Comment on Oil & Gas

Oil and Gas Majors trying to be competitive in a structurally lower price environment

It is an economic reality that when commodity prices are high and margins are healthy, resource companies are encouraged to develop new supply. Besides the obvious rationale of taking advantage of high prices at the time, it is also easier to attract funding when margins are large as these wide margins give funders, both equity and debt, a margin of safety. The problem near or at the top of the cycle is the so called “rent seekers” also want their share of the “super” profits. Rent Seekers can be governments, employees, consultants, manufacturers, suppliers and construction companies and they adjust their price expectations upwards thanks to good margins resource companies are earning. Over time as these expectations are met, the returns for the ultimate risk taker; the resource owner and the funders, may be much lower relative to the amount of risk taken. This process of changing resource prices and the resultant profits contribute to the cyclical nature of the resource industry. Resource companies always over invest at the top of the cycle and under-invest at the bottom of the cycle thereby increasing the volatility of cycles compared to other parts of the general economy.

But what happens when the fundamentals of the industry change after long periods of price stability?

Oil and gas companies are dealing with the reality that prices have dramatically changed after a long period of price stability. The chart below shows oil prices over the last 20 years. At the turn of the century oil price began a long period of upwards movement culminating in the very high prices just before the GFC crashed the party. I would argue the post 2000 “Goldilocks Economy” helped by the then fashionable theories around Peak Oil drove the price upwards from a low of $20 per barrel to the top of the market price of $144 per barrel 8 years later. Even post the crash the oil price recovered quickly to stabilise around $100 per barrel from 2011 to 2014. This re-rating from the depths of the GFC was more than likely driven by the vast quantitative easing programs that central banks unleashed around the world to try and stimulate the world economy. Oil prices remained high even when there was supply growth from the application of an old technology in a new way namely Hydraulic Fracturing.

Hydraulic Fracturing of source rocks close to existing oil fields revolutionised the oil supply/demand scenario the world had become used to. OPEC realising the threat of shale oil to its dominance as the swing producer of the world and deliberately increased supply to lower prices to make shale oil uneconomic.

Brent Oil over the last 20 years (Source: Factset)

 

The problem with this strategy of oversupplying the market is that as in most wars, there is always some form of collateral damage. Suddenly in 2014 the large margins that had encouraged the Super Majors such as Shell and Chevron to take large bets on deep sea oil and expensive Artic drilling programs evaporated in the space of 5 months. This left the industry in turmoil as producers, highly paid consultants and service companies and well paid and pandered employees faced the reality that the industry had become unprofitable almost overnight. One personal anecdote that was shared with me was that as the layoffs and salary reductions began to bite in the office of prominent oil and gas company, the engineers were incredulous and were saying to all that would listen “this does not happen to us, this is oil and gas!”

Advances in shale oil and gas technology changed the industry by bringing large amounts of supply onto the market albeit near the top of the cost curve. In the “new normal” of structurally lower oil prices all industry participants are trying to lower their cost base. The Wall Street Journal recently wrote “Royal Dutch shell PLC is trying to reinvent its business with a concept that sounds oxymoronic: budget deep-water drilling”.

Despite historically low oil prices the reality is that there are no more cheap barrels of oil in the world. Companies are having to drill deeper or explore in more extreme parts of our planet such as the Arctic or deep in the jungles of PNG. Working in these extreme environments is expensive and environmentally sensitive. Deep water exploration has emerged as a new source of oil but deep water drilling is costly and risky. Offshore Brazil and the Gulf of Mexico have been especially prolific ultra-deep water plays. Risks are high in this sector as proven by the Deep Water Horizon accident on the Macondo Prospect in 2010 that killed 11 oil rig workers spilled 4.9 million barrels of oil into Gulf.

Traditionally deep water drilling was a big boys game and oil prices of over $70 per barrel are needed just to break even. Shell is trying to change this by making deep water drilling more competitive. In the past Shell has spent big money on chasing elephants with the goal of replacing reserves and growing production year on year. Now the company is focussed on smaller scale projects that are lower risk and bring first oil market faster. Management focus has shifted from reserve replacement to focus on making better returns per barrel that it produces and to achieve this objective, deep water drilling needs to be competitive to shale and onshore projects.

Shell has cut deep water drilling costs by up to 50% and is drilling wells 30% faster. This has been achieved by redeveloping its operating model to be more efficient, by shedding staff and cutting support services. Looking at the financials of Transocean, who own the deep water rigs, its revenue has fallen ~60% over the last 2 years. One can assume they have also contributed to these savings by cutting rates to keep rigs working. Shell is working is planning to extend its lower cost operating methodologies to other parts of its exploration portfolio such offshore Brazil which is partnered with Petrobras.

As with other resource plays when commodity prices soften, resource owners are faced with 2 choices; stop activity or adapt to the new price structure. All across the oil industry we are seeing a lowering of costs as companies adapt to lower revenues and margins and this will ultimately provide a great return for investors as activity ramps up.


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Michael Eidne

Director - Research

Michael has over 14 years experience working in financial markets in South Africa, UK and Australia. Prior to joining DJ Carmichael, Michael held research analyst positions at Bell Potter Securities and Blackswan Equities. He also spent several years working as a consultant for various Perth-based resource companies before moving back to the equity markets. Michael is originally from South Africa where he was a portfolio manager at Edge Capital, which is a large South African alternative investment manager. He also worked for a number of years at Investec Asset Management as an investment analyst.

Michael has a MSc in Mineral and Energy Economics from Curtin University and a MBA in Finance from the University of Cape Town.