Risco's Chris Newton identifies four key themes for upstream oil and gas in 2015 at Credit Suisse's Oil and Gas Conference: oil price direction, industry costs and returns, mergers and acquisitions and identifying winning strategic themes.
Below is the text of his talk and the accompanying slides can be found in the presentation section here.
"There are four key themes that stand out to me as the upstream oil and gas industry heads into 2015: oil price direction, industry costs and returns, mergers and acquisitions and identifying winning strategic themes.
Oil Price Direction
While I doubt I will add anything to the extensive debate we have already had on this subject, given the trajectory of oil prices over the last six months and the current volatility levels, it is simply not possible to ignore oil prices as a theme for 2015.
My own view is that we have not seen the bottom of the oil market and will not until later in 2015, when supply and early demand responses begin to kick in. With the market still over-supplied, as the significant contango indicates, prices will not bottom out until supply starts to fall.
The only supply that can reduce in the short term, unless OPEC backflips, is US unconventional oil production. While US drilling rig numbers are starting to fall, I think we underestimate the supply growth from new wells and completions that is yet to come. I also think we underestimate how efficient the US fracking machine has become and how low full cycle costs have dropped in the sweet spots, especially where the remaining rigs will focus.
Productivity has increased sharply as per unit output costs declined - which is what happens in all manufacturing processes. That’s what horizontal drilling and fracking is.
On the demand side I think the risk is that we overestimate the demand response, especially when we consider that 50% of the demand growth in the last decade has come from oil producing countries.
So, a bottom to prices during this year and a gradual recover thereafter, but it could be a few years before we are back to US$75 Brent. The wild card as always is geopolitical supply disruptions and there are a good few candidates for that.
Oil Industry Costs and Returns
The US$100bbl years have not been good for the upstream industry returns, as cost inflation exceeded prices inflation, reducing margins and returns on capital employed. It’s not all about costs - project quality deteriorated, as it always does at the top of the cycle - but it’s now imperative that costs come down.
The viability of many projects depends on it and these will be delayed until that happens.
Offshore costs will be most responsive as these are more connected to global markets.
Unfortunately costs are unlikely to decline anywhere near as much as oil prices have so margins and returns are going to be further stressed.
The industry response will have to be portfolio rationalisation, quality through choice and enhanced capital discipline.
Discretionary costs such as exploration, which has been a major contributor to the poor returns through rising F&D (Finding & Development) costs, will be savagely reduced as they always are - and need to be.
Gas in SE Asia looks like a safe haven and the opportunity to close the gap between domestic and export process in many markets is presented.
Mergers and Acquisitions
Once oil prices settle, I expect a big upturn in M&A activity, corporate in particular, driven by a multitude of factors:
Necessary portfolio rationalisation.
Financial distress for those over leveraged or with limited access to capital.
Record cash levels for independents, NOC’s, majors and super majors after 5 five years of robust product pricing. RIsco analysis puts a survey of nearly 200 listed companies’ total cash levels at US$274 billion, vs US$155 billion in 2009 - a rise of US$119bn.
Great opportunity for the financially strong looking to:
High-grade and move down the cost curve
Opportunity to secure reserves below the cost of organic reserves replacement.
Reduced competitive intensity for deals with less capital chasing more deals.
What are potentially winning strategic themes?
The level, shape and timing of the bottom in the oil price and subsequent recovery will determine which type of companies and strategic themes will win and lose.
To benefit from the upturn when it comes, one must first survive the downturn and this means a low position on the cost curve, spare balance sheet capacity and project flexibility.
At Risco we have looked at the winners and losers by company type and strategic theme through various oil price cycles: for example, the 2009-10 rapid recovery and the 2004-2008 gradual recovery.
As equity investors, what does the past tell us about who the winners were?
In both the rapid and gradual recoveries of the last decade there were only two strategic themes that in both scenarios exceeded the returns displayed by the typically balanced E&P company, big on the ‘P’ and moderately ‘E’:
Upstream oil and gas companies with an acquisition strategy.
Seismic services: represents a high beta play on the overall sector, given it is also historically one of the hardest hit in a downturn. Its upside potential in an upturn, whether quick or gradual, underscores the volatility of discretionary exploration spending.
[Note - see accompanying presentation slides showing historic oil price recoveries, both rapid (slide #2: 2008-2009) and gradual (slide #3: 2004-2008). In these instances, seismic services' share price performance was: Rapid oil recovery: +179%pa / +209% in period; Gradual oil recovery: +130%pa / 564% in period]
Acquisition focus: Successful and correctly timed acquisition provides clear value generation through timely production and reserve addition subsequently rewarded in a higher pricing environment. It also highlights the merits of building and maintaining a balanced portfolio through both divestment and acquisition.
[Note - see accompanying presentation slides showing historic oil price recoveries, both rapid (slide #2: 2008-2009) and gradual (slide #3: 2004-2008). In these instances, Acquisition focused share price performance was: Rapid oil recovery: +91%pa / +106% in period; Gradual oil recovery: +85%pa / 369% in period]
Balanced E&P: A balanced portfolio in upstream oil and gas remains a key source of value generation – demonstrated by the strong return performance of the big ‘P’ and moderate ‘E’ E&P classification."
[Note - see accompanying presentation slides showing historic oil price recoveries, both rapid (slide #2: 2008-2009) and gradual (slide #3: 2004-2008). In these instances, E&P share price performance was: Rapid oil recovery: +75%pa / +187% in period; Gradual oil recovery: +86%pa / 371% in period]