Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Big Oil’s big numbers just aren’t adding up. It's time to change the equation.

The biggest Western oil companies -- Exxon Mobil, Chevron, Royal Dutch Shell, BP and Total -- were born in a storm. When oil prices collapsed in 1998, the industry’s biggest companies sought solace in each other's arms. BP hooked up with Amoco, and the round of megamergers creating the modern majors began.

Now everyone’s hurting again. As the five firms unveiled third-quarter results last week, all eyes were on their cash flow. Collectively, they generated more than $130 billion on a trailing 12-month basis. But they plowed that and more back into the business, while also either borrowing money or selling assets to fund roughly $50 billion of shareholder payouts.

Such extravagance can’t last forever, and investors have helpfully pushed up dividend yields as an unfriendly reminder. In response, executives spent much of last week’s conference calls seeing how often they could squeeze in mentions of cost-cutting and dividends.

There is one nagging question around all this: Why are dividends so sacrosanct?

Hear me out. First, in a world of zero interest rates and frothy-looking equity and bond markets, demanding more cash seems almost like portfolio masochism. Second, if you are holding stock in the majors, then presumably you are at least mildly persuaded that oil has a future and prices will recover at some point. So with prices of rigs and companies falling, surely it would make sense to let majors have more cash to scoop up assets in preparation for the next upswing.

Actually, though, demanding dividends is the rational thing to do. It isn’t just about the money. Instead, it’s a good way of forcing Big Oil to recognize that, just as at the end of the 1990s, things have got to change.

The windfall from China’s sudden rise was good to everyone in the oil business. Between 2003 and 2008, the big five companies raked in just shy of $870 billion of operating cash flow, according to numbers compiled by Bloomberg. They reinvested about half of it. The rest covered virtually all of the $439 billion paid out in dividends or share buybacks. Good times. 

The problems started then. All that money, in an industry that had been shedding capacity for a decade or more, stoked rampant cost inflation. Triple-digit oil prices were seen as the new normal, especially given how quickly they rebounded after the financial crisis.

In the five years after 2008, the big five made $961 billion of cash flow. But this time, given the outlook for oil, 84 cents of every dollar made went back into the ground. The $156 billion left over didn't even cover the $224 billion dividend bill, let alone $143 billion of buybacks.

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That chart above led all too easily to the one below below, which shows cash flow, capex and net debt per share of an imaginary merged version of the big five -- call it Leviathan Oil. Capex and net debt per share have raced up toward that cash flow number, which has stayed remarkably flat despite all the buybacks.

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And this has all happened just in time for an oil-price crash that clearly blindsided the majors. Chevron, having stacked up multiple big-ticket projects, has locked itself into spending billions despite the collapse in oil prices. It isn’t alone. Exxon bought XTO Energy just before natural gas prices crashed. Shell increasingly looks like it pounced too soon on BG Group earlier this year.

All this has made something of a mockery of the majors’ touted investing smarts. All that capex, all those buybacks -- it all looks so horribly pro-cyclical now. You can see this in the chart below, showing Leviathan Oil’s return on capital employed. This time, the line goes down, which is also not good.

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Notice how returns were already bad in 2013, when oil prices were still high. Big Oil had effectively handed its fate over to OPEC and China. And when China started wobbling and OPEC told everyone to go hang last Thanksgiving, the moment of truth finally arrived.

Slashing spending is the majors’ way of showing investors they get the joke and can refocus on profits rather than sheer barrels. Dividends are the down-payment on restoring the trust of their shareholders.

That remains a work in progress, and the majors must do more than merely cut spending. Resource nationalism and the rise of shale-fuelled E&P companies have crowded the competitive field over the past decade or so. The oil majors must show not merely that they can get their house in order, but reassert their strengths: What use is scale if you can’t make it work for you?

Until the Super-Majors change their business approach, there is no reason to believe that investor sponsorship will return and it is reasonable to believe that the Super-Majors, which have declined from 8 percent to 3 percent of the S&P 500, will decline further.

That’s Doug Terreson, an analyst at Evercore ISI, whose report “The Era of the Super-Major” back in February 1998 foresaw the consolidation that was coming back then. Absent a rebound in oil prices, he sees two potential levers the majors could pull to deal with a new landscape, where OPEC is conspicuously absent and competitors are crowding in.

One is to break up, as ConocoPhillips did to great effect a few years ago, giving investors the chance to invest in a big E&P company and a large refiner separately. Thing is, that worked when oil prices were still high. The big five just reported a third quarter in which more than three quarters of their collective net income came from downstream operations, ameliorating the carnage seen in upstream profits. Breaking up, always hard to do, looks impossible now.

The other option is the opposite: consolidate. That doesn’t mean further mega-mergers, which would likely stoke political and perhaps nationalist opposition. And if the last round is anything to go by, regulators would at least demand that the companies shed more refining assets, along with their precious profit stream.

Rather, the majors should be looking further down the food chain to E&P companies that have similarly spent too much but lack the diversity and balance sheets of the majors to ride out $50 oil for long.

Crucially, as Terreson points out, the majors’ traditional advantage in terms of return on capital employed in their upstream business versus the E&P sector has eroded enormously, from 21 percentage points in 2010 just six points last year.

That matters because, with the benefits of cost cutting, redirecting spending to the best prospects, and refinancing debt using a major’s credit rating, deals could actually enhance return on capital. Reining in an E&P target’s all-consuming desire to grow would also serve to help rebalance the oil market, as barrels that might otherwise have been pumped would inevitably be left in the ground.

Why would investors trust the majors to do deals at this point?

They likely wouldn’t right now. Next year could be a different story. If oil prices remain subdued, balance sheets across the E&P sector will be stretched even further and next spring’s round of talks with lending banks are likely to be fraught affairs.

At that point, Big Oil’s warm embrace could look very comforting and E&P stock prices would likely have reached rock bottom levels. And if deals were paid for in stock, then that would both conserve cash and let sellers keep some optionality on an eventual recovery in oil prices. As for the majors’ shareholders, the sight of Big Oil buying low rather than spending high, would be both novel, and welcome.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net