24 September 2014
Large-scale oil projects, especially offshore, often run behind schedule and over budget. Such setbacks, though rarely disclosed by oil giants, nonetheless materialize in disappointing returns.
The massive Kashagan oil field in Kazakhstan’s portion of the Caspian Sea, presents one such example. The field, with recoverable reserves of about 13 billion barrels of oil, was discovered in 2000 and initial production targeted for 2008.
Production in fact began in September 2013 – five years late – only to be halted after four weeks when the two 55-mile-long oil and gas export pipes that connect the field to the mainland began leaking, delaying production until mid-2016.
Royal Dutch Shell, one of the shareholders, did not mention this issue in its second quarter results release. However, in a recent investor conference call, Total S.A., which has an identical 16.81% equity interest, said that the latest production delay will lead to a $1 billion decrease in its cash flow projections. None of the partners have gone public on the expected additional costs.
The industry must also contend with political and security risks. Recently, it has been difficult or impossible to conduct business in Iraq, Nigeria, Libya, Syria and Egypt, for example, while Russia and Iran are hampered by sanctions.
The sheer size of the listed oil majors also works against them in terms of delivering growth. The production levels of most conventional oil fields increase sharply in the first year, followed by a plateau and then a period of gradual decline.
Large companies usually have a high proportion of fields that are “mature” (i.e. in decline) so trying to deliver growth in production is like trying to run up an escalator the wrong way – you look very busy but end up standing still.
To illustrate this, the combined output of the four European majors – BP, Royal Dutch Shell, Eni and Total – was 10.24 million barrels of oil equivalent per day (boe/d) in 2013. This is almost identical to their combined output in 2000 (10.17m boe/d) and 14% less than the peak level reached in 2004 (11.9m boe/d).
This stagnation is not unique to Europe. ExxonMobil and Chevron, the US majors, have a similarly flat profile, weighed down by portfolios of mature fields.
The bright spot in the industry, however, has been the resurgence of US crude oil production due to growth in production from shale. Since bottoming at around 5m boe/d in 2007, the country’s production has risen by 60%, passing a run-rate of 8m boe/d earlier this year.
Shale has a number of advantages over conventional fields. For instance, when drilled in known formations in the main US basins, exploration risk is little to none. The geology is often “layer cake” so the companies do not need to test for conventional oil traps (anticlines, tilted fault blocks, etc.), which can result in “dusters” when drilled.
Once a shale oil well is drilled, a large proportion of the ultimate recovery of the well is produced in a short period of time. Using the language of the bond market, the income stream is of low duration (i.e. low risk), compared with high duration (or high risk) for a conventional well, leaving opportunities for ongoing growth.
For example, the Apache Corporation, the fourth-biggest oil producer from Texas, has been selling off its international oil- and gas-producing assets to concentrate on its assets at home, partly due to pressure from activist investors. This process has spurred a re-rating of Apache shares, a trend that we expect to continue.
Another beneficiary of the shale oil boom is Schlumberger – the world’s biggest oil services company. It has an excellent long-term track record of growth and, at its recent investor day, set out ambitious projections for the period to 2017. It expects to deliver earnings growth of 17-20% a year, a return on capital of over 20% and strong free cash flow.
The group is investing over $1bn a year in research and engineering, and expects new technologies that come from this activity to account for more than 25% of its revenue by 2017. The incremental margins on this new business are expected to be in excess of 40% because of the premium pricing they will be able to justify.
With these precedents in mind, we can expect to see certain shale-focused companies attract investors seeking capital growth. Meanwhile, investors seeking dividends will continue to turn to oil majors as reasonably safe investments.
- Portfolio Adviser