In another of our occasional guest blog entries, Steven Kopits of the New York office of Douglas-Westwood Associates, an energy business analyst firm, looks at the relationship between the ability of an economy to shoulder a certain oil price level and what that means for the companies that produce that commodity. If you’d like the firm’s full presentation on this issue, Steve can be reached at firstname.lastname@example.org.
As in the second quarter of the year, third quarter results for the oil majors, the international oil companies and other major listed operators, were disappointing. Some were downright awful.
Why have results for the oil companies deteriorated so markedly, and what should we expect in the future? In this article, we’ll look primarily at upstream liquids — primarily crude oil production.
Historically, when crude oil consumption has reached 4.25% of GDP in the US, the consumer has chosen to reduce consumption rather than accept further price increases. This number represents a Brent oil price of $103 / barrel today. The equivalent numbers for China are about 6.25% of GDP and $120 / barrel, Brent basis. Take the combined average, and the global “carrying capacity”, the price the global economy as a whole can manage, is about $112 / barrel Brent, just a few dollars above recent Brent prices. Increasing oil prices from here means increasing carrying capacity, which is fundamentally a function of GDP growth and oil efficiency gains. In theory, this number (including dollar inflation) could reach 7% per year; empirically, it has averaged 4.5% per average in the last half decade. Thus, in our models, the oil price can increase, but not at nearly the 20-25% rate we saw from 2003 until 2011 (allowing for the recession). And as a practical matter, oil prices are essentially unchanged over the last two years.
At the same time, exploration and production costs have been rising at an 11% pace. Thus, costs have been rising faster than revenues, and this in turn has been putting pressure on upstream margins, which are 1-3% of revenues lower than a year ago.
Most of the large operators now require $120-130 / barrel Brent to maintain their current dividend and capex programs. As this is not forthcoming, oil companies are re-thinking their investment strategies and portfolios. “Capital discipline” has become a watchword in investor presentations, and most operators have significant divestment plans now in place. But they have not been able to cut dividends, as investors are increasingly demanding cash rather than growth.
Hess Oil, farther along than many of its peers, provides a cautionary tale of how this can unfold. At the behest of hedge fund Elliott Management, Hess divested a number of businesses and holdings. As a result, organic liquids production has fallen by about a fifth, and with it, Hess’s profits. The company may well be more capital efficient, but it is also becoming smaller. And as capex are generally about 45% of revenues at the oil companies, this implies that Hess’s capex will also be declining. France’s TOTAL was recently rewarded in its share price for doing exactly that.
However, if cost increases continue to outpace revenues gains, then additional rounds of capex cuts will be forthcoming, and the industry will enter a downward spiral. Will this then lead to a round of consolidation? Goldman Sachs has, sotto voce, begun to speak of mega-mergers.
Blog entry continues below…
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The key to the industry outlook is the path of costs. These are fundamentally driven by location and geology, with deeper, higher pressure wells in increasingly remote marginal fields becoming the norm. But there’s more to the story. Both Hurricane Katrina and the Macondo blowout have led to increasing regulations as well as more conservative project management practices. These have bloated costs and slowed decision-making. In principle, however, they should not get any worse than they are now. In addition, some costs may ease, for example, if the Australian labor market cools or the supply of drillships catches up with demand. If operators can limit their oil-related E&P cost increases to 4-5% per annum, the industry should stabilize. If not, then mergers will duly be in the cards, with the key to valuation being the likely path of costs.
For the moment, it is not clear that costs can be stabilized. They continue to outpace revenue gains, and the industry has become unstable as a result.
Get your Hess trucks while you can.