Building a case for long-term sustainability

‘Underwhelmed’ sums up investors’ indifferent response to the Majors’ Q1 results. The flicker of positive share price movement barely made an impression on the collective 16% underperformance against the stock market so far in 2017. This despite trouncing expectations as upstream ‘delivered’ for the first time in nine quarters.

What do they have to do to win back favour?

The numbers were good, and in themselves maybe deserved better treatment. Self help shone through: pared back costs dovetailing with higher prices to boost margins.

The Majors’ good work in slashing cash flow breakevens enabled some to generate positive free cash flow after dividend payments in the quarter. ExxonMobil was confident enough to deliver its annual dividend increase – modest at 2.7%, but an important signal.

But one swallow doesn’t make a summer, and investors tread warily in the sector. The Majors’ high dividend yield (Shell 7%) lays bare the market’s doubts as to the sustainability of dividend payments.

Weak oil prices are the immediate pre-occupation, with oversupply persistent. The recent flattening of the crude forward curve is an indicator that prices may be ‘lower for longer’.

Few are betting on a commodity price-led earnings recovery any time soon.

Future challenges

Further out in time lie existential challenges thrown down by decarbonisation and technology. We think oil consumption growth slows but peak oil demand doesn’t happen for at least a couple of decades.

However, oil companies have yet to present a coherent long term strategy that assuages concerns of an industry that will, eventually, face long term decline.

New energy will form part of that strategy. Most Majors, led by the Europeans, are already investing to varying degrees in renewables, a putative ‘third leg’ to the integrated model. Renewables fits the bill - it’s energy, it’s low carbon, and it’s got growth – a lot of growth. Statoil and Total could be allocating a fifth of their investment to renewables by the 2030s.

The commercial proposition can be attractive – perhaps well short of the best new projects in Upstream, but better than many high cost developments currently in the Majors’ hoppers. The long life of wind and renewables projects and stable cash flow visibility could provide much needed support for a dividend policy.

The opportunity posed by renewables

Renewables on their own are not going to transform growth prospects for the peer group as a whole.

Our latest analysis by Tom Ellacott and team suggests that the scale of opportunity is simply not there on our forecasts for solar and wind, at least not in the next twenty years.

Say the Majors captured the same market share of the global renewables market by 2035 as they have currently in oil and gas, a bold assumption in itself. Wind and solar output would reach 1.3 million boe/d, or just 6% of the Majors’ combined production.

Renewables needs to be part of the long term growth story, but for the foreseeable future will be just that – and a relatively modest part.

Even if market share parity in renewables is achieved, the task of replacing natural decline in oil and gas production will be formidable. We reckon the Majors will need up to 10 million boe/d of new oil and gas production by the mid-2030s to maintain total output at the peak levels we forecast next decade.

New oil and gas volumes will swamp the likely potential in renewables by a ratio of almost 10:1.

These new replacement volumes will, with renewables, perceptibly change the make up of future production profiles.

Cost will be a determining factor, but growth in gas demand and lower carbon intensity dictate that new gas projects will tend to dominate investment decisions. The best low cost oil projects, quick to commercialise, will always be developed. Oil is already dwindling in importance in many companies’ portfolios as gas rises; and the trend will accelerate as oil demand growth peters out.

The distant timescales are in sharp contrast to the relatively short investment horizon of most fund managers. The sector’s attraction to the stock market will also ebb and flow – it won’t always be as out of fashion as, at present, technology stocks are in. But oil and gas companies need to recognise the gathering signs of investor apathy and build a compelling case for long term investment.