Upstream strategies - early signs of a shift towards growth

The rally in oil prices this year from the Q1 depths of under US$30/bbl has breathed life back into the industry. Investors have responded - oil and gas shares have outperformed the wider market by 7% YTD. Oil prices now look set to average around US$43/bbl in 2016, 17% down on last year but, in our view, the annual low point in this cycle.

Self-help is the other factor which has drawn capital back into the sector. Our latest estimates suggest cash flow break evens will almost halve from US$93/bbl in 2014 to US$53/bbl in 2017.  This metric is the Brent price the 50 leading companies need for cash flow (including downstream) to cover planned investment and financing, including dividends. There is wide variation around the average among the companies and peer groups.

Driven in part by the need to avoid breaching debt covenants and keeping lenders at bay, it’s quite an achievement. All levers have been pulled – cost cutting on a grand scale, paring back discretionary investment spend, slashing distributions to shareholders.

Getting finances under control has already enabled some companies to engage in more constructive activity – growth investment. Six major projects have secured FID globally so far in 2016 - a combined investment of US$67 billion set to deliver 1.2 million boe/d of production at peak.

The broad characteristics of the six projects reflect the industry’s focus and current cautious appetite for risk – brownfield rather than green field; leveraging existing infrastructure; and a weighting to domestic gas with minimal oil price exposure. Cost deflation and project re-optimisation were also important factors in achieving much tougher economic hurdle rates.

Two more big projects have a good chance of getting the go-ahead before year end. If so, 2016 would equal 2015’s total of eight FIDs; and we reckon upwards of 20 projects might be sanctioned in 2017. This is a recovery from a very low base, and still well below the 40 p.a. averaged 2007-13; but progress nonetheless.

US tight oil drilling has picked up, demonstrating the sector’s predicted sensitivity to oil price recovery. The horizontal rig count has jumped by 24% from the April 2016 lows. Financing is still a challenge for operators with capital markets discerning to say the least. But US$19 billion of equity issuance to North American independents this year indicates that capital is there for the right strategies.

M&A is also on the up. The asset market is still illiquid, with transaction numbers in 2016 running well below pre-crash levels. But there has been a marked rise in deal values, with Q3 2016 set to be the best quarter since Q4 2014. The action is centred on US L48 unconventionals, with the Permian Basin tight oil play to the fore. Typically, financially strong companies are using the downturn to strengthen core positions, or diversify into complementary plays – and keep low down on the cost curve. However, there is little depth in the global asset market and the immediate prospects are dim for disposal programmes aimed at bolstering balance sheets.

Irrespective of these positive signs, the industry still has much work to do and oil prices slipping back from recent highs is a timely reminder to guard against over optimism. At today’s oil price, the sector’s debt would increase by US$40bn in 2017 given break evens at US$53/bbl (sensitivity analysis from the Corporate Benchmarking Tool).

So the foot still needs to be kept flat to the floor on costs, spend – and dividends. The Majors have the highest break even among the peer groups at US$59/bbl, and will pay out 37% of cash flow as dividends in 2017; double the proportion paid in 2015 and triple the rest of the industry. At today’s Brent price, half of the dividend is effectively borrowed or awaiting disposal success to be funded.

The industry is in a better place this planning season than last. But if oil prices don’t rise to match cash flow break evens tough choices lie ahead for capital allocation in 2017 – and the shift towards growth strategies will remain muted.