Big oil should exercise capital discipline as prices rise

Even if oil prices rise in the aftermath of the OPEC agreement on cutting production, the oil industry should be wary of high-cost projects.

Guest post by Paul Spedding, former global co-head of oil & gas research at HSBC and a current advisor to Carbon Tracker.

OPEC’s proposal to cut production may boost oil prices the way the cartel intends, but until details of the agreement are properly communicated it’s hard to be sure of anything. Indeed, if history is any guide, these sorts of agreements rarely deliver because of indiscipline. Price recovery can consequently take a long time. However, that such an agreement was seen as necessary shows that the financial pressures caused by low oil prices are becoming painful, even for Saudi Arabia’s deep pockets.

These pressures ultimately could lead to higher prices although perhaps not as high as some in OPEC (and the oil industry) hope. This is because of US shale oil, something OPEC has not had to deal with during its previous attempts to increase prices. Shale has relatively short lead times and low associated costs and so can – in theory – react to price rises more quickly than conventional oil plays. Much will depend on how many drilling rigs and skilled oil men have been lost to the industry since the oil price crash but nevertheless, it is a possible moderating factor.

But should oil prices recover, what does that mean for the oil industry?

Traditionally, higher prices tend to be followed by increased investment: management tend to be very reactive in their planning. Given that many companies have cut back budgets by over a third in the past two years, management are likely to find it hard to resist the urge to make up for lost time and pour more money into the ground.

Before doing this, company boards might consider asking what happened the last time they did so. Between 2011 and 2014, the oil industry’s capital budget rocketed. For example, Shell’s capital employed – a financial measure of its asset base – rose by 35 per cent over that period. But as a result its returns halved, despite $100 plus oil prices. And shareholders were rewarded with a return that was less than half that of the market. Investing for growth did not deliver for shareholders.

Sadly, it appears that the oil industry has a very poor memory. As philosopher George Santayana memorably said: “Those who cannot remember the past are condemned to repeat it.”

It is likely that the oil industry will ramp up its spend as the oil price recovers. We wonder whether the mistakes of the past could be avoided if oil companies had a board member appointed as “Head of Memory”. His role would be to explain what went wrong the last time a growth model was implemented.

The sad thing is that if the boards listened to the Head of Memory and adhered to a policy of capital discipline – which most oil companies profess to do (but don’t) – costs and the level of risk would be lower, most likely leading to superior returns. The reason for this is that ‘going for growth’ means going for higher-cost projects. The additional projects needed to meet a growth agenda almost always involve higher costs meaning lower margins and greater volatility in earnings.

Carbon Tracker showed in its “Sense and Sensitivity” report published earlier this year that an oil company with a business model tailored to a 2 degrees climate target demand profile has lower costs and lower risk than the traditional growth model pursued by the oil majors. Because it is a lower cost model, at prices below $100 it results in higher value than business as usual models. The growth model is effectively a gamble on higher oil prices. Of course, oil management will protest that they would never invest in unprofitable projects but the swathe of multi-billion dollar write-offs since 2015 show that they do just that.

Some financial analysts had been calling for greater capital discipline even before the oil price collapse of 2014. An article in the FT on November 7 2013 reported that investors wanted the oil majors to cut capital expenditure and boost pay-outs. It commented that Doug Leggate of Bank of America…

…had slammed Exxon’s frankly pretty awful share price performance this year and suggested it [cut] back capex and [was] a bit more aggressive on the buyback.

And as far back as 2006, McKinsey wrote a prescient report commenting that:

“The oil and gas industry has a history of over-investing at the top of a cycle. This time it should break the habit.”

Had Exxon followed McKinsey’s and Mr Leggate’s advice, they might well have destroyed less shareholder value when the oil price crash of 2014 arrived.

So we would suggest that oil management listen to their Head of Memory this time around. Don’t fall back into the old growth agenda that has depressed returns and increased risks in the past. Show capital discipline to deliver the returns that your long-suffering shareholders deserve.

Note: This article also appeared as a guest post in FT Alphaville