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Opinion: Improving picture for oil companies, but caution pervades

John Moore, Senior Investment Manager, Brewin Dolphin Edinburgh
John Moore, Senior Investment Manager, Brewin Dolphin Edinburgh

The tide appears to have turned for oil. This time last year, the oil and gas industry appeared to be drowning in a commodity price which seemed destined to hug the $50 mark for some time. Further back, in January 2016, it went as low as $30.

Since then, and back in the news following Donald Trump’s decision to pull the plug on the Obama-era nuclear agreement with Iran, oil prices have increased substantially. Yesterday they were north of $80 boe – a significant increase on the nadir seen just over two years ago.

Their rise can largely be explained by two influences.

The first is the cyclical nature of the industry: when the commodity price is low, extraction costs in some basins – certain parts of the North Sea, the Gulf of Mexico, and the Middle East, for example – are close to, or even above, the realisable price.

This forces many companies to take cost-cutting measures, whether it’s halting production or reducing staff numbers, while they wait for the price of oil to increase again. However, when that happens, it’s not as simple as flicking a switch to get the oil flowing again – it takes time to start producing, which causes a production gap.

The second, as demonstrated by Iran, is political tension, which adds a premium to the price of oil. Many oil-producing nations are politically unstable, which affects operations in these countries, as well as in their state-owned oil companies. In the case of some South American states, which are close to bankruptcy, there simply isn’t the capital to invest; while geo-politics in the Middle East are, to say the least, tricky.

We’ve seen these factors bear out in reality during the first few months of 2018. If sustained there are reasons to be optimistic about the sector, with some positive results from some of the sector’s largest companies.

But, an undercurrent of caution remains.

BP made an excellent start to 2018, with replacement cost operating profit before consolidation items 9% ahead of expectations. Upstream activity was strong, with seven new projects started in 2017 and production, excluding its venture with Rosneft, up 9%. Downstream was also better than expected, despite weaker refining margins in Europe.

That said, immediate cash generation was disappointing and as a result gearing rose despite capital expenditure being at the lower end of the annual rate. Operating guidance for the next quarter is also slightly underwhelming, with turnaround activity meaning BP won’t be able to take full advantage of the current rise in oil prices.

The story was similar at another supermajor: Shell also reported its Q1 figures last month. The company put in another solid performance on the back of a strong 2017 – but, current cost of supplies (CCS) earnings, a measure of net income, were less than 1% ahead of expectations.

What’s more, while Shell’s cash flow remained strong and return on capital employed improved, lower production volumes need to be watched given the sensitivity to cash flow and debt reduction. The return on capital is also still some way off its 10% target for 2020-2021.

In summary, it’s a case of good news, but not quite good enough at least not at this stage.

The indicators suggest there could be volatility to come. Current supply-demand dynamics, combined with the point we’re at in the cycle, suggests prices should be at $55 boe. Yet, they sit at around $70 – that’s the political premium in action.

While the picture has improved, challenges still lie ahead – largely dictated by the vagaries of geopolitics and a volatile oil price. The outlook for the sector is one of cautious optimism, at least in the short term. The question will be whether these companies can make hay while the sun has begun to shine again.

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