Musings: Understanding Oil Industry Restructuring Currently Underway
This opinion piece presents the opinions of the author.
It does not necessarily reflect the views of Rigzone.
The weak financial results reported by the oil majors for 2013’s fourth quarter and full year should be viewed within the context of the industry’s structural transition that is likely to last for some time. With the advent of activist shareholders, management changes and financial pressures due to the costs of the shale revolution, companies have been forced to re-examine their business models and corporate focus. Many analysts and investors are narrowly focused on the near-term impact these restructuring steps are having on company cash flows and production growth. While these are important near-term considerations, they should be viewed from a higher level and with a long-term perspective. From that level, the first observation is that the restructuring movement commenced several years ago and it began within smaller companies in this industry group in response to the desire of their managements and boards of directors to improve their corporate performance in light of the more limited capital and investment options they had available. Now, the restructuring movement has moved up the food chain and is being driven by the actions of larger integrated oil companies. The changes they are making are partially in response to how the American shale revolution is impacting the dynamics of the domestic crude oil and natural gas markets, and that are now beginning to impact the petroleum industry globally.
The current obsession on the industry’s restructuring actions was driven by the mid-January earnings pre-announcement from Royal Dutch Shell (RDS.A-NYSE), which marked the company’s first such earnings miss in a decade. The prior miss was the result of a corporate scandal in the form of an overstatement of oil and gas reserves, which ultimately cost several senior executives their jobs. Shell’s press release announcing that its fourth quarter earnings would be $2.9 billion, down 48% from the $5.6 billion earned in the same quarter a year ago, and importantly $1 billion below the consensus analyst estimate, created significant turmoil within the investment community. Shell also said that its 2013 full-year earnings would total approximately $19.5 billion, compared with $25.3 billion in 2012, which reflected a disappointing year.
Effective January1st, Shell now has a new chief executive officer, Ben van Beurden, a 30-year employee of the company and an unconventional choice to run the company given his downstream career. While some investors suggested Shell was merely “kitchen sinking” the bad news to provide a relatively clean slate for the new CEO, Mr. van Beurden said that the company’s performance in 2013 was “not what I expect from Shell” and that changes would be made. He went on to tell investors that his focus would be on improving Shell’s financial results and “achieving better capital efficiency,” code words for re-establishing an earnings growth trajectory. It is also code for cutting and re-ordering capital spending, streamlining the business and shifting priorities, which probably got employee attention.
Subsequent to the earnings warning, the financial media began evaluating the performance of the major oil companies. This led to several articles about the challenges major oil companies were encountering in managing their mega-projects needed to increase their oil and gas output. Many of these high-profile projects have been the subject of corporate reviews over the past six months due to cost-overruns that are raising questions about the projects’ financial viability. Chevron’s (CVX-NYSE) Gorgon project off the coast of Australia to produce and export liquefied natural gas (LNG) and co-owned with ExxonMobil (XOM-NYSE) and Royal Dutch Shell, has seen its cost estimate escalate from the original budget of $38 billion to $54 billion, a roughly 45% increase. This is only one mega-project, but the oil majors have seen similar cost escalations at other mega-projects around the world driven by labor shortages, regulatory requirements and delays, and bad weather.
The surprise announcement last May that Shell CEO Peter Voser, the company’s former chief financial officer, would retire at the end of 2013 after less than four years at the helm set in motion not only a search for a new chief executive but also a high-level review of the company’s investment performance and capital spending plans. Mr. Voser was highly regarded by investors as Shell had outperformed all but one of its oil company peers since he became CEO. In July, Shell’s directors surprised the investing community by naming Mr. van Beurden the new CEO. He was the head of Shell’s refining operations and had been a decade-long head of its chemicals operations, but he had also held a position for two years evaluating and trying to improve the operating performance of downstream operations. In anticipation of taking over, Mr. van Beurden spearheaded a review of Shell’s capital investment plans including a proposed gas-to-liquids plant targeted for Louisiana that was canceled and its investment in Arrow, a LNG project in Australia that was deferred. A decision about constructing a petrochemical plant in the U.S. Northeast to capitalize on the growing gas and liquids output from the Marcellus and Utica formations was postponed.
When Shell reported its earnings, Mr. van Beurden announced a change in direction for the company, partially reflecting the company’s capital spending review and clearly a statement about its view of the company’s needs for the future. Shell will curb its spending, temper its growth plans, increase divestments and restructure parts of the business. At the same time, Shell’s confidence in the future was reflected by the decision to increase its dividend by 4%. At the same time, however, the company cut total capital spending 20% below 2013’s level and targeted increasing organic investment by 8% to $35 billion. The company is stepping up its divestment program with plans to sell an additional $15 billion of assets during 2014 and 2015.
Rethinking the oil company business model is not a new phenomenon, and to a certain degree one can attribute some of the recent corporate moves to the growing and perceived success of the American shale revolution. In 2011, ConocoPhillips (COP-NYSE) elected to split its company into an exploration and production-focused company and a downstream-focused company. The split was completed at the end of April 2012 and new management took over running the businesses. The split enabled the E&P business to focus its efforts on growing its liquids output following the company’s untimely investment in dry natural gas with its 2005 purchase of Burlington Resources. That deal boosted ConocoPhillips’s gas reserves by 88% and its gas production by 77%, making the company the second largest natural gas producer behind BP Ltd. (BP-NYSE). Since the split, new management has continued to target liquids production over gas output and it has sold investments lacking solid profit growth such as in Algeria and its share of the Kashagan field in Kazakhstan’s sector of the Caspian Sea. At year-end 2013, ConocoPhillips reported that its organic oil and gas replacement ratio had reached 179% of last year’s production. It also highlighted that production in the Eagle Ford, Bakken and Permian, three attractive liquids-rich plays, had increased by 31% last year. These three areas are highly favored by investors who boost the value of companies active in the plays.
The chart in Exhibit 2 shows stock price trends over the past two years for three majors (ExxonMobil, Royal Dutch Shell and Chevron) and two smaller majors – ConocoPhillips and Marathon Oil (MRO-NYSE) that have been transformed into focused E&P companies. The chart shows some interesting trends. Marathon initiated the growing integrated company restructuring in 2011. Since its split into separate producing and refining companies, Marathon has focused its E&P efforts on expanding its unconventional production, especially in the Eagle Ford region of South Texas. A new CEO took over the top spot in mid-2013 and is helping direct this effort. Although some disappointing production results late last year hurt the stock’s performance, management continues to execute its game plan.
As shown in the chart, over the two-year period ending February 2, 2014, the Standard & Poor’s 500 Index produced the highest return to shareholders. While underperforming for most of the first half of 2013, ConocoPhillips actually matched the S&P 500 performance by the end of the year only to drop as we entered 2014. The two worst performing stocks for the entire period were Marathon and Royal Dutch Shell. Their performance convergence by early 2014 was due to the extended slide by Marathon from late fall and the rise in Shell’s share price toward the end of the year as shareholders turned more optimistic about the company’s future under its new leader. Both stocks subsequently declined in January along with the overall market and the entire petroleum sector. The shares of ExxonMobil and Chevron converged at the end of 2013 as ExxonMobil’s share price was boosted by the revelation of a significant new investment by Warren Buffett’s Berkshire Hathaway (BRK.A-NYSE). Up until that revelation, Chevron had outperformed ExxonMobil for virtually all of 2013.
A mid-December Lex Column in the Financial Times asked the question “Why own shares of Big Oil?” The writer offered an explanation – the integrated model generates enormous amounts of cash, and implicitly attractive organic returns. The writer examined Shell’s financial performance based on interim results and research estimates. For 2013, Shell generated cash flow from operations of $16.5 billion and total cash flow after tax of $40.4 billion. Total capital expenditures for 2013 were $40.1 billion and the company paid $7.2 billion in dividends. It increased its debt outstanding by $2.2 billion and repurchased $5 billion of shares outstanding. Essentially, Shell failed to generate any free cash flow last year, which certainly supports Mr. van Beurden’s statement about unacceptable results and the need to change how things are done at the company.
The lack of financial performance is demonstrated in the series of charts that accompanied another Financial Times article dealing with the need for the major oil companies to adjust their capital spending. The charts show oil and gas capital expenditures from 2003 through 2012 and the estimated value creation through exploration for 2008-2012. Note that in terms of value creation, only two oil companies of the seven analyzed generated positive returns, yet the industry has continued to ramp up capital spending during this period as companies have pledged to grow their production even as the cost to find and develop new oil and gas reserves escalates.
So with Shell’s performance as an example of a company generating substantial cash flows but failing to earn meaningful returns, the Lex Column suggested that the returns attracting investors must be coming from merger and acquisition activity. The example pointed to by the Lex Column of the industry’s failure in this regard was ExxonMobil’s purchase of XTO Energy for $40 billion at the end of 2009, just in time to catch the collapse of domestic natural gas prices. As ExxonMobil’s CEO Rex Tillerson said early last year, the company was losing its shirt on its gas activities. The Lex Column pointed out that since the acquisition ExxonMobil’s shares were up only 30%.
It also pointed out that U.S. oil companies lagged the S&P 500 by “a distance” over two- and five-year periods, which is confirmed by Exhibit 2 and also by the chart above.
The Lex Column concluded: “What matters now is to rein in capex and start focusing on returns. This will happen in two ways. One is by asset disposals – 2014 could see a flood of oil and gas assets come on the market. The other is through a clampdown on capex and greater control of costs.” It is rapidly becoming clear that both of these strategies will be executed this year and likely for a while longer. On the one hand, energy transaction facilitators – investment bankers and petroleum asset brokers – may be looking at a better year in 2014 than in 2013. On the other, oilfield service companies may be facing a tougher year for generating pricing gains, meaning they, too, will need to tighten their belts and strive to become operationally more efficient if they want to generate adequate returns on the investments they have already made. We could also experience a wave of restructurings within the oil service sector. The American shale revolution isn’t entirely to blame for these developments, but it has to be examined within the context of how it has reshaped investment opportunities and challenges, especially given the significant over-investment in shale developments relative to the cash flows those plays are generating. Games can only be played for so long.
WHAT DO YOU THINK?
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Managing Director, PPHB LP