merrrill lynch april 4 th, 2006 securing revenues in a volatile crude market not an official unctad...
TRANSCRIPT
Merrrill Lynch
April 4th, 2006
Securing Revenues in a Volatile Crude Market
NOT AN OFFICIAL UNCTAD RECORD
Table of Contents
Securing Revenues in a Volatile Crude Market
1. Oil Market Outlook
2. Securing Oil Revenues
3. Securing Revenues from Energy Distribution
1. Oil Market Outlook
1
Oil Price Outlook: Short Term Support, Long Term Threat
Historical and Forward IPE Brent Curves
Global Market for Crude Oil
Oil Market Outlook
High Marginal Cost Oil Fields : Oil Sands (1)
Strong demand (particularly in Asia and South America) combined with bottlenecks in the refining sector (due to lack of investment) and a fundamental shift in oil production (from sweet/light to sour/heavy) have driven oil prices higher over the past 3 years
After 2007, forces driving oil prices lower might become dominant:
Upstream and downstream investments coming on-line in 2008
Chinese economic growth slow down
Risk of pandemics such as Avian Flu
Iraqi oil production recovering from current low levels
Development of a global gas market with the LNG production coming on-line
As seen during the oil shocks in the 1970’s, fear of a long term high oil price environment will stimulate
Development and production of high marginal cost oil fields (Venezuela, Canadian Oil sands) where majors are already making heavy investments
Investment in alternative technologies such as electric engines, fuel cells, hydrogen propulsion
10
20
30
40
50
60
70
$/b
bl
Spot shift in response to Supercycle
Forward shift in response to Supercycle
Current Mark et
ML Expectation
Historical
259
236
179
126 11597 92
6036 25
0
50
100
150
200
250
300
Saudi
Ara
bia
Venezu
ela
Canada
Iran
Iraq
Kuw
ait
Abu D
habi
Russia
Lib
ya
Nig
eria
Canada’s Reserves:
Oil Sands: 163 mmbblsConventional: 16 mmbbls
Conventional
Oil Sands
____________________(1) Source: Alberta Department of Energy and Oil and Gas Journal.
Boom and Bust of Commodity Markets: Cause, Effect & Remedies
2
Paying for Decades of Underinvestment
5-6 yearsNew Copper Mine
3-4 yearsCopper Smelter
7-10 yearsOil Field (new area)
2-3 yearsOil Field (existing area)
5-7 yearsOil Pipeline
5-7 yearsNew Refinery
2-3 yearsRefinery Upgrade
2 yearsShip (wet)
1-2 yearsShip (dry bulk)
Average Construction Lead-Times for Major Commodity Supply Infrastructure Projects(1)
Average Construction Lead-Times for Major Commodity Supply Infrastructure Projects(1)
____________________(1) Merrill Lynch Commodity Research
Low investment returns have led to a lack of capital flowing into the industry over the last decades (instead chasing more ‘desirable’ sectors, such as pharma, technology, telecoms)
As a result, we are looking at a chain of bottlenecks throughout the industry …
Exploration
Transportation
Refining
Labour
Etc …
… requiring high and sustained prices to justify investment
In any case many of these bottlenecks will take a long time to fix
Oil Market Outlook
Unconventional Low Margin Product Coming Online
3
The high forward oil price environment is stimulating production in unconventional oil which poses a threat to conventional producers
Unconventional Crude Production
The current high forward oil price environment encourages the production of low margin product
Canadian Oil Sands Venezuela Heavy Oil
Even at low margins, Unconventional Oil represents a clear threat to convention oil producing nations
The elevated forward curve allows low margin producers to lock in profit and potentially steal North American market share
High oil prices are stimulating increased investment in technology to efficiently extract unconventional oil
This flood of new crude will ultimately place downward pressure on commodity prices
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500
5,000
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Synthetic Crude
Canadian Bitumen
Venezuelan Synthetic
Canada Venezuela
- Large resource base - Large resource base (similar potential to Canada)
- Stable political environment - Unstable political environment
- Developed and stable fiscal regime - Currently more favourable fiscal regime but could be potential changes
- Higher extraction costs (energy intensity)
- Lower extraction costs than in Canada
- Some market access constraints for output (limited refinery capacity)
- Limited market access constraints for output (U.S. Gulf Coast, Caribbean refineries)
- Acquisition and greenfield opportunities
- Primarily greenfield opportunities (must deal with PDVSA)
- Industry participants: ExxonMobil, Shell, ConocoPhillips, ChevronTexaco, Total, Canadian Independents and Integrateds
- Industry Participants: PDVSA, ExxonMobil, Petro-Canada, ConocoPhillips, ChevronTexaco, Total, Statoil
High Forward Oil Price Environment as a Potential Threat
kboed
Oil Market Outlook
Current Inelasticity of Demand is not Sustainable in the Long Term
4
The current growth in oil demand despite rising prices is unsustainable in the long term
Fear of an extended period of high commodity prices will drive investment in alternative technology
To date, global demand has proven to be highly resilient to the steady growth in oil prices
However, the fact that demand has failed to slow down despite the high prices does not mean that demand is price-insensitive in the long-run
As seen during the oil shocks in the 1970’s, fear of a long term high oil price environment will stimulate conservation efforts and fuel investment in environmentally friendly technologies such as:
Gas / Electric hybrid engines
Fuel Cells
Hydrogen propulsion
Gas fired Vehicles
The ultimate effect will be long term price elasticity of demand as consumers look to return disposable income from fuel expense to their pockets
Long Term High Oil Prices Will Lead to a Softening in DemandOil Market Outlook
5
High Demand will Lead to Increased Efficiency and SubstitutionIncreasing Inelasticity of Gasoline
Demand(1)…
-0.25
-0.2
-0.15
-0.1
-0.05
0
77 79 81 83 85 87 89 91 93 95 97 99 01 03 05
% change in gasoline demand for 1% change in price
%
____________________(1) Rolling regression coefficient on a 100-month window where the latest data point signals current price elasticities of gasoline demand, as estimated
over the past 100 month
0
10
20
30
40
50
60
0
5
10
15
20
25Average mpg/km per litre of city and highway
mpg km per litre
…Leading to Higher Fuel Efficiencies
US gasoline demand has become more price inelastic over time
A shift from SUVs to hybrid vehicles in the US could result in phenomenal energy savings
Oil Market Outlook
Overlap in the End Use of Oil and Gas may Lead to Substitution
6
Though it may be unlikely that the oil and gas price divergence will persist into the long term, should it occur, a significant amount of switching out of oil and into gas would be expected
Long dated crude oil prices have nearly doubled over the past 12 months, but long dated gas prices have not kept up
The emerging LNG market which is poised to increase substantially on both sides of the Atlantic will likely lead to an LNG spot market and …
Environmental reforms will increase pressure to take advantage of the disconnect in oil and gas prices as high pollution industries such as the power generation sector seek cleaner burning fuels
Any further divergence in oil and gas prices will accelerate the pace of demand adjustment
Overlap in the End Use of Oil and Gas
Growth of Global LNG Fleet
0% 20% 40% 60% 80% 100%
Rail TransportationInternal Navigation
Domestic Air TransportInternational Civil Aviation
Road TransportationAgriculture Sector
Non-specified Transport Construction
Feedstock In Petchem. Ind.Mining and Quarrying SectorChemical and Petrochemical
Non-specified Other UsesWood and Products IndustryTextile and Leather Industry
Non-specified IndustryNon-Metallic Minerals
Commercial/Public ServiceFood and Tobacco Industry
Residential SectorTransport Equipment
Paper, Pulp and Printing Ind.Machinery Industry
Non-Ferrous Metals IndustryIron and Steel Industry
Pipeline Transport
Gas Oil
92 99 104 109 115127 128
138153
176
201
237
276 286
1996 1998 2000 2002 2004 2006E 2008E
Number of LNG ships
Fuel Substitution: Relative Value in Natural Gas vs. Crude OilOil Market Outlook
2. Securing Oil Revenues
Cost and Access to Capital Markets Highly Correlated to Oil Prices…
Oil Price and Borrowing Cost
7
$10
$20
$30
$40
$50
$60
1996 1998 2000 2002 2004
0
1000
2000
3000
4000
5000
6000
7000
Brent Crude
Mexico Credit Spread
Russia Credit Spread
Credit Spread of Russia and Borrower (bps) vs Oil Price (Brent $/bbL)
0
250
500
750
1000
1250
1500
1750
$10 $20 $30 $40 $50 $60
$/bbl
bps Credit Spread of Borrower (bps) vs Oil Price (Brent $/bbL)
Source: Merrill Lynch
Securing Oil Revenues
Credit Spreads vs. Oil Price
Over the past 7 years, oil producing countries have faced both historically low and historically high oil price environments
The volatility creates challenges to policy makers and jeopardizes sustainable and stable economic growth
Currently oil producing countries are enjoying low credit spreads resulting from high oil prices, and this translates into cheap and ample access to Capital Markets
However, 7 years ago these same countries were facing capital outflows, limited access to capital markets, and high borrowing costs (wide credit spreads) mostly as a result of historically low oil prices…
Oil Price Swap
(optional)
8
Oil Linked Financing
Description
Client issue Oil Linked Notes (OLNs) and receive Issuance Proceeds from Investors
Investors may choose to keep indexation to oil price or swap out price exposure with Merrill Lynch
Investors may require security over the Producing Assets against the possibility of default by Client
Client continue to sell oil in the market as usual:
Merrill Lynch may act as an offtaker for the transaction in order to improve credit quality of offtakers and potentially transaction rating
Client make debt service payments to Investors fluctuate in conjunction with movements in oil prices:
Lower debt service when oil price is low
Higher debt service when oil price is high
– Greater ability to meet payments
1
2
3
4
5
Flows At Issuance
Client
OLNs
($)Issuance Proceeds
Security (optional)
Producing Assets
100%
Ownership
InvestorsMerrill Lynch
1
2 3
($) Payment for
Oil
Oil
Ongoing Transaction Flows
ClientProducing
Assets
($)Oil Linked Payments
ML/Customers
Investors
4
5
4
Oil
Securing Oil Revenues
Coupon Linked to Oil Price
Coupon Linked to Oil Price
Illustration of Credit Spread vs. Oil Price
Indicative Terms and Conditions / Sample
Issuer: Client
Principal Amount: USD 300,000,000
Effective Date: March 2006
Maturity Date: X years after Effective Date
Interest Rate: 12M USD LIBOR - 50bppa + Oil Spread
Oil Spread 95bp p.a. × Max [Oil Price – USD 65/ bbl, 0]
capped above USD 70/bbl at 425bppa
Volume equivalent: 2,885,000 bbls per annual Coupon Period
Oil Price: Annual average of PLATTS mid prices for Dated Brent crude oil
* Assumes Client standard funding at 100 bppa
9
Oil P
rice ($/bbl)
Client issue USD bullet bond with 5-year maturity for which credit spread is indexed to oil price
Oil price indexation results in credit spread subsidy in low oil price environment
Investor will receive enhanced coupon payment in high oil price environment but this will be capped allowing Client to participate above this level
-1.0%
0.0%
1.0%
2.0%
3.0%
4.0%
5.0%
52
54
56
58
60
62
64
66
68
70
72
73
75
77
Oil ($/bbl)
Coupon (%
)
$50
$55
$60
$65
$70
$75
$80
Oil Linked Spread Standard Funding Spread Oil Price
Securing Oil Revenues
Client issues USD amortising bond with 5-year maturity for which amortisation payments are indexed to oil price
Credit spread over LIBOR will be reduced due to inherent credit mitigation of oil price risk
Amortisation payments will be reduced in low crude price environment
Principal Linked to Oil Price
Principal Linked to Oil Price
Illustration of Amortisation vs. Oil Price
Indicative Terms and Conditions / Sample
Issuer: Client
Principal Amount: USD 300,000,000
Effective Date: March 2006
Maturity Date: 5 years after Effective Date
Interest Rate: 3M USD LIBOR + 75 bppa
Tranches: XXX quarterly linear amortisation payments
Amortisation Payment: Standard Amortisation + Oil Amortisation
Standard Amortisation: USD 15,000,000
Oil Amortisation: Volume x { Max [Oil Price - $78/bbl, 0] - Max [Oil Price - $100/bbl, 0] - Max [$55/bbl – Oil Price, 0] + Max [$40/bbl – Oil Price, 0] }
Volume: 100,000 bbl per quarterly Coupon Period
Oil Price: Quarterly average of PLATTS mid prices for Dated Brent crude oil
* Assumes Client standard funding at 100 bppa
10
Oil P
rice ($/bbl)
$12
$13
$14
$15
$16
$17
25 30 36 41 46 51 57 62 67 72 78 83 88
Oil ($/bbl)
Am
ort
isati
on
Paym
en
t ($
MM
)
25
35
45
55
65
75
85
95
Oil Amortisation Payments Standard Payment Oil Price
Securing Oil Revenues
11
Protection Range and Opportunity Cost versus historical and forward
The strategy offers effective protection from falling oil price, limited to the difference between the Put Strikes
The opportunity cost of the strategy is limited to the Call Spread
____________________Source: BloombergProtection and Risk Range refer to an Asian Single Settlement Four-Way Strategy maturing 31st December 2009
Lower Amortisation Payment
Higher Amortisation Payment Call Spread
Put Spread
0
10
20
30
40
50
60
70
80
90
100
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$/bbl
Securing Oil Revenues
Solving the Problem of Revenue Stability…
Stabilising Revenues
12
Traditional hedging by buying puts or selling forward can be a delicate decision if the market goes against the hedge
In retrospect, any put premium lost will often be seen as money wasted… putting the decision makers at “political risk”
AAA oil bonds achieve the same objectives as the puts, without incurring any political risk
Securing Oil Revenues
Fiscal Policy and Stabilization Funds can be complementation do NOT solve the problem entirely
Risk Management via Oil Price Insurance (Put Option) is the most conservative
Protect against lower prices
Retain upside to higher prices
Risk Management via Oil Forward Sales does not benefit from upside
Risk management via Over-The-Counter (OTC) derivatives, such as buying put options, selling forwards, or selling call options, may not be an efficient nor suitable approach for governments
AAA oil bonds provide AAA insurance, better suited for governments
AAA Oil Bonds are highly conservative investments, that simultaneously combine the benefits of stabilization mechanisms and hedging of oil price risk
Current historically high oil forward prices provide a short term OPPORTUNITY to oil producing countries… but also a long term THREAT on how to manage falling revenues if oil price drops
The bullish outlook in the immediate-near term, should not blind policy makers of the opportunities and threats arising from current long-term prices
AAA Oil Bonds provide significant improvements versus traditional Over the Counter Derivatives or Money Markets
Investing in Oil Indexed Notes
13
10
20
30
40
50
60
70
$/b
bl
Spot shift in response to Supercycle
Forward shift in response to Supercycle
Current Mark et
ML Expectation
Historical
0%
20%
40%
60%
80%
100%
120%
10 30 50 70 90
Oil Bond Coupon (% p.a.)
Fixed Income Coupon (% p.a.)
$/bbl
3 year Oil Bond vs Fixed Income
Current Crude oil Price
AAA Oil Bonds Optimise Revenue Management
Securing Oil Revenues
Favourable Market – High Oil Forwards
AAA Oil Bonds
Indicative Termsheet
14
The PV of the interest available is around 13% of the notional, which given current put options prices allows to purchase 11 million barrels of $40/bbl puts spread over the next 3 years
The AAA bond will return 100% at maturity, and protects $440 Million of oil revenues over the next 5 years
Issuer: African Development Bank (AAA/Aaa)
Issue Size: [USD 1 Bio]
Maturity Date: [3 years] from Issue Date
Issue Price: 100% in USD
Redemption: 100% in USD
Coupon: An amount in USD, payable ANNUALLY, equal to the maximum of zero or the difference between the Floor Level and the Final Price, per the Oil Volume Protected
Max [ 0 , Oil Floor – Oil Final ] x Oil Volume Protected
Oil Floor: [40 USD/bbl]
Oil Final : Daily average of IPE Brent over year prior to each Settlement Date
Oil Volume Protected: [3.65] million bbl per annum (total 11 million bbl over 3 years)
Fees: None
Dealer/Underwriter: Merrill Lynch InternationalListing: UnlistedProgram: Global Debt Issuance FacilityFormat: Permanent Global Note
3 Year AAA Oil Bond, 40 $/bbl Floor, 100% Principal Protected
Basis: IPE Brent: 62.96 $/bbl, assuming 3 Year AAA Oil Bond, strike 35 $/bbl, 100% Principal Protection
Securing Oil Revenues
15
Three-Way Zero Cost Strategy - Oil Derivatives
Benefits & ConsiderationsDescription
Graphical Illustration
The Three-Way Zero Cost strategy enables Producer to achieve price protection on crude oil while partially participating in rising oil prices. Producer can finance the purchase of a Put Option by selling a Call Spread. The structure limits the opportunity cost of the hedge to the difference between the Higher and Lower Call Strike
At maturity, assuming cash settlement:
If the oil price is less than the Put Strike, then Producer receives the difference between the Put Strike Price and the prevailing oil price
If the oil price is higher than the Put Strike and less than the Lower Call Strike, neither party makes a payment
If the oil price is greater than the Lower Call Strike and less than the Higher Call Strike, then Producer pays the difference between the prevailing oil price and the Lower Call Strike
If the oil price is greater than the Higher Call Strike, then Producer pays the difference between the Higher Call Strike and the Lower Call Strike
The Three-Way Strategy can be implemented in Asian and Quanto forms
Producer receives compensation when the oil price drops below the Put Strike
Producer’s payment occurs only if the oil price is above the Lower Call Strike and is limited to the difference between the Higher and Lower Call Strikes
Structure is zero premium
Producer has the flexibility of customising maturity, Put Strike and Call Strikes, as well as the notional
DownsideProtection
HigherCall Strike
LowerCall Strike
Put Strike
Realised Price
Oil Price
Forgone Appreciation
Securing Oil Revenues
16
Three-Way Zero Cost Strategy – Potential Exposure
The Three-Way strategy offers effective protection from large market shocks
The risk is limited to the range of the Call Spread and is at much higher levels than both long-term oil prices and current analyst predictions
____________________Source: BloombergProtection and Risk Range refer to an Asian Single Settlement Three-Way Strategy maturing 31st December 2009
Call Spread
0
10
20
30
40
50
60
70
80
90
100
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008
$/bbl
Protection Range
Opportunity Cost
Put Strike
Securing Oil Revenues
17
Indicative Prices
Fixed Price Swap on IPE Brent
Three-Way Zero Cost Strategy on IPE Brent
Swap Contract Period
Jan-07 to Dec-07 Jan-08 to Dec-08 Jan-09 to Dec-09 Jan-10 to Dec-10 Jan-11 to Dec-11 Jan-12 to Dec-12
Fixed Price $/Bbl 67.12 66.21 65.21 64.24 63.36 62.63
Period
Underlying Swap
Price $/Bbl Put Strike $/Bbl Lower Call Strike
$/Bbl
Upper Call Strike
$/Bbl
Jan-07 to Dec-12 65.35 55.00 65.00 84.18
Securing Oil Revenues
3. Securing Revenues from Energy Distribution
Description Financial Hedge
The Power Plant is exposed to the risk of higher Fuel/Coal Market Prices as revenues from electricity sales are regulated
Increasing regulated electricity Tariff is a highly political decision
purchasing cost is directly driven by market price which have proved to be very volatile
Regulated electricity Tariff in most countries aim providing price stability to final consumers
Ideally, the Power Plant would like to stabilise its Fuel/Coal purchasing cost in line with the the regulated electricity Tariff
Merrill Lynch proposal is to secure cost of Fuel/Coal supply at a Fixed Price level through a financial swap or a fixed price physical delivery
Fixed Price Physical Delivery
Physical Transfer
Financial Transfer
Fuel/Coal Fired Power Plant with a Regulated Electricity Tariff
18
Basis Risk
Fuel Oil Supplier
Power Plant
Retail Market
Merrill Lynch
Floating Market Price
Floating Market Price Fixed Price
Regulated Tariff
Electricity Delivery
Physical Fuel Oil Delivery
Physical Transfer
Financial Transfer
Basis Risk
Power Plant
Retail Market
Merrill Lynch
Fixed Price Regulated Tariff
Electricity Delivery
Physical Coal Delivery
Securing Revenues from Energy Distribution
19
Structuring the HedgeBenefit and Considerations
Risk of a margin squeeze
By entering the proposed hedging strategy, the Power Plant can secure is purchasing cost over the future.
It helps to mitigate the risk of margin squeeze when purchasing costs increase more than the regulated Tariff
The Power Plant gives up potential benefit from lower purchasing cost
The basis risk between hedged purchasing costs and revenues from regulated tariff is low as long as price stability drives regulated electricity Tariff
When financing project or restructuring existing financing, Development Banks will value the hedging strategy as
– It provides improved visibility on future cash flows generated by the power plant
– it helps stabilising retail electricity prices avoiding political tension from Tariff increase
Following solutions facilitate the hedging execution
Guarantee from the State or from a Devlopment Bank
Pari-Passu with the financing banks
Collateral under the form of a partial pre-payment of future purchasing cost
Paying premium for an insurance against higher purchasing costs rather than fixing it
Fuel/Coal Fired Power Plant with a Regulated Electricity Tariff
0
10
20
30
40
50
60
70
80
jan
v.-
95
jan
v.-
96
jan
v.-
97
jan
v.-
98
jan
v.-
99
jan
v.-
00
jan
v.-
01
jan
v.-
02
jan
v.-
03
jan
v.-
04
jan
v.-
05
jan
v.-
06
US
D/b
bl
IPE Brent
Regulated Tarif f
Securing Revenues from Energy Distribution
20
Disclaimer
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