crude oil would be subject to a $12 penalty relative to Brent crude oil as discount for quality. Let's indulge in a simple analysis. Suppose we use Tullow PLC’s 2015 cash operating costs of $15 per barrel (see 2015 Tullow PLC half year results) as potential operating costs for Uganda’s oil. To obtain a rudimentary breakeven price for Uganda’s crude oil, we would add PwC’s offshore finding cost and the Foster Wheeler cost of pipeline transport to the $15 providing an estimated cost of about $63.01 per barrel. Given the quality discount mentioned above, Brent would have to be priced at $75.01 for Uganda’s oil to sell at a price that meets the rudimentary breakeven cost. This simple analysis ignores other potential costs such as overhead, financing, etc., and assumes that Uganda receive no royalties which is certainly unrealistic. Accommodating these considerations, however, only creates a murky set of prospects. The chart below provides a comparison of crude oil production costs by region. The African region has by far the highest costs. For interested readers and indeed many are encouraged, the Wall Street Journal provides an excellent link that allows you to take a pick at the breakeven prices of many oil producing nations at http://graphics.wsj.com/oil-producers-break-even-prices/. It is unimaginable that the GOU has not established a breakeven price for different oil reserves regardless of current oil prices.

true

Table 3: Crude Oil Production Costs – 2009

Moreover, projections of future global production and consumption point to a recovery of sorts, albeit not going back to the early 2014 price levels. In its short term outlook, the US Energy Information Administration (EIA) forecasts that Brent crude oil prices will reach $60 per barrel in 2015 and $67 in 2016. The chart below compares the outlook for both demand and supply of liquid fuels bolstering the sluggish growth in demand relative to supply.

true

Table 4: World Liquid Fuels Production and Consumption Balance
In its 2014 medium-term market report, the International Energy Agency (IEA) put the Americas as being net crude oil exporters by 2019 owing to soaring supplies from the US, Canada and Brazil which will “outstrip regional refinery capacity growth”. It projects Asia, more specifically China to be the largest oil importer then. It further reports that the US will lead many of the OECD countries in the downward trend in demand for gasoline as newer vehicles become more efficient and alternative sources of energy take center stage. This growth in demand peaked at 1.5% in 2014 and will fall to -2% by 2019. It also posits an exceptional strong non-OPEC growth in demand towards 2019, which slows later in the forecast period. A crucial trend it points out which is worth noting by African oil producing nations is that China will consolidate its position as the world’s largest importer of crude by diversifying it suppliers away from dependence on the Middle East and Africa as seen in the charts below.

true

Source: IEA 2014 Market Report

Finally, it shows that refinery margins and refinery utilization rates remain under pressure amid surplus capacity as indicated in the graphs above. It contends that in order to get the refineries back to the 2006-2008 utilization rates when profit margins were meaningful, “another 4.8 mb/d of capacity would have to be cut, whether through plant closures, projects delays or cancellations.” It's no wonder RT Global Resources East Africa Regional Representative Andrey Kozenyashev, points to a refinery completion date of “2020 at the earliest” even when government officials offer a 2018 guidance date.

true
Source: IEA 2014 Market Report

With global markets looking as they are, Uganda now is advancing the opportunity to supply domestic and regional markets as it seeks to fend off the growing chorus of pessimism. It is seeking partnership with neighboring countries. It remains to be seen if our neighbors can find our oil more cost effective than alternatives in dollars per barrel.

Thus, when you sum up all these disparate forces bearing on Uganda’s oil sector and wear on the hut of any one of the selected companies, you can see why the PSAs Uganda entered may point to prospects for Ugandans that pale in comparison to current expectations. The oil partners are certainly re-evaluating the relative merits and limitations of each license they have across entire spectrum of countries in which they hope to begin production. The changed times have likely moved their financial viability bar higher as they decide where to deploy their significantly reduced capital expenditure budget. As PwC puts it, these conditions are “a sure recipe for re-evaluation of prospects”. Tullow PLC is focusing efforts in West Africa going by their proportionate capital deployments in the first half of 2015. In Total’s 2014 end of year outlook, out of a portfolio of 29 major projects, only 2 have their current status listed as “study”. The others have mainly either “production” or “development” status. One of the two study projects is its 33% holdings in Uganda’s oil which Total gives a planned date of late 2017.
 
Does this spell doom to Uganda’s oil industry? Not so fast, the jury is still out there. Historically, oil has and will always be a volatile commodity and companies that have been around for some time such as Total S.A., Chevron, Exxon Mobil, BP, Royal Dutch Shell, and others understand this. In simple terms as the times have gotten tougher, Oil and Gas companies have had to and will continue to seek ways to stay afloat by being lean and mean. The small and less liquid firms may fold into those with stronger balance sheets in M&A related activities. It is worth noting that at the first mention of oil in Uganda in 2006, crude oil was priced at between $50 and $60 a barrel and there was so much excitement about the discovery. Recent prices have hovered around the same range. The most profound challenge, however, is that the changing terrain as described here seems to undermine the potential for prices to rise to the levels of yesteryear.

For a young oil nation such as Uganda, the silver lining in this dark cloud resides in the old adage “do not put all your eggs in one basket!” The agony of this experience is going to be felt by those countries that rely extensively on oil revenues. A few African countries rely significantly on oil receipts. For instance, Libya’s and Angola’s oil revenues are 52% and 42% of their GDP respectively.  Unless reserves are created that can sustain prolonged continuance of fiscal funding, significant reliance on oil receipts can subject a nation to enormous fiscal duress as oil revenues plummet and can lead to dire political, and socio-economic consequences. Hence the great lesson here is that it is incumbent upon our policymakers to broaden the rack of exports as they plan and wait for oil revenues. All told, however, the exuberant expectations in the form of magnificent rewards that would accrue from the anticipated oil boom may need to be moderated to come to terms with contemporary reality.

The writer is an Associate Professor of Finance and the current Chair of the Department of Economics and Finance of the College of Business and Public Administration at Drake University in the US