09 Apr 2018
The share prices of global integrated oil majors crashed in 2016 alongside the oil price and company earnings. Martin Walker explores the main bear arguments for the sector and explains where he sees fundamental valuation opportunities:
Remarkable capital discipline, technological advances and management commitment have created businesses, which are more profitable with an oil price at US$63 per barrel than they were at US$100
Focus on cash flow breakeven costs as the main metric has led to dividend payments that are now well covered by free cash flow – a signal for more progressive dividend policy
Back in 2016, when oil was under US$30 a barrel, I had spare change for a Mars bar when filling up my little VW Tiguan. The world had called time on the oil industry, the share prices of global integrated oil companies were through the floor and I had a near 20 per cent weighting in the sector: it was prime time for a pity party at the pumps.
Two years on, the oil sector has made a remarkable recovery from these lows, in part due to a rising oil price, but more broadly as a result of some serious capital discipline. Faced with their own mortality, integrated oil majors have responded with stringent measures to cut costs and drive capital efficiencies across their businesses, underlining their commitment to delivering shareholder value. But while the oil price tracked up over 2017, oil equities experienced muted share price performance: so what’s the market’s beef?
At our most recent quarterly meetings with the management teams of the oil majors in my portfolios – BP, Royal Dutch Shell (Shell) and Total - we went through some of the key bear arguments for the sector. These are teams that have worked tirelessly to bring down the breakeven cost of production and cover dividend pay-outs with cash flow; all three have drastically pared back costs in order to adapt to the economics of a US$50 oil price and have achieved this to the extent that dividend cover for all three companies is better now at an oil price of US$63, than it was at an oil price of over US$100.
Even bears of the sector should acknowledge the sector’s success in pushing down cash cost (both operational and capital expenditure). Cutting headcount was an obvious starting point for cost reductions - BP has nearly halved its upstream workforce since 2010 despite operating a larger operation – but the industry’s capital discipline programme drills much deeper.
Structural developments have been central to improving capital efficiency, with technological advances in exploration, construction driven design and the standardisation of assets at the forefront of maximising capital expenditure in the upstream businesses. The bears would push back by saying that this cost reduction is cyclical and that if the oil price firms for a significant period of time they will give all these savings back. Given that the majority of cost-cutting has been structural, management believe it should be sticky in nature; for example, changes in the design of Shell’s deep-water platforms have reduced costs to 1/3 of original plans. Nothing at Shell is being commissioned with a cash flow breakeven of over US$40 a barrel, with 90 per cent of pre-final investment decision (FID) projects being below this level, 50 per cent of which breakeven below US$30. This compares compared to just under US$75 in 2014.
Prior to the price collapse, the exploration mantra was always to maximise production through specialisation of assets through bespoke and elegant engineering; in the new world, this approach has been replaced by a focus on standardised design to derive the lowest possible break-even price of production. This is a collective recognition and the industry has created a forum to discuss the standardisation of equipment. The major players - Royal Dutch, BP and Total, alongside Chevron (not held in my portfolios) – have all agreed to use standard equipment, thereby driving synergies when they’re working on the same projects.
The focus on breakeven costs may mean some barrels are left in the ground, but this structural shift has led to material cost reductions. At BP, upstream costs are down 46 per cent since 2013, with modernisation and digitalisation helping to reverse base decline rates; BP typically expects 3-5 per cent decline rates1 but in 2017 the base actually grew by 0.6 per cent as digital technology helped to achieve record uptime.2 Sensors for predictive maintenance, drones for inspection, business intelligence, cloud computing and use of big data for analytics have all contributed to driving industry-wide operational and capex efficiencies, whilst also improving safety and reducing emissions.
On capital discipline, management teams have been explicit of the need to ration capital, recognizing that not all areas can be in a growth phases simultaneously – some free cashflow is required to pay the bills and the dividend! Given the attractiveness of LNG (liquefied natural gas) economics, we enquired why companies are not allocating more and more capital to the area. Since its acquisition of BG, Shell has put a lot of resources into LNG and management said it was now time for it to demonstrate strong cash generation.
“The oil majors are only able to pay their dividends by selling the family silver” is a common refrain of the non-holders. Oil majors often dispose of assets in their portfolios, a move that I regard as part and parcel of good portfolio management – a natural pruning of assets in order to strengthen the business and deliver value for shareholders. Given that Shell is now within sight of its US$30 billion disposal programme, we could take the view that the BG acquisition was a very large example of this process. The company have effectively used the deal to ‘high-grade’ their portfolio, which has proven to be a significant contributor to progress seen in reducing its free cash flow breakeven level.
There is a further point to make here, however; the oil majors have diversified, asset-rich balance sheets which equip them to not only sail through market lulls, but also to realise cash when required. Even while the sector is languishing in the market doldrums, we have seen other non-market buyers are ready and willing to mop up access to the commodity which enables global GDP.
One bearish analyst of Shell is basing his sell case on the relatively short SEC (Securities and Exchange Commission) proven reserve life at Shell (8.7 years vs 11-14 years at its IOC (international oil companies) peers). Shell’s management team remains focused on the businesses capital across all seven business strategies with the aim of generating free cash flow. With a robust project pipeline out to 2025-26, the team has no concerns about rebuilding future reserves. In addition, Shell has significant unconventional resources such as ‘Deepwater’ where barrels are only counted by the SEC when they are at the surface. Sometimes you have to be careful what you wish for; in the ‘old days’ some companies suffered from ‘reserve tyranny’, where sellers of assets saw them coming. When the reserves are in sight it’s easy to fill a void overnight, but this scenario doesn’t always give rise to the best outcome for investors.
With most of the market on the fence about the future direction of the oil price, the key point to focus on is that none of the businesses are modelling on a crude price much above US$50. Management teams all see further supply growth coming on stream from US Shale to varying degrees. For some, supply growth will at best match demand due to limited spare capacity elsewhere in the world. However, it’s important to consider demand in the context of exploration spend; wells that are coming online now saw FID in 2014, when the oil price was US$100 barrel. I expect to see a lagged impact of market weakness on production in the coming years and declining project rates are already symptomatic of this trend; in 2010-14 there were 30 giant projects sanctioned p.a., compared to just 10 p.a. over the past three years.
All of the businesses are now focusing on free cashflow as the key metric to manage and, as discussed above, have been successful in dramatically reducing free cashflow break-evens in the sector. Dividends are now well supported by cashflow, scrip dividends are being neutralised by share buybacks, dividend cover is being rebuilt and it is near inevitable that at some point the businesses will start to think about growing the dividend pay-out.
Historical FCF Yield for European Integrated Oil sector
Source: Bernstein, as at 25 January 2018.
The chart above shows the free cash flow yield of the European integrated sector at US$60 oil; it is at the top end of its historic range which suggests that the line has to revert back towards the average.
There are two ways this could happen; either the oil price collapses or the share prices move north – no prizes for guessing what my view is!
Delivering total shareholder return has remained a strategic priority for these companies through the lower pricing environment and remains at the forefront of their thinking as the industry assesses the wide-reaching implications of energy transition over the longer term.
1Decline rate: a method for estimating reserves and predicting production in oil reservoirs and oil fields. The decline curve shows how oil and gas production rates decrease over time.
2Uptime: the ratio of the total time during which a machinery or equipment is operational/ in production to the total time for which the machinery or equipment is available.
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