The Fuse

Q3 Earnings: Big Oil Raking in Cash, Long-Term Outlook Uncertain

by Nick Cunningham | November 06, 2018

Higher oil prices and a campaign to cut costs produced a windfall for the oil majors in the third quarter. The largest integrated oil companies in the world saw a huge jump in their earnings, leaving them flush with cash.

While they are inching forward on select projects, they are largely refraining from returning to the old days of reckless spending on enormous megaprojects. Investors are pleased with this approach, but it also raises questions about long-term supply.

Earnings surge

Without exception, the oil majors saw earnings spike in the third quarter. Here is a quick rundown:

  • Royal Dutch Shell: $5.6 billion in earnings in the third quarter, up from $3.7 billion in the third quarter of 2017.
  • ExxonMobil: earnings of $6.2 billion, up from $4 billion a year earlier.
  • BP: a replacement cost profit of $3.1 billion, up more than twofold from the $1.4 billion it earned in the third quarter of 2017.
  • Chevron: earnings of $4 billion, up from $1.95 billion in the third quarter of 2017.
  • Equinor: $1.6 billion in net income, up from $0.8 billion a year earlier.

The improvement is the result of several factors. The multi-year cost-cutting campaign that began with the oil market downturn in 2014 continues to yield benefits. The majors have each gone through a series of spending cuts and divestments, trimming down their businesses in order to focus on core assets. Also, the third quarter of 2017 was also a three-month period that saw the highest oil prices in years. The majors have reoriented themselves around a lower breakeven price, so the upswing in prices have left them in their strongest position in years.

Strong footing, but spending kept in check

A surge in profits has allowed the oil majors to continue to pay shareholders via buybacks and dividends, while also leaving enough left over to move forward on some key priorities, even if those objectives vary from company to company.

BP said that the higher-than-expected earnings will allow the company to pay for its $10.5 billion acquisition of the shale assets from BHP Billiton entirely in cash instead of 50 percent equity, which was the original plan when the deal was announced several months ago. “We’re very confident in the outlook for the company,” BP’s CFO Brian Gilvary said, according to the Wall Street Journal. “The oil price is currently north of $75; we break even at $50…we have more than sufficient surplus cash.”

Shell gave the greenlight to a massive LNG export facility on Canada’s pacific coast. The final investment decision was notable since the company had shelved the project two years ago, after the downturn for both crude oil and LNG. The go-ahead was a strong signal that the global LNG market has turned a corner. ExxonMobil is ramping up its downstream investments on the U.S. Gulf Coast, while also developing its huge discoveries off the coast of Guyana.

However, despite a handful of high-profile moves, the oil majors have gone to great lengths to emphasize their commitment to capital discipline, a mantra that took hold in recent years and has become somewhat sacrosanct after a previous era of cost blowouts and overspending. The stronger earnings has thus far not enticed the majors to dramatically step up spending.

The stronger earnings has thus far not enticed the majors to dramatically step up spending.

Instead, oil executives continue to put emphasis on shareholder returns via share buybacks and dividend increases. For instance, after reporting the sharply improved financials in an earnings call to investors and analysts, BP’s CFO said that the stronger figures “supports our commitment to growing distributions over the long-term as evidenced by the dividend increase we announced in the second quarter.” There were no major changes to spending plans, despite the larger quarterly earnings.

“Our valuation as an industry is still low because people worry we’re off to the races and we’re going to be spending too much money,” BP CEO Bob Dudley said in London in October. “The industry has learned such a painful lesson; capital discipline is really important.”

Peak demand

Ballooning profits and spending discipline is exactly what investors want, but Wall Street is still treating the oil majors with some skepticism.

The combined positive cash flow position of the six largest oil majors—which includes ExxonMobil, Chevron, Royal Dutch Shell, BP, Total SA, and Equinor – could top $90 billion this year, according to the Wall Street Journal. Notably, however, the share prices of these companies are only up modestly this year, despite the sharply improved financial position. The WSJ notes that their combined share prices are up an average of just 4 percent through October, even though Brent crude rose by 20 percent (although prices have recently backtracked).

There are several reasons Wall Street has fallen out of love with Big Oil. First, as previously mentioned, years of cost overruns and exploding debt has left investors skeptical of a return to reckless ways. Second, peak oil demand may not be imminent, but it is increasingly within sight. Demand does not need to fall precipitously for the valuations of the oil industry to hit the rocks—consumption only needs to stop growing.

The uncertainty over the longevity of demand is exactly why many within the industry are approaching growth plans with caution. But the flip side of this coin is the question of adequate supply. The oil majors may be steadfast in their capital discipline, but independent analysts wonder whether this sets up the market for supply problems down the road. Exploration spending has fallen by more than half since 2014, from $60 billion to just $25 billion, according to Wood Mackenzie. New discoveries have plunged as a result, down from 8 billion barrels per year to just 2 billion barrels over the entire three-year period between 2014 and 2017. The shortfall in spending today could create supply problems in the 2020s, with a supply gap reaching 3 million barrels per day by 2030. “Barring technology breakthrough beyond what we already assume, we’ll need new oil discoveries,” WoodMac said.

The Anglo-Dutch oil major has its eye on peak oil demand, and could conceivably begin to shift much of its capex to renewables at some point in the future, although it has no plans as of yet to begin winding down offshore spending.

However, if demand peaks earlier than expected, the oil majors will need an off-ramp. Shell’s executives have outlined a vision in which investing in deepwater will generate the revenue the company will need to transition into cleaner forms of energy, including natural gas and renewables. “The responsibility deepwater has is to generate the cash that is going to pay for shales and for renewables,” Wael Sawan, Shell’s head of deepwater exploration and production, told the FT. “We are trying to navigate what is an evolving landscape.” The Anglo-Dutch oil major has its eye on peak oil demand, and could conceivably begin to shift much of its capex to renewables at some point in the future, although it has no plans as of yet to begin winding down offshore spending. Notably, Shell sold its new LNG Canada project as one that will thrive as the world begins to make the transition to cleaner fuels.

The tension between inadequate investment in new supply on the one hand, and peak demand and stranded assets on the other, is a problem that will increasingly bedevil the industry in the years ahead.

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