It had to happen eventually. At the end of November, Saudi Arabia gave in and brokered the supply cut agreement that finally signalled an end to two-and-a-half years of bloodletting in the global oil sector. The arrangement – which curtails Opec and Russian production to the tune of 1.8m barrels a day – in a sense marks the end of an overdue period of industry rehabilitation, a boot camp that may just have created a more investable sector.
Indebted they remain, but London’s integrated giants Royal Dutch Shell (RDSB) and BP (BP.) emerge from the rout with a renewed understanding of the importance of cash flows and costs. As demonstrated by short-seller Jim Chanos, there is a convincing case that the oil majors lost sight of these essential planks of any business model in the years when a barrel of oil fetched triple figures. Testament to this is Shell’s promise that it can make more cash at $60 (£49) now than it did when oil was at $90. For a company whose dividend yield very recently stood at more than 7 per cent, and whose relevance is predicated on such shareholder returns, that is an important and necessary commitment.
Analysts at HSBC recently cited $60 oil as the point at which the majors effectively become free-cash neutral, in a clear sign of the cuts that have been made to operating and capital expenditure in the past three years. This should reach its lowest point in 2017, just as supply tightens, although final investment decisions are likely to creep back as unproductive capital is put back to work. One would expect that the industry’s recent pain is simply too fresh for projects to be sanctioned on anything but a highly economical basis. Cancellations to both Arctic and deepwater drilling projects suggests boardrooms have started to think straight again.
The return to cash generation requires a fine balancing act, and if prices trail back down towards $50 in 2017, then dividend funding gaps will intensify the pressure on asset disposals, $30bn of which Shell has promised to make by the end of next year, regardless of Brent’s trajectory. Progress on that front will help to further underline the case for the sustainability of Shell’s dividend, which at more than 5 per cent still carries a degree of scepticism. The same is true of BP, which has the competing distraction of offsetting up to $6.5bn (£5.3bn) of Deepwater Horizon costs this year and next through asset disposals. Ideally, HSBC notes, these would be passed on to shareholders or BP’s lenders.
Of course, for all the cost-cutting, the sector’s long-term history shows that shares in the biggest energy companies tend to correlate with the oil price. On that count, the market is once again subject to the inflections of the globe’s two swing producers: the US shale industry and Opec. Theoretically, the latter should be more predictable following the recent supply entente, which leaves the balance with the tight oil producers of the Permian, Eagle Ford and Bakken basins. The next few months is therefore set to be as much a test of the frackers’ collective profligacy as it is the majors’ commitment to austerity.
A failure to uphold the supply agreement, or a ramp up in shale production in excess of Nordic bank SEB’s forecast increase of 30 onshore rigs a week, is likely to kick the oil price recovery back into touch. That could be particularly bad for Tullow Oil (TLW), whose highly leveraged shares have had a very strong correlation to the oil price throughout the downturn. The company could also find its heady valuation questioned if it is unable to sell stakes in its east African development projects this year.
| Price (p) | Market value (£m) | PE | Yield (%) | 1-year change (%) | Last IC view | |
| BP | 505 | 98,360 | na | 5.8 | 48.3 | Hold, 463p, 1 Nov 2016 |
| Cairn Energy | 242 | 1,396 | na | 0.0 | 88.1 | Buy, 220p, 5 Jan 2017 |
| Nostrum Oil & Gas | 472 | 872 | na | 3.8 | 43.7 | Hold, 300p, 31 Aug 2016 |
| Royal Dutch Shell (B) | 2,347 | 187,206 | 79.4 | 5.9 | 75.4 | Buy, 2,200p, 1 Nov 2016 |
| Tullow Oil | 312 | 2,860 | na | 0.0 | 147.3 | Hold, 204p, 27 Jul 2016 |
Favourites: Cairn Energy (CNE) cannot boast the same income appeal as its larger FTSE 350 peers, at least not until its major Sangomar project off Senegal starts to throw off cash. But our Value Tip of the Year is a relatively low-risk way of getting exposure to the Kraken and Catcher fields of the North Sea, both of which should start producing free cash flow by the end of 2017. And because Cairn has spent the downturn developing its resource base, the company does not bear the scars of three years of unprofitable production, impairments and debts.
Outsiders: Unlike almost every natural resources company on the stock market, Nostrum Oil & Gas's (NOG) shares failed to end 2016 significantly above their starting point. That was largely due to falling production and heavy losses on a derivative financial instrument, neither of which sits comfortably against a net debt figure that exceeded total equity by the end of June. But investors in the Kazakhstan-based company should have reason for confidence if the enormous GTU3 project delivers the long-promised 150 per cent increase in production over the next five years.
