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International Investing and Risk: Political and Economic

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The sharp and prolonged drop in oil and gas prices has injected turbulence into energy markets as companies and investors alike try to figure out what the final outcome will be—and where opportunities or pitfalls may lie. In oil and gas, that’s been particularly tricky. Here are some of the factors affecting the sector.

In what seems like a counterintuitive move to many, OPEC is keeping production levels steady. Prices began falling last June when OPEC, in response to higher production through shale wells, did not cut production, but instead increased it to win market share through cheaper prices. Even now, Saudi Arabia has declined to be the only country to cut production to keep prices from falling even lower.

With Saudi Arabia the largest OPEC producer, it was expected to eventually knuckle under to falling prices and reduce production. However, OPEC produces 30% of the world’s oil and non-OPEC countries 70%. Saudi oil minister Ali al-Naimi was quoted in reports saying, “[E]verybody is supposed to participate if we want to improve prices.” And non-OPEC countries are not dialing back.

In fact, Russia could boost oil exports by as much as 5%, according to James Henderson, a senior research fellow at the Oxford Institute for Energy Studies. Henderson said in reports that because of reduced demand for refined oil products in Russia, thanks to sanctions and lower oil prices globally, its “teapot” refineries—small facilities that process crude into fuel oil—are cutting back. Falling oil prices make the Russian government reduce the discount teapot refineries receive to export. When that happens, refineries lower production—leaving more oil available for export.

If that happens, prices could be further depressed.

Then there are the oil companies, which are cutting costs—and jobs. Prices that have lost nearly 50% since June are forcing them to try to figure out ways to counter increasing exploration and drilling costs. Some companies are dialing back exploration or canceling planned projects, while others—notably several in the North Sea, such as Shell, BP and Chevron—are reducing personnel. Yet they’re wary of discouraging investment, lest they end up making a bad situation worse when (and if) prices increase.

In addition, companies are scrambling for storage, thinking to hold stocks until prices recover. As a result, not only are land-based storage facilities reaping profits, but companies have even been storing oil in tankers afloat and making plans to up their actions.

Thanks to “contango”—a phenomenon in which the price for future deliveries of a commodity are higher than the prices for that same commodity in the spot market—traders have been storing oil until many facilities are at or near full capacity. That’s been a boon for storage facilities, as well as a gamble that the price of oil will rise again.

The sudden upsurge of solar and other alternative energies has surprised many who thought low oil prices would hurt alternatives, but increasing pressure from environmental groups and increasingly alarming environmental studies have instead boosted the outcry against controversial extraction methods like fracking. Leave-it-in-the-ground advocates have also gotten louder.

In addition, the trend toward fossil fuel divestment is gaining momentum, with recent high-profile moves—such as the announcement by the Rockefeller Brothers Fund last summer that it would divest from fossil fuels, and recent calls in England for members of Parliament’s pension fund to divest—boosting the movement’s visibility. That’s put a different kind of pressure on the industry.

George Masek, senior director, credit policy at Fitch Ratings, pointed out in a special report that the effects of low oil and gas prices reach far beyond the energy sector, and that many are positive. Consumer debt payments will be better off, since “most structured finance and covered bond issuance is concentrated in economies that are not highly dependent upon oil export revenues, there will be a positive impact on consumer default rates,” said Masek. “Performance of consumer asset classes—such as credit cards, auto loans, and residential mortgages—will benefit.

In addition, Masek said, increased consumer spending will “support improvement in asset performance trends.” However, “[c]ertain assets in securitizations and cover pools would be negatively impacted by a sustained period of low oil prices. This includes, for example, some commercial or residential mortgage loans in parts of Texas, Alberta, and Norway. Corporate obligors in some segments of the oil industry, such as exploration and drilling, would also be hurt.”

The upsurge in oil and gas production in the U.S. from fracking and other extractive technologies that became feasible when oil was over $100 per barrel, and the potential opening of the Arctic as a new field of exploration, have seemed to quiet those who fear the “peak oil’ phenomenon. However, one factor that may be particularly telling is the fact that the region of the world known best for oil and gas production is looking at alternative energy sources—and for ways to boost investment not just within that sector, but in other unrelated sectors in times to come.

The Arab world is exploring investment in alternative energy production and infrastructure, and working to reduce its dependence on oil as a source of revenue. A report by the University of Cambridge and PwC for the National Bank of Abu Dhabi that explores “the changing nature of the global energy system over the next decade, highlighting the growing demand for sustainable energy in the Gulf region,” makes the case for the Gulf’s financial services sector to support this demand by “providing products and services which will support the growth of the low carbon economy.”

From a purely practical standpoint, of course, diversified sources of income make sense. But for countries that have been so heavily dependent on oil for so long that it has contributed to their national identities, switching gears is a tough job.

Still, considering that low oil prices have caused Fitch Ratings to lower credit ratings for Oman and Bahrain, and to switch the outlook for Saudi Arabia to negative with the potential for its credit rating to fall if oil prices remain low, the Arab world has recognized the need to broaden its economic structure. This is something that the United Arab Emirates has done, according to the International Monetary Fund, thanks to Dubai’s move into exports of services and manufacturing that are not reliant on oil and its products.

Taking a page from Dubai’s book, other Gulf nations are pushing their citizens into launching their own businesses. The six countries that make up the Gulf Cooperation Council, Bahrain, Kuwait, Qatar, Oman, Saudi Arabia and the U.A.E., are providing incentives and regulatory changes to entice entrepreneurially minded Gulf citizens to go into business for themselves and create jobs that are dependent neither on the oil sector nor on the government—which employs as many as 75% of working people.

And therein may lie the key to diversification, since many of those entrepreneurs are launching tech businesses—including everything from e-commerce to gaming.

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