Musings: Understanding Oil Industry Restructuring Currently Underway
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.
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Managing Director, PPHB LP