The Edge

Improving upstream performance and winning over investors

The Majors need to keep on doing what they’re doing

What have I got to do to make you love me? What have I got to do to make you care?

You can imagine the Majors' CEOs musing over Elton John's lyrics, wondering what it takes to win over investors after the stock market's dismissive reception of results that clearly demonstrated the extent of the upstream performance improvement underway.

It’s a sad, sad situation. Three things in the 2017 results stood out for us.

First, production. Volumes rose by 4% on average across the seven companies, with Eni's output reaching record levels and BP (+12%), Total and Chevron (both +5%) also standing out.

Delivering production growth after three years of low oil prices is an achievement, and combined with higher oil prices, was the primary factor behind good upstream earnings.

Weaker refining margins took the edge off the overall results.

Secondly, regenerating the business. Questions have been asked these last three years about the industry's ability to sustain itself with lower oil prices and reduced investment. The Majors answered emphatically in 2017 on a critical metric – reserve replacement of 137% on average (148% if Eni's write down of its Venezuelan asset is excluded).

This reverses decidedly unspectacular performance over the previous five years and reflects a) the Majors' success in sweeping up bottom-of-the-cycle business development opportunities, b) reduction of costs and improved execution enabling the sanction of new projects on a 15%-plus IRR at US$50-60/bbl and c) a much-needed turnaround in exploration performance where lower, but targeted, investment is starting to pay off.

US tight oil continues to be an advantage for some; both ExxonMobil and Chevron added Permian reserves. There were contributions too from legacy assets, BP crediting digitalisation as a factor in the Thunder Horse reserve upgrade.

Thirdly, financial performance. Unit capital and operating costs have continued to fall, and investment is still being carefully rationed. These are among the chief contributors that have brought cash breakevens down to US$50-55/bbl on average for the Majors.

At today's oil prices, the Majors will generate substantial free cash flow in 2018. Balance sheets continued to strengthen – net debt fell by US$30 billion (14%) over the year, helped by portfolio rationalisation.

BP was the odd one out, with increased investment in growth projects leading to a marginal rise in net debt.

The Majors' newfound financial strength bolsters their dividend-paying ability no end, and income is the primary reason many investors buy shares in integrated companies. Scrip dividends served their purpose in preserving cash in the downturn and are now being phased out; cash pay-outs are back.

Total plans to grow dividends by 10% over the next three years; Statoil increased by 4.5% for 2017, Chevron by 3.7%. Total unveiled a US$5 billion buyback, and Shell wants to buy back at least US$25 billion of shares by 2020.

It all adds up to a package of returns to shareholders unimaginable a year or two ago. Yet investors appear unenthused. The MSCI Energy index lagged the market by 18% in 2017 and the underperformance has continued in 2018.

Even during the brief late-January market correction, the sector's defensive qualities of high dividend yield didn't kick in. Market volatility hit currencies and commodities too – the oil price dropped, and the sector with it, more than the market.

And there's the rub. Regardless of the progress made, the sector's correlation with oil prices tends to swamp all other factors.

No other sector of scale has quite such singular dependency. It may be that an investor bias against oil stocks won’t change until a sustained price recovery is in sight.

Until that happens, management shouldn’t change anything – they should keep doing what they are doing, because they are doing the right things. Investors will gradually wake up to it. In the meantime, they'll lap up the income.