Oil majors spend more but find less

For the oil majors, quarterly results were once a ticker-tape parade. Last week, they were more like a walk of shame. ExxonMobil, Chevron, Royal Dutch Shell, BP, and Total SA all suffered a drop in earnings year-on-year. Oil and gas output for all, bar Total, contracted, despite big hikes in capital spending. Costs were up and returns down – even with oil prices at more than $100 a barrel. Companies that just a few years ago bestrode the corporate world like colossi are now in the doghouse, unloved by investors and dismissed by many as dinosaurs.

The majors seem trapped in a downward cycle of spending more and more to find and produce less and less oil. Increasingly, investors are ditching them for smaller, more nimble rivals, especially those in the vanguard of North American shale. “It’s a real challenge for them to grow volumes, despite the strong oil price,” says Dan Pickering, co-president of Tudor Pickering Holt & Co. “The independents are growing 30 per cent a year and the majors are struggling to stay flat.” That is inevitably affecting valuations. As a group, the five largest majors have underperformed the S&P 500 by more than 15 percentage points year-to-date on a total return basis.

The reasons for the majors’ poor performance in the second quarter were often specific to the company. Shell, ENI and Total were hit by oil theft and pipeline sabotage in Nigeria. A higher tax rate and foreign exchange effects took their toll on BP. Exxon was affected by weaker refining margins, Chevron by higher repair costs at its US refineries. But through it all, there was one big common theme. Capital expenditure, or capex, was up across the sector. In some cases cash flow from operations was insufficient to cover both capex and dividends. As a result, some companies had to borrow, or sell assets, to bridge the funding gap. “For many companies across the marketplace, balance sheets are improving, but with the majors, they’re deficit spending,” says Dan Pickering. Energy groups experienced a similar squeeze in 1999 and early 2009, following sharp falls in the oil price. But this time is different: the oil price has remained high. Instead of cash flow falling, it is capex that is rising.

While it was a downbeat quarter for the majors, things looked much rosier for the midsized independents, who are riding high on a wave of shale oil success. EOG Resources, which has positions in two big shale plays, North Dakota’s Bakken and the Eagle Ford in South Texas, says it is expecting to increase crude oil production by 35 per cent this year. In contrast, ExxonMobil has said its production will fall in 2013 for a second straight year. In many ways the comparison is unfair. EOG has a market value of $42.5bn, while Exxon’s is $406bn. EOG’s production of 506,000 barrels of oil equivalent a day pales into comparison with Exxon’s 4.1m. But that isn’t stopping investors drawing parallels between the two – often to the detriment of the majors. That is happening because companies are pushing into ever more remote, technically challenging and more capital-intensive frontiers. Canadian tar sands, US tight oil, Brazil’s deepwater “pre-salt” discoveries and the offshore Arctic are all proving much more expensive to develop than more conventional fields in places like the Middle East.

But there is a positive side to the capex increase. For years, the majors were out in the cold, shut out of oil-rich countries in the Middle East and squeezed by rising resource nationalism in Russia, Venezuela and Central Asia. They compensated by building big positions in places like the North Sea, Alaska and the deepwater Gulf of Mexico, but further growth was constrained. The shale boom has changed all that. Fracking and horizontal drilling have opened up vast new unconventional plays in the US and Canada, places where western oil companies are free to operate. For the majors, it is a feast after years of famine. “In contrast to a few years ago, CEOs are now saying they have one of the best opportunity sets they have had for a long time,” says Martijn Rats, an analyst at Morgan Stanley. Or, as Peter Voser, Shell’s chief executive, put it earlier this month: “Today, Shell is capital-constrained rather than opportunity-constrained”. But despite that, the capex increase is unsettling shareholders. Growth investors long ago abandoned the majors, dismayed by their seeming inability to increase production. But the sector is still popular with income investors who like the steady dividend flow. Any threat to that is a matter of acute concern for them. “If income investors see that the dividend isn’t covered by organic free cash flow they don’t consider it a safe income stream,” says Mr Rats. Hence the underperformance: the oil sector has been flat or slightly down over the past 18 months while the rest of the European market is up about 27 per cent. Some companies are getting the message. Total made it clear last month that its capex will peak in 2013 and start falling in 2014 and over the medium-term. Analysts say that should put its dividend on a much more secure footing. Others are getting another message – that investors no longer expect, or even want, the majors to chase higher production if they end up having to pay too much to achieve it. “They are all moving away from the idea of growth at all costs towards better value management,” says Charles Whall, co-portfolio manager at Investec Asset Management.

One crucial sign of this shift came earlier this month when Shell said it was abandoning its production targets, adding that financial metrics like cash flow and capex were a better way of measuring its performance. It also indicated that it would be streamlining its portfolio by announcing a strategic review of its North American shale and onshore Nigeria assets. BP did something similar last year, saying it would prioritise “value over volume”. Having shed so many assets to pay for the Deepwater Horizon disaster, it didn’t have much choice. And yet despite this shift away from growth for growth’s sake, the majors should still see some increase in output in the coming years as all that rising capex begins to pay off. Wood Mackenzie, the energy consultancy, sees the majors’ oil and gas production growing 3 per cent on a compounded annual growth rate out to 2020. “The underlying potential is better than the recent quarterly results would suggest,” says Norman Valentine, a corporate analyst at WoodMac. “The majors are investing more than they have in the past, and that should support higher production growth in the future.”

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