Daniel Lacalle

Exxon was right. Where will oil companies invest in 2015?

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(This article was published in Spanish in Cotizalia on 14th April 2011)

In 2008, Rex Tillerson, CEO of ExxonMobil, was facing a General Shareholders Meeting with a request, almost a demand, by a California pension fund, a group of nuns and the Rothschild family. The requirement: to dedicate a substantial portion of its investment program to renewable energy. It was the culmination of a process of harassment of U.S. oil majors that started with the then young administration of President Obama. The request was unsuccessful. The general meeting of shareholders rejected it by a majority. Not even to make a “wink” to an administration hostile to the sector.

The explanation was simple. It is a different business. It is valid for other companies, where the competitive advantage requires in sustained institutional support and where returns are well below those demanded by the Exxon group. With or without subsidies. Because, as Tillerson himself “if we really wanted to see subsidies for renewables eliminated, the only thing we should do is spend millions on those technologies, because then the government would immediately withdraw the premiums, or rather, retire them for us only.”

Today, Exxon is the most profitable oil company in the world, with a return on capital employed of 22%, has distributed $112 billion to shareholders over the past five years, has the highest return per barrel in the industry ($20 per barrel produced 2006 -2010), a reserve replacement ratio 210%, with virtually no debt and no divestiture requirements from ruinous adventures like other competitors. And the interesting thing is that these rates of return are not be generated because they are a very large company (just check the poor returns of comparable European companies), but because of the focus of its strategy on two principles that I would call:

a) Focus on the core business and activities where they have real competitive advantage to return those benefits to their shareholders. It’s a company that invests $35 billion a year of capital that belongs to its shareholders, not an NGO.

b) An organization focused on generating superior returns, not intangible objectives. Return on capital employed (ROCE) as an absolute objective. Intangible benefits and costs are imaginary inventions to justify losses.

Chevron and ConocoPhillips also turned away from experiments and generated significantly higher returns than those oil companies that diversified into other technologies, despite the weak dollar. Meanwhile, competitors who took to strategic adventures outside their industry are in the process of selling at a bargain price their “star” projects.

Many European oil companies boast in their advertising of their investments in alternative energy. But behind the image lies a very different reality. In fact, after years of multibillion-dollar losses, the reality is that most have returned to their core business.

We made a detailed analysis of the plans of oil companies for the next five years. The results (only Oil Majors, ie Big Oil) are:

. Over 85% of the annual investment in the sector, ie, well above the $200 billion annually, will be dedicated to Exploration and Production. Nearly half destined for natural gas and half oil. Of this amount, almost 30% will be dedicated to exploration of new reserves in “frontier areas” or areas where they expect to find the next mega-field, the new Kashagan, Tupi (Brazil), Uganda or Jubilee (Ghana). Greenland, the Russian Arctic, Mozambique and Namibia in addition to the large investments (over $10 billion in 2011) in the U.S. in shale oil, where it is estimated that we could see a revolution similar to the gas shale (shale gas).

. Less than 14% will be dedicated to refining, marketing and chemicals. The returns are relatively poor and do not justify further investments. The OECD industry is facing overcapacity with nearly 7 million barrels per day of excess capacity in refining and 65% of average utilization in chemicals.

. Less than 1% of investments will be devoted to “alternative energies.” And when the oil majors talk about alternative energy, over 67% of that money is for “biofuels” which is a derivative of refining, not wind turbines or solar panels. ExxonMobil invests in technology and development more than $200 million per year, mostly to improve transport efficiency and liquefied gas.

. The only companies that will explicitly invest in wind turbines and solar panels are BP ($10bn in ten years, less than 2% of their annual investment), and the market does not reward them for this low-return capex, Petrochina (a gigawatt in wind, less than 1% of their investment) and Total (a little solar and CO2 capture and storage). Shell divested most of its activities in solar and wind energy smartly at peak valuations (2009).

Why don’t these companies invest more in alternative energy?.

. First, because the returns are very low and more risky (politically) than its main activity, and as the average cost of capital of Big Oil is close to 9% upstream, the sector should require higher returns than those generated by regulated sectors. Alternative energies generate returns of 11-12% with a debt of c80% at project level, which is impossible to for oil companies, who know you can not gear by more than 25% an energy project, being a cyclical business. So the integrated utilities, which have a lower cost of capital and relatively low but stable returns, are more willing to include alternative energy in their investment plans. At the end of the day, renewable energies are utility-type of businesses, as we have seen now that the “supernormal growth” prospects have moderated to more logical 5-6% pa.

. Second, because the electric-utility model requires concentration in countries with great political influence and government control and concentration is exactly what the oil sector tries to avoid, following the disasters seen from 1975 to 1999. Thus, since the end of the era of nationalization and break-ups forced by anti-trusts, the oil companies want to avoid accumulating more than 20% of their assets in one country. Governments are very greedy when it comes to demanding long term investments from private companies but also very quick to cut private profits.

. Third, avoid subsidies because they are removed at the first opportunity. The oil industry endures some of the most onerous taxes (up to 80% in some countries) in the industrial sector, multi-million dollar investments with very long maturity periods in cyclical sectors, risks in unstable countries, PSCs (Production Sharing Contracts), and the sword of Damocles of “surprise” taxes, as we saw in France last week. $400 million into the pockets of government. that is the reason to avoid regulated activities, and the oil sector has divested more than $30 billion in these activities since 2008.

I read many articles saying that oil subsidies are enormous, but such analysis is flawed, by bringing together private companies and state owned ones. For the IEA and others to count as subsidies what Saudi Arabia gives to its company, Aramco, or what Rosneft and Gazprom get from Russia or China provides to PetroChina and Sinopec, etc. is a joke. When comparing subsidies to industries, these should not be included, that’s cheating. And most of what the articles call “subsidies” are deductions for double taxation. It is quite funny to expect that oil companies pay 60% tax in the North Sea, for example, and then pay for them also in the U.S or elsewhere.

For years the chief executives of American oil companies were criticized because they did everything wrong and were obsolete while counterparts in Europe and the United Kingdom were betting “on the future”, from investments in Business To Business and the Internet (in 2001 some oil companies spent more on this part of their strategic plans than in E&P), transmission networks, nuclear energy, healthcare (I swear), or hydrogen fuel (with multibillion-dollar losses). No more experiments. As an example, Shell, after the arrival of Peter Voser, immediately imposed a “back to basics” focus on exploration and production, generating cash flow and high returns on any part of the cycle. They reached in three years the goal of becoming the second most profitable company in the sector.

Now, with the sector at record levels of cash generation, investment plans in the oil sector are simple. No more adventures. Exxon was right.

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