The Edge

Building upstream portfolio resilience

The search for robust cash margins

Resilience is the new mantra. Two oil price shocks in five years have battered the industry’s finances and some companies have been found wanting. Resilience separates the wheat from the chaff. Tom Ellacott and the Corporate Analysis team have explored upstream resilience in the Majors.

What is resilience?

Simply, the ability to thrive through the cycle, making money at the bottom as well as performing well when prices are higher. The financial framework is important – balance sheet strength, liquidity and cash flow, as well as flexibility on spend. It’s also a lot to do with portfolio. Whether in refining, petrochemicals, new energy or upstream, the lowest cost producers will typically be the most resilient, able to generate free cash flow even at depressed commodity prices.

The metric we’ve used is pre-capex upstream cash margin – that is, post-tax cash flow plus capex, on a unit of production basis. We’ve tested the Majors’ cash margins at Brent US$30/bbl and US$70/bbl through 2030.

Which assets are the most resilient?

They come in all shapes and sizes and depend on where the asset is in the investment cycle. Scale, maturity and carbon intensity will all affect portfolio resilience.

First, there’s high upfront investment and low operating cost. Deepwater oil projects, while expensive to develop, can have very robust margins once onstream. The flip side is production decline – any conventional producer, deepwater or not, is on an investment treadmill to maintain production and cash generation.

LNG projects, too, are highly capital-intensive up front but then long-life and can deliver stable, high-margin cash flow for decades. Domestic gas projects may have even more dependable cash margins if the gas price isn’t linked to oil.

Second, assets that require ongoing spend. Tight oil wells can have high cash margins, and unconventional assets generally have flexibility – operators can cut, or increase spend in response to price. But tight oil wells decline rapidly, and the plays need continuous investment to maintain production.

Oil sands have been a core part of some majors’ portfolios, the attraction is the huge scale and putative long life of the resource – reserve replacement isn’t a concern. The drawback is it’s very high cost with the added barb of high carbon-intensity.

Who’s got resilience?

The Majors all manage diversified portfolios – balanced between oil and gas production, geographical and fiscal spread, assets differing in scale and at various stages of development. Yet diversity doesn’t always equate to resilience, and there are marked differences between the Majors.

Chevron and Shell have the most resilient upstream portfolios at US$30/bbl, offer the highest cash margins at US$70/bbl and can deliver the biggest margin expansion – proving it is possible to be both resilient and leveraged to price. Both portfolios have a big weighting to deepwater projects and cash-generative LNG. Neither has much exposure to high-cost assets (Shell sold most of its oil sands in 2016). BP’s portfolio is another that performs well at US$30/bbl, buoyed by the big domestic gas projects in Oman and Egypt.

Chevron’s Australian LNG projects show how serendipity plays a part in resilience. Gorgon and Wheatstone suffered big development cost overruns, which have depressed returns – our base-case IRRs are 5% – but have led to robust cash margins.

ExxonMobil’s cash margins are at the low end of the Majors’ range at US$30/bbl, despite a growing weighting of deepwater assets. The problem is its exposure to high-cost, low-margin assets, principally oil sands but also other areas such as Alaska. ExxonMobil owns 60% of the Majors’ 30 lowest margin assets by production at US$30/bbl. Kearl, Cold Lake (oil sands) and Prudhoe Bay (mature onshore oil) are a huge drag on margins at low prices.

How do you build resilience?

Active portfolio management can boost resilience. Portfolios should become increasingly concentrated through the value chain on the core, advantaged assets with high cash margins. Business development can be used to strengthen these positions.

Most of the Majors have made progress rationalising their upstream portfolios but there’s much more to be done. High-cost, low-margin assets need to be divested. High carbon-intensity doesn’t affect resilience much today, but increasingly will. Assets with high carbon-intensity weaken emissions and ESG metrics so companies should look to reduce exposure to improve portfolio sustainability. ExxonMobil, in particular, has a great opportunity to boost upstream cash margins by selling its ‘awkward’ assets.

Easy enough to strategise, harder to pull off. And with a limited pool of buyers, will the Majors be prepared to sell unwanted assets at steep discounts?

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