The Fuse

Oil Majors to Thrive as Market Enters a Period of ‘Restraint’

by Nick Cunningham | March 28, 2018

The largest oil companies usually thrive during periods following downturns, when the oil market rebounds but has not entered a new boom phase.

Even though oil prices are sharply down from pre-2014 levels, the largest oil companies are entering a “Golden Age” in which they will see wider profit margins. One would assume that the oil majors would typically perform best when oil prices are high, “but historical evidence shows that producers actually fare poorly” during these boom times, Goldman Sachs wrote in a new report.

Instead, the largest oil companies usually thrive during periods following downturns, when the oil market rebounds but has not entered a new boom phase. This environment is ideal for the majors: Lower production costs, consolidation, and cautious spending allow them to post massive returns.

Oil market in a period of “restraint”

Soaring shale production and the prospect of muted price gains, perhaps for years to come, does not seem like a promising period for the oil majors. But Goldman Sachs laid out its case in a new report that the large multi-national companies are currently well positioned. The oil and gas sector typically goes through 30-year investment cycles that are characterized by three distinct phases, which the investment banks dubs Expansion, Contraction, and Restraint.

On the surface, the majors would appear to benefit the most from the boom, or Expansion, phase. After all, higher oil prices should translate into higher profits. But Goldman notes that cost inflation and overspending typically undermine returns during these upcycles. From 2003-2013, a period of rising oil prices with the exception of late 2008 and early 2009, the oil majors “underperformed the market by 1 percent on average, driven by weak free cash flow and multiple de-rating,” Goldman analysts wrote.

Ultimately, a wave of new supply comes online after the increased investment and drilling reaches completion, leading to a crash in oil prices and a period of “Contraction.”

The “Contraction” period of 2014-2017 is now very familiar to most market watchers. Oil prices plunged sharply during the second half of 2014 and bottomed out in early 2016. The oil industry suffered from a sharp decline in revenues, resulting in layoffs, a slowdown in drilling, project cancellations, and bankruptcies. The oil majors survived, but were forced into severe spending reductions as debt mounted.

Goldman says that the “Restraint” phase has historically been a period of time in which the majors have performed the best. The market has mostly healed from the “Contraction” phase, clearing away excess inventories. Demand growth has absorbed the supply surplus. But there are still lingering concerns about long-term oil prices, which means that in the aggregate, the oil industry is holding back on investment, keeping spending in check.

Uncertainty about long-term oil prices creates barriers to entry, solidifying the position of the majors.

Moreover, uncertainty about long-term oil prices creates barriers to entry, solidifying the position of the majors. “[L]ong-cycle investment consolidates in the hands of a few large companies that can self-finance the new investments,” Goldman says, while cost deflation leftover from the bust helps keep costs down. An example of this might include BP’s decision to greenlight its Mad Dog Phase 2 in late 2016, a large offshore drilling project in the Gulf of Mexico. The market downturn allowed BP to slash its cost estimate for the project by more than half to $9 billion.

Meanwhile, the largest oil companies, unlike their smaller counterparts, were able to purchase discounted assets during the bust, allowing them to benefit from a wave of consolidation. While some E&Ps may have suffered irreparable damaged during the “Contraction” period, the majors emerged on the other side with new opportunities that they took over from struggling companies.

Goldman pointed to the 1987-2002 “Restraint” phase that saw high returns for the majors, even as returns for ordinary E&Ps “lagged.” The “Seven Sisters” outperformed the global market by a 6 percent annual average in terms of total shareholder returns over that time period.

“Golden Age” for the majors

The historical context is important because Goldman says that 2018 marks the beginning of a new “Restraint” phase. The oil market has recovered from the collapse that began in 2014. Yet, there are very few signs yet of an extremely tight market that would usher in a new period of “Expansion.” The majors have sold some assets but purchased others to strengthen their positions. There are long-term concerns for the oil industry over the threat of alternative fuels in the transportation sector and peak demand, holding back investment. That dynamic leaves potential growth mostly in the hands of the oil majors.

The one caveat—albeit a long one—to Goldman’s argument is shale, which is a brand new factor when looking at decades of investment cycle history in the oil market.

“The Restraint phase, instead, sees a slow, consistent improvement in returns, led by an oligopolistic market structure, better management of the supply chain and advantaged resource access,” Goldman Sachs wrote in a note. “This is reflected in Total Shareholder Returns, which are driven by [cash return on cash invested], not the oil price.” Returns grow steadily in the Restraint phase, with credit ratings repeatedly upgraded.

The one caveat—albeit a large one—to this story is shale, which is a brand new factor when looking at decades of investment cycle history in the oil market. That means that E&Ps, not just the oil majors, can also grow in this period of Restraint. Nevertheless, the shale sector may not significantly alter the outlook for the oil majors. In a show of confidence about its argument, Goldman issued “Buy” ratings for Total, Shell, Eni, Chevron, and ConocoPhillips.

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