A health check for the oil majors

The demise of the oil majors has, once again, been announced. NGO’s refer to them as slowly moving dinosaurs, sitting on stranded assets that cannot be (fully) produced. They maintain that their shares are massively overvalued and that the majors should rapidly change their business model or perish. Financial analysts are worried about high costs, future oil demand and low reserves replacement ratios. They point out that majors should prepare for an oil price that stays lower for longer rather than to keep on repeating that the current low oil prices are not sustainable. Are things really that bad for the majors?

Weaknesses

Oil majors face a number of issues that they have been struggling with for a long time. They have lost their edge in technical knowledge to smaller companies, service companies and, to a lesser degree, to NOC’s. For “easy” oil NOC’s do not need them anymore. But also for more complex projects some NOC’s have made a lot of progress (e.g., Petrobras’ technical capabilities in deepwater). Service companies, working for many oil companies large and small, have the economies of scale to develop knowledge, software and techniques superior to that of the majors in many areas.

The majors have trouble replacing reserves. The lack of access to regions with low cost, easy to find oil has been a key issue for many years. There may be no shortage of oil in general but there is a real shortage of low cost (easy to find and cheap to develop) oil in countries outside the Middle East. In the exploration realm the oil majors’ track record is worse than that of smaller, niche exploration companies like Tullow, Anadarko or Lundin. Technical knowledge travels more easily these days. Specialised exploration geoscientists flourish better in smaller companies that focus on a particular niche than in larger, more burocratic organisations that tend to rotate their staff every few years.

Majors are gradually becoming gas producers rather than oil producers (some more so than others), given the much greater geographic spread (and resulting easier access) of gas reserves compared to oil. This seems a risky bet though. Gas is likely to be systematically less profitable than oil, given the lack of an OPEC equivalent for gas. Transport of gas requires pipelines or LNG; both of which are expensive. Only about 30% of LNG cost is related to feed in gas; with the bulk of the cost related to liquefaction, transport and regasification. Oil is primarily used for transport, for which there are no easy alternatives in the short term. Gas is primarily used for industry and electricity generation where coal and renewables are strong competitors. For oil the industry is expecting that the current low oil prices are not sustainable beyond 2017/2018 when non OPEC supply will start to drop in earnest as a result of the recent drastic investment cuts. For gas the long term price outlook is more bleak – given a likely more prolonged gas oversupply due to the number of LNG plants coming on stream now and in the coming years.

Majors are not well suited (company culture, strengths) to compete in the US shale oil / gas boom. This is all about standardisation and cut throat efficiency. It requires a different way of working than the one off, complex, large technical projects that the majors excel in. The entry hurdles for new players are relatively low (technically given an efficient and knowledgeable US service industry and financially given the access to cheap financing).

In short, majors have trouble competing with niche players (whether it is in shale oil, near end-of-field-life assets or greenfield exploration). Large new opportunities (their niche area) that are accessible to them are increasingly rare and located in increasingly difficult areas (ultra deepwater, arctic, etc).

Strengths

In many of the areas where they operate the majors have been the first movers. With the biggest oil fields typically found during the early phases of exploration and with advantageous license terms dating back a long time to periods of lower prices, the majors often have a systematic advantage to later entrants. Throughout the last 20 years the majors have tended to spend a relatively large part of expenditure on existing developments rather than greenfield exploration (in contrast to smaller companies), simply because it provided them a better return on capital. The heartlands of the oil majors have given them a systematic tailwind – enabling them to better withstand periods of low oil prices and to refrain from overly ambitious and costly growth projects in times of high oil prices.

The majors’ downstream assets greatly improve their financial performance in periods of low oil prices.

The majors’ financial strength remains unsurpassed in the industry. With their low gearing and high rating they can obtain funding – when needed – at much better terms (whether to keep up dividends or make acquisitions).

The majors have the technical, financial and organisational capabilities to execute projects that are beyond the capabilities of many smaller players. This is not just about certain areas or plays (deepwater, arctic) but also about (floating) LNG or gas to liquids projects. The scope for such large scale, capital intensive, long term projects may be shrinking but it has not disappeared.

Smaller niche players indeed have made inroads on the oil majors’ turf. But have they made much money out of it? Many US shale companies have been cash flow negative for a long time. They are like house owners whose house is of substantially less value than their mortgage. They are still able to pay for their mortgage (by rigorous cost cutting or more worrisome by reducing or even stopping activities) but the shape of the shale oil industry is much worse than the still impressive production figures would lead us to believe. The rigorous capital spending procedures for the majors may have have resulted in some missed opportunities. But their financial performance has benefited and the performance of their stock has, in general, been far superior to that of smaller players in the current downturn. Oil majors are not out there to produce more oil. They are out there to make more money, in the long term. In that respect they may be more similar to OPEC than expected (with whom they have a relationship that could be described as symbiotic).

Challenges

Concerns on global warming, resulting in a renewed push to reduce global CO2 emissions, limited economic growth and the long term reductions in energy intensities will all result in a downward pressure on oil demand. Limited economic growth and the reduction in energy intensities are long term trends that are relatively well established. What is less clear is to what extent climate policies following the Paris agreements will result in a reduction for oil (and fossil fuels in general) demand. To what extent will electric vehicles and energy storage take off? No reduction in the fossil fuel part of the global primary energy mix whatsoever was achieved in the last 20 years (post Kyoto). This time is likely to be different given the dramatic reduction in cost for power generation by renewables and the much increased awareness of the downsides and costs of climate change. But to what extent? The 2040 fossil fuel fraction of the global primary energy mix ranges from as low as 60% (450 scenario) to 75% (new policies) to 80% (business as usual) for different IEA scenarios.

Should the oil industry as a whole plan for 60% we may face issues with security of supply (in a world of higher oil prices and oil majors’ profits). Should the oil industry as a whole plan for 80% we may see oil prices lower for longer for real. Luckily for the oil industry their shareholders, financial analysts and NGO’s may enforce the capital discipline on them that they are less well capable of when left to themselves.

What is clear though is that the majors’ oil producing assets can be produced to the full. The production from global developed reserves falls far short from the oil demand projected for the 450 scenario. What is at risk of not being produced are undeveloped oil reserves (more so for NOC’s, less so for the majors) rather than developed reserves. It is the oil majors’ business model that is at risk in the long term; not their existing producing assets where they have made the bulk of their investments. With oil major valuations primarily based on their proved reserves (not the same as, but similar to, developed) I cannot see the case for a bubble in the valuations of the majors (or at least not a bubble caused by stranded assets). The low reserves/production ratios and the current low oil price environment are much more important for the valuation of the majors than stranded producing assets. Doubts about the longevity of the oil majors business model have been around for a long time (be it primarily driven by the majors’ lack of access to new low cost reserves, rather than by long term reductions in oil demand due to climate concerns) and have been the driving factor for relatively cautious valuations (with a relatively low value attached to possible reserves).

It is the expectation in the industry that, barring major demand shocks or geopolitical events, the current low oil prices below $50 per barrel are not sustainable in the medium term. US shale oil is likely to see a more significant drop in production in 2016 compared to 2015 but the major non OPEC supply drop will only take place in 2017/2018 and beyond, as the effect of the ongoing major investment drops in non shale oil take time to kick in. On the other hand, prices above $80 per barrel do not seem sustainable in the long term either, given the expected resulting increase in global shale oil production and lowered oil demand forecasts.

Political support for oil companies is diminishing. Although most governments realise all too well that the energy transition will take time and that a secure supply of fossil fuels is indispensable, they also know that the tolerance for pollution and risk (whether perceived or real) amongst their voters is minimal. Oil companies need not be concerned that their assets will be closed down (as happened to utility companies during the Energiewende) given the large amounts of money that oil and gas assets contribute to governments. Carbon taxes will actually be welcomed by the industry as they provide a more level playing field than subsidies and will help gas taking away market share from coal. But what about extra taxes on the profits of the oil and gas industry? In a time when oil prices and oil majors’ profits have returned to higher levels and when the adverse effects of global climate change have become more pronounced the majors may become an easy target, especially during times of economic downturns.

In general, the unpredictability of government measures (resulting in an inconsistent stop start approach) remains a risk. Massive subsidies and “leading by example” can follow CO2 pricing and “let the market do its work” in rapid succession. Different countries may make radically different choices.

Responses

The majors are adapting, although not in the way as envisaged by the NGO’s. They are not completely changing their business model. Their strengths after all are in finding and producing oil and gas. They expect oil demand is there to stay, be it at lower levels than envisaged 10 years ago. They expect the energy transition to take the better part of this century rather than the 25 years as envisaged by some NGO’s. They expect demand for fossil fuels to continue shifting away from the developed world. The new engineers and geophysicists they hire are increasingly from India or China.

They are, and will continue to be, more reluctant to go ahead with new developments, focusing on developments at the lower end of the cost curve. The ability to manage cost and a flawless project execution are more critical. Given the larger uncertainties on future oil price and demand they are more reluctant to go ahead with large, complex projects with long lead times. No more Kashagans! Every major has been going through a ranking process of potential developments and only the best of deepwater (e.g., Appomattox) and the best of non US shale oil (e.g., Vaca Muerta) and hardly any oil sands projects have survived; at least in the short term.

They are looking into acquisitions. Their financial strength and the much reduced share prices of smaller and midsize companies enables them to cherry pick, aiming for companies that have existing or new developments at the lower end of the cost curve. This is the time to address the low reserves replacement ratios from the last 10 years. Again, every major will have gone through a ranking process. At this stage companies like Tullow and Lundin look like takeover targets. At the moment, Middle East and South East Asian NOC’s do not seem to be in the market; a situation that is unlikely to last forever. The main challenge is timing. No one wants to blink too early as Shell did in the BG takeover (how easy to say in hindsight). No one wants to finance acquisitions by having to sell assets in the current market.

They will continue to promote gas and aim at gas taking away market share from coal; if necessary by promoting carbon pricing. If it is just about reducing emissions in the short term, replacing coal by gas is a much more cost efficient way than many of the measures currently put in place by governments. The dilemma for governments and NGO’s is whether to accept gas as a transition fuel. The dilemma for the majors is whether they want to get serious about CCS, not waiting for government subsidies but funding a much more substantial activity level (and hoping that the subsequent learning will bring down costs to an acceptable level – with a highly uncertain chance of success).

In conclusion

So basically majors are increasingly going into sunset mode. They will accept a gradual decline of production and safeguard their profitability by being very disciplined in spending capital. They should keep on doing what they are good at – within the limits of the law. But it will be in a more difficult environment with a long term downward pressure on oil demand and oil price. Majors have a long history of adapting. They have seen many of their assets nationalised throughout their history. They have seen the loss of control over the industry in the 1970’s and the following dramatic swings in the oil price. But their reason for being, the world’s demand for oil and gas, is still there. Their niche may be shrinking but it is not about to disappear. The majors may have entered old age but they are not dead yet.