Big Oil and the illusion of Capital Discipline

A couple of months ago, I wrote a post here on LinkedIn suggesting that what the industry and the world needed was a “goldilocks” oil price. A few days later Goldman Sachs published a thought piece entitled Goldilocks and Big Oils – The temperature is just right in “The Age of Restraint”.  As someone once said, whoever believes in coincidences doesn’t understand maths.

The GS piece was a detailed analysis of how and when Big Oil makes value for its shareholders – a pertinent distinction compared to the more usual analysis of how oil companies make money for themselves (then blow it all).  Their conclusions is that (a) “periods of restraint” were the best for shareholders of Big Oil and (b) we are entering to a period of restraint.

GS have analysed the historical record by looking at key shareholder metrics.  In this world view Restraint is caused by a perception of long-term abundance of oil resources.  Backwardation in the forward curve creates structural positive earnings revisions as consensus oil price gets rolled up over time, following the forward curve. The low price at the end of the curve preserves capital discipline. Expansion, in contrast, is a period of perceived tightness in the supply side which tends to favour service companies and explorers as big oil scrambles for resources.

Whilst this analysis has the usual rigor and depth one would expect from a big Investment Bank (and indeed makes a lot of sense), I think it is wrong one respect: that we are entering an age of restraint. I see a period of expansion and in all likelihood, a subsequent period of contraction, ahead, but only a tiny window for restraint.

It is a Net Margin Business (except when it isn’t)

It is often said, and is indeed generally true, that the upstream oil industry is a “Net Margin” business.  Simply put, oil companies don’t make any more money at high oil prices than at low oil prices.  Anyone who works in the industry can work this out – costs rise, windfall taxes appear, companies go after more marginal barrels and so on. Likewise, at low oil prices, costs are squeezed and (in some places) taxes and regulations are relaxed, and companies focus on core, low-cost areas. The result is similar net margins in both scenarios.

The key to this is that the above descriptions hold true if prices and costs are stable, or more-or-less stable.  2010-2014 was a case in point for high oil prices. This period was famously characterized as being “an eerie calm” by the EIA.  1986-1998 was a similar period of stable(ish) oil prices. It seems incredible now that (even if inflation adjusted) project sanctions were taken with long-term $14 oil price forecasts.  But oil companies did fine during this period – this was indeed a period of restraint.

In Russia in the mid-naughties companies had to pay a tax that was calculated on a look-back oil price – averaging the previous 6 months. The result was that the tax burden was a function of the derivative of the oil price. If the oil price was stable tax was stable and commensurate with the intended rate.  If the oil price was dropping fast the tax lagged and remained high (just when you had less revenue; everyone complained). Conversely, in a fast-rising oil price, the tax lagged and margins expanded; not unsurprisingly no one complained.

This same mechanism explains oil company profits. It is the periods of change, and the rate of change in the oil price and the cost base, that determines oil company profits.  Fast falling prices with costs dropping slowly with some lag, can seriously weaken the balance sheet of any company, woe betide the company who is over leveraged. Conversely, rising oil prices hide many sins. The margin expansion that this creates, is happening now and is mind-blowing.

Margin Expansion

Pareto Seurities have, by way of example, calculated that Equinor (you know, that wannabe ex-oil company) is going to make more Free Cash Flow in the next three years than it did in the previous seventeen years combined!  I’m just guessing here, but I think analysis will show it is not the result of its well-meaning diversification into renewable energy that is the origin of these record profits.

(NB the data of this image doesn’t exactly reflect the headline, but is part of the same logic. The cumulative total of the past 9 years are beaten by 2018 alone)

This wall of cash will be a huge relief to CFOs and CEOs across the sector. Shareholders will be happy as dividends can now be covered by organic cash flow. In recent years dividends have been supported by asset sales and/or increased leverage. This policy would be suicidal if you didn’t have faith in the near-mid-term recovery in margins.  Asset sales, increasing leverage and no investment in project sanction and/or exploration – whilst maintaining dividends – would create magical shrinking oil companies.

Part of the logic of the periods of expansion in net-margins is that costs stay low (lag) whilst revenues driven by the oil price, increase.  Go to any current conference or Big Oil Capital Market Day webcast or Annual Report and you’ll see the same mantra.  Big Oil says we are focused on “capital discipline”, there will be “no return to the bad-old days”, projects “must screen at $40 oil…” etc. 

To my mind this is Little Red Riding-Hood looking at the wolf and saying “what big teeth you have Grandma”.

It is laudable to aim for capital discipline and rigor, and it is telling people (shareholders) exactly what they want to hear. So, it is politically correct but it is only words. The reality is the same as a consumer who “rejects” price increases of food – but is left with two choices (1) pay more, (2) eat less. 

Pay more or eat less

For all the talk of “sustainability” with oil companies, the basic business model is not sustainable in any true sense of the word. Oil companies extract a finite and depleting resource. Everything else is spin. As a side note, although oil is inevitably finite on a finite planet, I am not saying anything about Peak Oil – we have plenty of the stuff. As per previous posts (and here) I do believe in Peak Cheap Oil and the likely resultant Peak Prosperity, but am not worried about running out of the stuff any time soon.

Sustainability of an Oil Company is really just about replacing the produced volumes – to ensure that the business can continue.  I am ignoring the question of Peak Demand here as I think it is sufficiently far off to be a huge red-herring – which will be the subject of my next article.

If an oil company has no new discoveries, no acquisitions and/or no project sanctions, then it will decline as its existing reserves are depleted and cash is paid out to shareholders.  This is not rocket science.

Reserves Replacement

Ignoring Chevron and Equinor – we can see that the trend for Big Oil has been reserves reductions over the last four years. I am assuming this is BOE, so will include gas. I suspect just oil would look far worse.  This should be caveated by the fact this is (I’m assuming) Proven reserves – and clearly that is – to use an inappropriate analogy – the tip of the iceberg.  Decreased prices mechanically decrease reserves (for the non-specialist, reserves are defined as being “economically producible” so smaller volumes pass that threshold as price decreases). Likewise, low prices delay the passage of projects to Final Investment Decision (“FID”). So, all else being equal, declining oil prices reduce reserves, increasing oil price increases reserves.

(side note – how can any company have identical reserves 4 years in a row, with 4 big variables of production, technical revisions, acquisitions/divestments and oil price related reserves adjustments?  Go figure.)

Low prices, low spending

What is clear is that the past four years have seen an unprecedented decline in project sanction, as well as a massive drop-off of exploration activity – both seismic and drilling.  Ironically, the exploration success ratio has increased – but this is partly a function of companies having to be really really focused on high-grading prospects before drilling.

Overall, however, the trend is clear – companies are not replacing their production.

Combine this with the huge cash positions Big Oil will find itself with, and the inevitable consequence will be an up-tick in activity, both organic as well as inorganic (M&A).

Exit stage left, pursued by a wolf.

If you think the upstream industry has had a few tough years, spare a though for the service industry.  The high-end seismic fleet has been halved in four years as ships have been mothballed or scrapped (most cold stacked ships and rigs will never see service again).  The rig industry was heavily over-built running into 2014 – a classic problem of the industry – which was amplified by the availability of tons of cheap debt. As with seismic, the rig industry has seen a massive scrapping program along with a lot of stacking. 

The cost of getting rigs out of stack is tens of millions of dollars, so there is a barrier.  It is estimated that for a Business as Usual “BAU” scenario, the global rig fleet (floating) will be about right sized. Any increase in activity over BAU and we’ll be under supplied and the build cycle will start again. As a side note, the era of cheap debt is coming to a close – so the cost of capital for new rigs will increase…

Crucially in these industries is where the pricing power sits.  A good rule of thumb is that as worldwide utilization reaches about 80-85%, so the heavy-metal owners start to dictate pricing. Below this level and Big Oil dictates terms (or just delays contracting).

As an anecdote I recall seeing this supply/demand power-play unfold first-hand when in Angola in the mid 1990s. A deep-water rig came off a well earlier than expected (it was the only well not flow-tested in a sequence of easy successes) and the anchor handling boat had been sub-contracted “to save money”. The result was that the only other vessel in the world that could do the job – which of course belonged to the same OSV company, had to steam from Norway. Forget the cost of the fuel – which was huge, but imagine the price negotiation on the day-rate, on top of the idle rig… pretty uncomfortable for the operations manager who had tried to save money!

Neither the rig market nor the seismic market are at these utilization levels yet, but it will happen. The CEO of a seismic company recently said, diplomatically about 2019

“we expect to start testing pricing in 1Q”

So the starving wolf is sniffing around the door, and there will be blood.

Capital Discipline

The reality is that oil companies don’t control their costs.  The “Big Bad Wolf” in my analogy is the service industry, and having been starved in the long cold winter, its hungry and waiting in the woods.  And for those in this vital sector, please don’t get me wrong – there is nothing “bad” about it, its just terminology borrowed from a folk-tale – and pricing pressure is just normal business!

The speed at which the cost-base dropped in the 2014-2015 price crash was remarkable. It is likely that the cost-base will now rise quickly, and indeed this is already starting.

It is unlikely that Big Oil will go back to having operating service companies as subsidiaries; a model that has not worked in the past. Consequently, for all the fine words how anyone can promise capital discipline? If you don’t pay for services, you will not replace your reserves, and you will wither on the vine.

I don’t see a period of restraint anywhere on the horizon.