Monday, February 28, 2011

Political Risk: What Higher Gasoline Prices Mean for U.S. Legislation

Higher gasoline prices are starting to put pressure on consumers just as many people are starting to feel better about the economy. What does this mean for the near future relative to new energy legislation? For now, prices aren't high enough to warrant serious concern, but keep your eyes on the horizon.

Higher energy prices impose an effective “tax” on households and businesses, leaving fewer funds available for spending and investment.
This poses a threat to the current recovery and could significantly set back an improving labor market. Higher prices also impact headline inflation (inflation measures the rate of change of prices, not their level). Politicians, especially Democrats, hate news about unemployment and inflation. This means the oil and gas sector is a prime target for Democrats' legislative efforts, especially in light of the ever-closer presidential election. It also explains why the Obama administration has come back four times with proposals for new taxes on the industry. Since most consumers have no clue about the relationship between oil and gasoline prices (the "gas crack") we are an easy target.

Many analysts believe that gas prices would probably have to stay closer to four dollars per gallon to create sufficient political pressure to force Congressional action. Never mind the fact that there is little Congress can actually do to impact the price of gasoline (besides increase it by imposing even more taxes). Nonetheless, high gas prices create political pressure to be seen as "doing something."

The rumbling has already begun.

Last week Senate Democrats called for Obama to release the Strategic Petroleum Reserve to help drive oil prices lower, though it's unlikely he will do so at current prices. Democrats will also demand an FTC investigation of price manipulation (blaming increases on some sort of cabal). Expect these types of proposals to increase in frequency (and volume) as we near the next presidential election cycle.

In the near future, Republicans will continue to pressure the Obama administration to force BOEMRE to change its behavior (which has virtually stopped new drilling in GOM). Interior Secretary Ken Salazar testifies before Congress tomorrow and could announce that a few permits will be forthcoming. However, even if BOEMRE relaxed the standards for permits, the resulting new production would represent a drop in the bucket of world oil supply and have little, if any, short-term impact on prices.

As prices increase further, there will be more calls for an energy bill. This means another bite at the apple for Democrats; another opportunity to use the industry as a whipping post and an excuse for new taxes and new regulations.

Brace yourself.

Tuesday, February 8, 2011

The Risky and Profitable Business of Investing in Spin-Off Companies

Investments in spin-off companies are often profitable (depending on their timing, of course). These transactions can take many different forms (spin-off IPO, carve-out, split-off, etc.). Marathon Oil Corporation’s decision to spin off its refinery business, Marathon Petroleum Corporation, for example, is one of many spin-offs in 2011’s transaction pipeline. Other recent and pending spin-offs include ConocoPhillips’ divestiture of its 20% ownership interest in Lukoil, Lundin Petroleum and Petrofrac’s spin-off of EnQuest PLC, and Norse Energy’s spin-off of Panoro Energy, to name a few.

What is a “spin-off” really? Provided certain rules under the Internal Revenue Code are met, spin-offs are a tax-free way for a company to divest a business (compared to an outright sale). And while a company’s specific circumstances may alter the outcome, the basic requirements to qualify for spin-off treatment include:

1. The parent company must control the “spun-off” company through either 80% or more of the total combined voting power of the company and 80% of all of the classes of shares entitled to vote.

2. The spun-off company cannot be used to distribute earnings and profits of the parent company.

3. The spin-off must have a legitimate business purpose.

4. The parent company and the spun-off company must have been involved in an “active trade or business” for the 5 year period leading up to the transaction closing date (and must continue to do so immediately after the spin-off).

5. There must be a “continuity of interest” (ownership) among the parent company and the spun-off company after the closing.

6. The parent company must distribute all of the stock it owned in the spun-off company.

Once a company chooses to spin off part of its business, there is a lag time between announcement and when the transaction becomes effective. This is because certain tax, legal and regulatory steps are required. Company lawyers must draft documents to legally divide the business and file the necessary paperwork (e.g., an SEC Form 10 registration).

Historically, in a spin-off transaction, the parent company’s stock does well, outperforming industry averages, in these months leading up to the announced transaction, but often not nearly as well in the months following the closing. Making a short term gain on parent stock in a prospective spin-off, therefore, means investors should understand how likely the company is to meet the legal requirements for completing the transaction because this can impact the speed and possibly the “steam” behind a pre-closing run-up.

Spun-off companies, by contrast, often tend to have negative share price returns in the months following a transaction. For example, take Pride International’s (PDE) 2009 spin-off of Seahawk Drilling (HAWK). According to some industry analysts, Seahawk experienced a -60% share price return in 2010. Spun-off companies can make attractive acquisition targets and are valued as longer term investments, however, because spun-off companies (especially smaller cap companies) have relatively high and absolute share price returns over the long term. A word of caution, however: analysts say that energy industry spin-offs have historically underperformed when compared to similar size transaction in other industries.

Have you been involved in a spin-off transaction? Please share your thoughts on spin-offs with us.

Friday, February 4, 2011

Obama Tax Hikes on Oil & Gas Now Unlikely

Earlier this week Senate Republicans voted unanimously against an amendment that would have offset the revenue loss associated with repealing a controversial proposal in the health care bill by raising taxes on oil and gas companies.

This amendment included a number of tax increases, the most important of which would have the effect of (1) raising the corporate tax rate on oil and gas companies by denying them a more favorable rate than other manufacturers pay, and (2) reduce oil and gas companies' ability to claim a credit against foreign taxes paid for purposes of calculating their U.S. tax burden.

This vote is the best indicator that a tax "Obamination" on the industry will have little chance of becoming law in the next year to two years.

Wednesday, February 2, 2011

Enemy Mine: Munitions Cause Explosive Situation in Iraqi Hydrocarbons Development

Estimates put the number land mines scattered across Iraq at 25 million or more (most in the southern part of the country). Yet despite their obvious danger to human life and their impediment to economic development, you won’t find Hollywood celebrities on camera in these areas asking for your donations or thoughtfully nodding while a village chieftain explains the plight of his people. That’s because many of these mines are concentrated in areas being developed by foreign oil companies.

The Iraqi Oil Ministry and Iraqi NGOs describe the mine problem as “catastrophic.” Yet despite the fact that oil production represents the country’s best hope for raising the Iraqi people out of poverty, international organizations are not contributing enough to the de-mining effort and the government can’t seem to get its act together. Why?

There are nearly a dozen national and international agencies working to get rid of munitions in Iraq. Sources within the energy community have told me, however, that cooperation among these groups has been problematic, based on a perceived bias by non-Iraqi NGOs, in particular, against cooperation with the petroleum industry. The result: the burden has fallen on the service companies to make their areas of operation safe for development. Without the effective support of the government and NGOs, oilfield companies must turn to private firms for help.

Outside of Kurdistan, all development is being let by the Iraqi government on a service contract basis. This means that oil companies don’t share on any of the upside of oil prices, but instead receive a low, flat fee per barrel produced.

Since the Iraqi government did not take mines into account until after the bid rounds closed on current contracts, it made no allowance for delays and cost increases attributable to de-mining activities. Foreign oil companies that have signed contracts to develop Iraq's oil reserves may therefore be unable to meet deadlines due to the danger of land mines. This theoretically places their whole contract at risk.

Service companies, already on thin margins (because many of these contracts are considered brownfield developments in established fields) stand to get the worst end of this situation. With a relatively impotent government and little cooperation from international non-profits, they have had to turn to contract assistance. The impact on margins is obvious.

Iraq could hold the greatest potential for growth in global oil production. With 115 billion barrels of oil, Iraq has the world’s third-largest proven reserves, behind only Saudi Arabia and Iran. Some geologists believe that Iraq’s reserves are even greater than that, as many oil fields have yet to be fully explored. There are few, if any, places that have as much oil that’s untapped and close to the surface (and thus relatively economical to extract) as Iraq does. But oil production in Iraq has fallen woefully short of its potential. The government has announced double digit projections for mmboe production. These numbers are far from realistic, and, more to the point, should the Iraqi government fail to resolve issues like de-mining, continued development under a service contract model could make new projects unprofitable, and untenable, for IOCs.

Tell me what you think (or what you have heard) about these and other operational issues on the ground in Iraq!