Tightening Opportunities For IOCs

BMI View:   Listed oil and gas companies are increasingly supporting their share price through buybacks as growing industry costs are limiting low-risk investment opportunities. Investment growth will be focused on higher-margin projects, with North America and the Middle East offering the best opportunities.

Cost increases and low interest rates are driving public oil and gas companies to take on more debt. In the EIA's review of 127 listed oil and gas firms, based on 2013 year-end reports, there was a USD109bn difference between income from operations and total cash expenditure. Much of this was supported by low-cost debt.

Capital expenditure (capex) on exploration and production (E&P) has risen strongly over the last five years, supported by high oil prices over this period. According to Barclay's E&P survey for 2014, which covers over 300 companies including national oil companies (NOC), global capex is forecast to reach USD723bn in 2014, up USD281bn from that spent in 2010. At the same time oil prices have remained more or less flat. Companies are therefore investing more, though not receiving the same increase in oil price.

Rising Expenditure
E&P Capex (USDbn) And Front-Month Brent (USD/bbl)

Tightening Opportunities For IOCs

BMI View:   Listed oil and gas companies are increasingly supporting their share price through buybacks as growing industry costs are limiting low-risk investment opportunities. Investment growth will be focused on higher-margin projects, with North America and the Middle East offering the best opportunities.

Cost increases and low interest rates are driving public oil and gas companies to take on more debt. In the EIA's review of 127 listed oil and gas firms, based on 2013 year-end reports, there was a USD109bn difference between income from operations and total cash expenditure. Much of this was supported by low-cost debt.

Capital expenditure (capex) on exploration and production (E&P) has risen strongly over the last five years, supported by high oil prices over this period. According to Barclay's E&P survey for 2014, which covers over 300 companies including national oil companies (NOC), global capex is forecast to reach USD723bn in 2014, up USD281bn from that spent in 2010. At the same time oil prices have remained more or less flat. Companies are therefore investing more, though not receiving the same increase in oil price.

Rising Expenditure
E&P Capex (USDbn) And Front-Month Brent (USD/bbl)

However, looking more closely at the source of capex, it is clear that investment is being led by national oil companies (NOCs) and not international oil companies (IOCs). Whereas NOC spending will continue to grow, shareholder pressure is driving fiscal prudence in IOCs as investors demand returns following five years of high spending levels ( see 'E&P Capex Tapering Amidst Shifting Fundamentals' January 6).

NOCs Outpacing IOCs
Capex By Major NOCs Vs IOCs (USDmn)

  Growing  Costs

The high level of investment is being driven by industry costs related to the development of new oil and gas projects. Growing complexity of extraction and increased competition for these services have pushed up costs. For example, day rates have see a strong increase in price over the last few years, particularly for deepwater rigs. This is due to both more companies looking to the strong prospectivity of offshore acreage and the 2010 Gulf of Mexico accident which has driven stringent safety regulation throughout the industry ( see 'Opportunities In A Bearish Deepwater Rig Market' May 28).

Unrelenting Cost Increases
Day Rates - 4000ft+ Drillships (USD/day)

It is not only the competition for modern ultra-deepwater capable rigs that is sustaining costs, but also the increasing technical challenges of the below-ground resources. Even with over 3,000m of water depth, hydrocarbon structures in pre-salt basins or high temperature, high pressure (HTHP) wells are further driving costs. In addition, rising labour costs due to limited expertise in highly technical areas, and the growing integration and constant improvement of technology are further pressures adding to costs.

Funding The Gap

While costs are increasing, and capex programmes and dividend payouts are also sustaining, cash from operations are flat. According to the EIA survey, the 127 major oil and gas companies received USD568bn from operations in 2013 - a shortfall of USD109bn over total cash expenditure for the year. This gap has been plugged by both asset sales - as companies increasingly divest non-core operations - and debt - as companies take advantage of low borrowing costs and tax deductable interest on debt. According to the EIA, the reviewed companies took on USD106bn in debt, while raised USD73bn from asset sales. However, as borrowing costs rise and IOCs continue to divest non-core assets we anticipate greater amounts of capital to be raised from assets sales to supplement the income/spending divide.

Investor Focus

Companies are also ramping-up share buyback schemes, largely funded through debt and asset sales. According to the EIA review, cash spent on share repurchases grew by an average of USD39bn from the 2010/11 period to the 2012/14 period.

This highlights that the oil price required for a large part of the remaining new development opportunities in the oil and gas industry increasingly lies around the USD100/bbl mark. Publically traded oil and gas companies are therefore looking to buy back shares to support their stock price instead of re-invest in low-margin high-risk projects. As such we are seeing a more cautious approach towards investment in Arctic exploration, ultra-deepwater development and HTHP plays, as the plus USD100/bbl oil price is insufficient to mitigate the risk of these high cost developments ( see 'Arctic E&P: Norway And Russia Moving Ahead While The Rest Fall Behind', February 10).

In addition, an increasing surplus of light-sweet oil in the Atlantic basin is putting downward pressure on global oil benchmarks. The vast reduction of light-sweet imports to the US - as a result of rapid shale oil production growth - has substantially reduced the market for West African crudes, driving price discounts ( see 'West African Crude Losing Markets' July 9). We see weakness in the Brent price over the coming years due to this dynamic, further jeopardising cost dynamics of new high cost oil and gas projects. 

Soft Outlook Jeopardising High Cost Projects
Brent Oil Price (US$/bbl)

Middle East And North American Upside

Over the next two years the lower cost oil and gas projects around the world will be prioritised over the more costly areas where IOCs specialise, such as deepwater and LNG.  We believe the North American market will benefit with most shale oil developments thought to cost in the range of 50-70USD/bbl. Not only is this sufficiently profitable below the USD100/bbl mark, but operational efficiencies are continuing to improve cost structures. Similarly, some oil sands projects in Canada are thought to require just USD65/bbl to be profitable, though many developments remain restrained by the lack of midstream infrastructure from Alberta ( see ' Pipeline Delays To Temper Growth', February 20).

America And Middle East Upside
Regional Oil Production (000b/d)

The Middle East is home to some of the lowest oil lifting costs and will also be able to benefit despite softer oil prices. Iraq, and in particular Iraqi Kurdistan, will continue to be an area of focus for international oil and gas companies, though instability in the region is limiting progress. Other more reclusive investment markets, such as Saudi Arabia and Kuwait, stand to benefit, again highlighting the strengthening position of NOCs over IOCs.

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