Doom and gloom in the oil and gas sector is warranted. The industry is based on extracting and burning fossil fuels, the emissions from which are pushing the world towards climate catastrophe. Covid-19 also sped up change within the industry because it immediately cut earnings and added to the pile of stranded assets based on lower long-term oil price estimates.
The oil price is back to $70/bbl, however, and almost a year on from the oil price crash of last March, the industry has rebounded more strongly than anticipated.
The London majors’ share prices are not back to pre-pandemic levels, but their valuations have perhaps been hit by payout cuts made last year on top of earnings tumbling.
Of the big five global majors, Exxon Mobil (US:XOM), Chevron (US:CVX) and Total (Fr:FP) have recovered the most from last year's sell-off, and trade at just over 80 per cent of their share prices at the start of 2020, while the share prices of Royal Dutch Shell (RDSB) and BP (BP.) are still a third down. In a sign of improving market sentiment, Shell is back to a forward enterprise value (EV) to Ebitda ratio of around 5 times, compared to 3.7 times when the pandemic hit. The higher ratio is indicative of investor interest given cash profit forecasts have also climbed along with a rising oil price.
Analysts have become steadily more optimistic about these companies in recent months, as well. The mean EPS forecast for BP in 2021 has climbed to 22.72p from 18.54p at the start of December. This increase is mirrored in Shell’s EPS forecast for this year, which are also up more than a fifth.
The global recovery varies between regions, as well. China is largely back to normal while North America and Europe are still balancing Covid-19 exposure risks with more open economies, so there is much more demand still to come back to the oil market. Macquarie Bank analysts said last week a full 8 per cent of global oil demand is yet to fully return from the aviation sector.
“If and when Covid-19 is controlled, we are likely to see oil demand recover rapidly, as the substitution from services to goods seen over the past year unwinds, and aviation recovers,” the commodities team wrote.
It all comes back to the oil price
The most important number right now is the oil price. Brent crude is up almost two-thirds at $66/bbl from the $40/bbl it landed on by mid-2020. This followed the dive to as low as $9/bbl last April. And as recently as the start of January, when vaccination programmes were raising recovery hopes even as economies roiled from fresh lockdowns, oil was trading at around $50/bbl. This suggests the speed and scale of the recent price increase has been unexpected.
Helpfully for producers, the Organisation of Petroleum Exporting Countries (Opec) has shown restraint despite the higher prices. The cartel decided to keep the supply cuts brought in last year when demand dropped due to the pandemic, surprising observers who assumed governments would push hard to increase supply to refill state coffers.
Pessimism over the sector’s short- and medium-term prospects was surely related to Opec’s willingness to pump supply into an already weak market. Saudi Arabia proved it was happy to blow things up in March 2020 when it upped supply in the face of a global meltdown over Covid-19.
Nearly a year later, the Kingdom has taken a different tack. Last week, it again surprised the market by postponing the return of 1m barrels of oil per day (bopd) it had voluntarily reduced in January.
Consultancy Rystad Energy said the production moderation shown by the cartel was unexpected. “Although oil prices are making members itch to open their taps again and bring in some extra cash, most members are showing surprising restraint and are happy to extend the existing production cuts for a month or two,” said head of oil markets Bjornar Tonhaugen.
Cash stream
Tom Ellacott, WoodMac’s senior vice president of corporate analysis, said free cash flow of the top 40 international oil companies (IOCs) could hit a 15-year high this year.
“At an average price of $55/bbl, our $140bn estimate of 2021 free cash flow before shareholder distributions exceeds any previous year since 2006,” he said.
These highs would partly stem from the cost cuts made last year. The IOCs made tens of thousands of people redundant in the rush to become cash flow positive below $40/bbl, given weaker long-term price forecasts. Shell managed to almost double its free cash flow margin last year, to 8.2 per cent, alongside massive declines in sales and profit, although profitability has jumped around in recent years.
For those 40 companies in WoodMac’s analysis, the cumulative surplus cash flow over three years could hit $400bn if oil holds at $70/bbl.
This kind of cash flow is based on the assumption that most of those workers let go last year won’t be handed their jobs just because prices are higher.
Ellacott said deleveraging would remain a priority, as would energy transition spending. Debt levels have hit a record high, with leverage in the top IOCs at 44 per cent on average as of the end of September 2020, up from 35 per cent at the end of 2019.
Pumping billions and billions into green infrastructure also carries its own risks.
BP was seen to have overpaid for the right to build offshore wind farms in the Irish sea last month. The licence auction run by the Crown Estate saw prices rocket from the last undersea auction in the US in 2018, which had an average price of £70m per gigawatt (GW), according to Jefferies. BP won its leases with a bid of £154m/GW per year while Total claimed its site with an £83m/GW bid. BP’s lease costs come to £231m per project per year.
Total chief executive Patrick Pouyanné told the Financial Times last month some green investment valuations were “just crazy” and warned of a bubble.
Then again, possible overpayment for some wind rights might look small-fry if oil gets any higher than $75/bbl and the oil industry regains its financial might.
