Thursday, 24 November 2016

Majors - failure to make sufficient returns will affect the entire sector in next cycle - raising costs of capital

By Will Forbes

The total shareholder returns of the majors outperformed the NY industrial average since 2000-2016 buoyed by the Chinese supercycle and resulting oil prices. However, the total returns seen by investors have lagged badly in the last decade, as inefficient capital bases in a newer world of higher costs and moderating/falling oil prices dragged on returns.
Source: Edison, Bloomberg
Green line is the New York Industrial average, grey lines are total returns of the major oil companies


At the beginning of a new oil cycle it is right to examine how companies fared in the previous cycle and see what they may do in the next. In this post, we look at  returns made by the majors and how these compare to the WACC. Since 2006, the majority of companies have produced below-WACC returns, and as the chart below indicates, only Exxon has averaged above cost of capital returns over the last five years.


Source: Edison, Bloomberg

This compares to stronger returns from 2000-2008. We believe this was primarily due to the sharply increasing oil prices during that time co-inciding with a capital base built on sub $20/bbl oil. It was only as costs increased the returns turned below WACC and have been consistently below since 2008. As the tide moved out in 2014-2016, the majors were exposed as modestly clothed.


Source: Bloomberg

Companies will have to take proactive steps, especially in the lower oil price environment, to increase these returns to at least above WACC if they are to maintain their value and investor base. Many have taken writedowns which reduces the capital base, but we expect additional work will have to be done to increase post tax operating profits. This can't be achieved purely through cost cutting. If we assume this is achieved purely through new projects introduced into the capital base, this means new projects will have to make sharply higher returns to re-balance this picture.

What returns will new projects have to achieve? In the analysis below, we assume the companies will move from average ROIC (20012-2015) towards WACC through four years of investment. This indicates that any new projects will need to achieve returns of 11-17% on average.
Source: Edison, Bloomberg


How does this effect E&Ps?
If the company funding your project requires a return of X% for its investment, then X% is the marginal cost of capital for the seller.

If the majors (taken here as a proxy for industry as a whole) will be more stringent in investment decisions, it therefore follows that the cost of capital suffered by E&Ps in need of funding will (structurally) rise. This needs to be more fully reflected in the discount rates used to value E&P companies in search of capital.





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