This opinion piece presents the opinions of the author.
Last week, Chevron (CVX-NYSE), the second largest oil company, held its annual analyst meeting at which time the company’s management laid out its plans for the next five years, including projections for capital spending and oil and gas production growth. The meeting followed on a presentation at the IHS CERA Week conference in Houston by Chevron CEO John Watson in which he proclaimed that today’s $100 a barrel oil is the equivalent of the past’s $20 a barrel oil. By that he meant that the oil industry must now figure its budget outlooks based on the need for oil prices to stay around the $100 a barrel level in order for the company to generate the necessary cash flow to support spending plans and for projects to offer future returns to meet or exceed required investment hurdles. Mr. Watson has talked about the impact on his business of rapidly escalating costs for finding and developing new oil reserves, which is why he says the company now needs that $100 a barrel price. Chevron is the latest major oil company to implicitly declare that the oil industry has entered a new era – one marked by higher costs and more disciplined capital investment programs that will require higher oil prices. Capital discipline forces companies to sacrifice production growth targets on the altar of increased profitability in order to boost returns to shareholders. What does this new era mean for the oil and gas business? Equally important, what does it mean for energy markets?
Chevron now projects it will produce 3.1 million barrels a day of oil equivalent (boe/d) in 2017, down from a target of 3.3 million boe/d that the company established in 2010 and reiterated to the analysts last year. If Chevron attains its target, it will have increased production in the interim by 19%, a not inconsequential gain. Mr. Watson attributed the reduction in the company’s output target to lower spending for shale wells due to the fall in North American natural gas prices, higher volumes of oil going to the host countries where the company operates under production-sharing arrangements, and “project slippage.” Mr. Watson also indicated that the company would raise $10 billion from the sale of assets, up from its previous target of $7 billion. The company plans to sell oil and gas fields and acreage to raise the funds.
The Chevron outlook mirrors that presented earlier by the industry’s largest company, Exxon Mobil (XOM-NYSE), at its annual analyst meeting. There, not only did ExxonMobil CEO Rex Tillerson announce a reduced production target, but he also said that the company would cut back its capital investment program. While neither the world’s number one nor number two oil companies signaled that the changes in their targets were the result of the industry entering a new era, their actions and similar ones by several of its smaller sisters do suggest that reality.
BP Ltd. (BP-NYSE) announced it was going to split off its shale operations into a separate company, still wholly-owned by BP, in an attempt to transform the operation into a more nimble explorer and developer of shale properties. If mimicking the organizational structure of larger independent oil and gas operators was BP’s goal, one has to wonder what structural impediments necessitated the total separation of the unit. Maybe the move made it easier for BP’s senior management to highlight the drag of its shale business and establish the entity as a stand-alone business. It may also be advertising the unit’s potential in order to attract a joint venture partner or another energy company’s investment.
The strategic moves by ExxonMobil, Chevron and BP fit with the efforts that Shell (RDS.A-NYSE) is making to improve its financial performance. The company is constraining its capital spending and reassessing the economic attractiveness of every exploration and development project. Another large oil company that recently made a strategic move was Occidental Petroleum (OXY-NYSE). The company is planning to spin off its California oil and gas assets and operations into a new company for its shareholders, while the remaining corporation is picking up stakes and moving its headquarters from Los Angeles to Houston where it maintains significant operations. While this move may say more about the desire of OXY’s management to exit the unfriendly confines of California’s regulations and costs, it also says something about the future direction of the company’s exploration and development focus.
We have seen similar statements about revisions to strategic plans by the large, European-based oil and gas companies – ENI (ENI-NYSE), Total (TOT-NYSE) and Statoil (STA-NYSE). These moves are being undertaken by the management teams in response to flagging performance from their huge shale investments and other challenges similar to those outlined by Mr. Watson.
We were intrigued by the decision by Chevron to boost its oil price outlook from $79 a barrel for Brent crude oil to $110 per barrel. This move is designed to help the financial outlook for the company’s earnings and to offset the reduction in the production target. The oil price assumption is consistent with the average Brent price for the past three years, but it is at odds with the trajectory for prices derived from the futures market, which call for lower levels in the future. We wonder whether this price-target revision will rank with their statement about the future course for natural gas prices a few years ago when the major oil companies jumped on the shale gas bandwagon. Their timing essentially marked the top for gas prices as North American gas prices collapsed due to the surge in gas output. This would not be the first time major oil company planning departments incorrectly projected the course of global oil prices.
Strategy adjustments by major oil companies are seldom quickly reversed even when near-term industry trends suggest an adjustment should be made. If the newly defined financial discipline mantra demanded by investors is followed and industry capital spending is restrained, and possibly falls, there will be ramifications in the energy market. If Mr. Watson’s declaration, as echoed by other oil company CEOs, is true, then the cost of finding and developing new reserves is too high and the pressure to drive down oilfield service costs will grow more intense. We may now be witnessing the fallout from that discipline in the offshore drilling business where the expansion of the global rig fleet with more sophisticated and expensive rigs, necessitating higher day rates, is leading to near-term “producer indigestion.” Could the offshore drilling industry be on the precipice of a significant wave of older rig retirements in order to sustain demand for its new, expensive drilling rigs currently being delivered without contracts?
Another question for the industry is who will supply the risk capital for exploratory drilling, both on and offshore, if the majors pull back their spending? Onshore, for the past few years, a chunk of that capital has been supplied by private equity investors who have supported exploration and production teams in start-up ventures. They have also provided additional capital to existing companies allowing them to purchase acreage or companies to improve their prospect inventory. Unfortunately, the results of the shale revolution have been disappointing, leading to significant asset impairment charges and negative cash flows as the spending to drill new wells in order to gain and hold leases has exceeded production revenues, given the drop in domestic natural gas prices. Will that capital continue to be available, or will it, too, begin demanding profits rather than reserve additions and production growth?
The amount of capital flowing into the oil and gas business is extremely important for the future growth of the nation’s oil and gas output since shale wells experience sharp production declines in the early years of their production. A series of questions flow from that production profile: What will happen to oil and gas prices in the medium-term if drilling slows and production rapidly declines? Will manufacturers who currently are building billions of dollars-worth of new plants designed to capitalize on cheap American energy find their investment returns not what they anticipated? How will they react? Will first-mover advantages in this manufacturing renaissance become a disadvantage? What about the billions of dollars targeting new liquefied natural gas (LNG) export terminals? Will we actually have the volumes of natural gas to export, and especially at the low prices projected that are anticipated to give American gas a competitive advantage in European and Pacific gas markets?
These questions should be raised at the same time the national debate about exporting domestic crude oil is commencing. There are various subtleties in that debate that are often lost in the broad debate themes. For example, how quickly can the U.S. refining industry build new refineries or expand existing ones in order to use more of the light, sweet crude oil coming from the tight shale oil formations? If the refining expansion doesn’t keep pace with the growth of light oil, then there could be a cutback in drilling for shale oil that will certainly result in a sharp reduction in the current bullish outlook for U.S. oil production as shown by the significant increase in future output estimated by the Energy Information Administration in its 2014 outlook versus its 2013 projection. (Exhibit 2, next page)
A cutback in oil drilling would also reduce the volume of associated natural gas being produced, which could result in an unexpected spike in gas prices. For some time, U.S. oil producers have been able to secure export licenses to send oil out of the country, primarily to Canada, but will that avenue continue to exist and can it be expanded to prevent a shutdown in shale oil drilling? The political debate over exporting domestic crude oil is being described as 310 million American consumers versus a handful of oil company CEOs with fat pay packages. We doubt the industry can win that battle.
Those are only some of the critical questions that must be asked and answered as the oil and gas industry transitions into the next era of its existence. Much like the performance of the United States economy, the oil and gas business has internal momentum that will keep it going as managements reassess its future. We have been watching the industry over the past couple of years with one historical perspective in mind – the generational change underway in the executive suites of energy companies. While we are not denigrating the experience levels or intellect of the new CEOs, we are merely reflecting on the past periods when industry leadership changes occurred. Those transitions often resulted in the new leaders having to make their own “learning mistakes” like their predecessors did. That may be an important aspect of the industry transition currently underway.
G. Allen Brooks works as the Managing Director at PPHB LP. Reprinted with permission of PPHB.
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