Penang Institute Insights: Crude oil price dynamics for the nation

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OIL and gas play a significant role in Malaysia. Petroliam Nasional Bhd (Petronas), the national oil corporation, contributed RM73.4 billion in total to the federal and state governments in 2013, comprising RM27 billion in dividends, RM33.3 billion in taxes, RM12 billion in cash payments (royalty) and RM1.1 billion in export duty, according to its annual report. This amounts to 30% of the government’s expenditure in the same year.

The average selling price of crude oil between 2011 and 2014 was US$109 per barrel. However, the average price in the first 20 days of this year was US$49.66 per barrel. As such, the recent fall in crude oil prices will have a profound impact on Malaysia since the oil price is unlikely to recover to over US$100 per barrel this year. According to the International Energy Agency (IEA), the energy watchdog of the developed world, there could be a surplus of two million barrels per day (bpd) by the second quarter. Near-term demand is therefore expected to remain weak amidst slower global economy.

Besides, the commercial oil stocks of the Organisation for Economic Cooperation and Development are above the five-year average levels in October 2014 and 2013. With additional surplus coming in the first half, more downward pressure could be exerted this year. This continuous additional supply is coming from shale oil producers in the US, given that the crude production of the Organization of Petroleum Exporting Countries (Opec) has stabilised over the past few years.

The tussle between Saudi Arabia — the world’s largest exporter of crude oil, which has decided to defend its market share — and US shale producers is intensifying. Of the 11 US shale producers with more than 20,000 barrel of energy equivalent (BOE) per day that announced capital expenditure cuts, only two have projected flat output in 2015, while the rest are projecting production growth of 5% to 43%. This is because exploration cost is often the largest part of total cost. When it is regarded as sunk cost, the on-going production cost, which is variable, has little effect.

Both the International Monetary Fund and the World Bank recently cut the global growth outlook for 2015 and 2016. This, together with a stronger US dollar, will put a cap on the rise of crude oil prices.

However, given that the fall in oil price amounts to an effective tax cut for oil-consuming countries (which include most of the EU countries and the US), these economies would likely perform better than would otherwise be the case.

Their economies might also be helped by the European Central Bank’s (ECB) quantitative easing announcement. If demand picks up in the second half of 2015, then the oversupply situation could be corrected. However, the current oil inventory level is higher than the seasonally adjusted level. Hence, potential price recovery is likely to be delayed to 2016, barring unforeseen geopolitical risk.

Through the commodity effect, a fall in crude oil price is obviously negative for an oil and gas company like Petronas. And although gas is sold under long-term contracts, liquefied natural gas (LNG) prices, despite the lag time, will eventually be affected as prices are benchmarked against oil prices. However, crude oil and LNG are priced and traded in US dollar, and the ringgit has depreciated against it. Hence, given that Petronas reports in ringgit, a weakening ringgit against the dollar is positive for the national oil corporation through the currency effect.

As the results for 2014 are forecasted to hold up, 2015 may differ significantly. Using data from 2011 to 2013 and assuming that the composition of Petronas’ business remains stable, different oil price and currency scenarios will affect this year's performance.

A bad case scenario occurs when the crude oil price drops further to US$40 per barrel and the ringgit strengthens slightly to 3.5 to the US dollar. In this case, Petronas might yield a revenue of RM120 billion, Ebitda of RM49 billion and dividends of about RM13 billion — about half of 2013’s dividends.

Likewise, a rosy case scenario occurs when the crude oil price recovers to US$70 per barrel but the ringgit depreciates to 4.0 to the US dollar. In this case, revenue, Ebitda and dividends are forecasted to be RM241 billion, RM98 billion and RM26 billion respectively. Using the case of US$55 per barrel, dividends are likely to fall to RM19 billion if the ringgit depreciates slightly more to 3.75.

Therefore, Petronas’ performance and its possible distribution to the government in 2015 will be halved if crude oil falls to US$40 per barrel and dollar-ringgit rate holds close to the current level. However, a depreciating ringgit-dollar exchange rate will help cushion the impact of weak crude oil.

Oil and gas reserves are crucial to Petronas for obvious reasons. “Reserves is described as the recoverable quantity of oil and gas volumes that are commercially viable for development given the prevailing economic situation present at the time of estimation”. (Petronas Annual Report 2013, emphasis added). With the fall in the crude oil price, there will potentially be some reserves which are no longer commercially viable. In such cases, the carrying value of these assets will be impaired.

In 2012, Petronas purchased Progress Energy Resources Ltd (a natural gas producer in British Columbia and Alberta, Canada) for C$5.5 billion, and 75% of Talisman’s Montney shale holding in the Farrell Creek and Cypress area of British Columbia, Canada, for US$1.4 billion. It also announced an investment of US$10.25 billion in Azerbaijan and Turkmenistan in 2014.

Due to the ringgit having depreciated since then, these assets would have been worth RM58 billion now if the crude oil price had maintained above US$100 per barrel. However, since the crude oil price has fallen substantially, there are strong grounds to believe that part of the assets will be impaired since their carrying amount would be less than the recoverable amount of the cash-generating unit. Although the impairment loss does not involve an outflow of cash, it would have an impact on the profits before tax, and thus the tax payable by Petronas to the government.

The breakeven levels for North American shale producers and onshore producers for the rest of the world are estimated at US$65 and US$51 per barrel respectively. While these levels are higher than or close to the assumption of US$55 per barrel used in the revised Budget 2015, it does not mean that Petronas’ investments would be worthless because: one, there are other factors in determining the value of the oil field such as quality (viscosity) of the oil/gas, ease of extraction, cost of transport and so on; and two, owning the oil field conveys a real option which is of positive value.

For example, Petronas has chosen to leave the gas deposits of Progress Canada not extracted with the deferment of the LNG project. Nevertheless, a 10% to 20% impairment to these four investments would mean a write-down of RM5.8 billion to RM11.6 billion using the current exchange rate of 3.61. Should the ringgit depreciate further, the write-down would be larger. This will certainly affect the taxation paid and the distribution of dividends in 2015.

Bottom line: the recent crude oil price fall will affect Petronas’ revenue and profitability through a lower sale price per barrel and asset impairments. Some of the negative impact from the fall in crude oil price is cushioned by a depreciating ringgit. However, the crude oil price (commodity) factor is likely to dominate the currency effect (barring significant depreciation) such that Petronas’ tax bill and its ability to pay dividends to the government will be affected.

Dr Lim Kim-Hwa is CEO and Head of Economics at the Penang Institute, a Fellow in Finance and Financial Reporting at the University of Cambridge and associate chartered accountant of the Institute of Chartered Accountants in England and Wales.Tim Niklas Schoepp is senior executive officer and visiting analyst (Economics) at the Penang Institute.

This article first appeared in Forum, The Edge Malaysia Weekly, on February 9 - 15, 2015.