Cheaper Oil Could Be a Gift for Big Energy Companies – Baron’s

Posted: December 8, 2014 in Econ 101, Technology and Energy

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Cheaper Oil Could Be a Gift for Big Energy Companies

The plunge in crude will force Big Oil to spend more wisely and manage costs better. It could also spur more acquisitions.

Dec. 6, 2014

If, as Friedrich Nietzsche once mused, what doesn’t kill us makes us stronger, then big oil companies should emerge from oil’s selloff stronger than ever.

We can hear the protests already. Not to state the obvious, but oil companies sell oil, and with crude having lost a quarter of its value since the end of September, companies like Total (ticker: TOT), ExxonMobil (XOM), and BP (BP) will be making a lot less money doing it. No wonder energy companies have tumbled as much as 15% in the past three months.

So how can any of this be good for global energy giants, which we’ll henceforth refer to as Big Oil? By forcing them to change the way they do business. For years, $100 oil masked the fact that Big Oil has been spending gobs of cash to generate lower returns, all while keeping investors happy with big dividends. Lower oil prices will force them to run leaner and more efficiently, and they just might be able to take advantage of turmoil among smaller players by making some smart acquisitions, too.

Let’s get one thing straight: The convulsions in the oil patch are far from over. Earnings estimates for Big Oil companies have been slashed: Chevron (CVX), Statoil (STO), and ConocoPhillips (COP) are now expected to make at least 10% less than just four weeks ago, and estimates will continue to fall as analysts account for oil prices staying lower for longer. Some oil companies—we’re looking at you, Chevron—will likely be forced to cut back on the number of shares they repurchase. Prices will stay volatile.

Yet, there is also a bright side to this turn of events. Even before oil’s plunge, the integrated oil companies were struggling to compete with more nimble rivals. Consider Big Oil’s return on equity, a measure of how well companies turn profit into more profit. Three years ago, companies such as ExxonMobil, Chevron, and ConocoPhillips had ROEs near 20%. Citigroup analyst Alastair Syme thinks that ROEs could fall to as low as 7% in 2015, a level last hit in oil plunges in 1998 and 2008.

The way to solve this problem is by controlling costs, which Big Oil hasn’t always done. Some cost savings will come through better execution on spending, and some, through cost-cutting along the supply chain. Big Oil will also get a boost, ironically, from the falling price of oil itself. Syme estimates that oil consumption is about 14% of costs, so with oil’s deep dive, industry costs have already dropped by about 3%. All told, he believes Big Oil can cut costs by as much as 15%, which would turn into a two-percentage-point increase in ROE, even if oil stays near $70.

Oil companies have to want to make those cuts—and that’s where their dividends come in. Take ConocoPhillips. Right now, it is expected to produce $13.4 billion of cash flow in 2015, not enough to cover capital spending of $15.6 billion and a $4 billion dividend. Something’s gotta give, and with CEO Ryan Lance calling the dividend “our top priority” in an Oct. 30 conference call, it’s not going to be the payout. “Part by accident, part by design, ConocoPhillips is forced to prioritize the dividend and act with aggressive capex discipline,” says Wolfe Research analyst Paul Sankey. The good news is that volume has been rising, and capital spending looks to have peaked, so it might not be the worst thing in the world for Conoco—or its investors. Sankey thinks Conoco could hit $80, up 18% from Friday’s close.

THE PROCESS MIGHT BE PAINFUL but not nearly as injurious as it would be for smaller energy companies. The debt of junk-rated energy firms has dropped more than 10% in price in the past three months, a sign investors are starting to worry about the companies’ viability. Their pain, however, could provide the solution to one of Big Oil’s biggest problems: finding new sources of crude. One of the reasons Big Oil has struggled with costs is that companies have had to make do with finding crude in hard-to-reach places, while smaller explorers have reaped the profits from the U.S. shale revolution in the Texas-New Mexico Permian Basin or in Montana and North Dakota’s Bakken. But with prices falling and production curtailed, smaller companies could become acquisition targets, especially now that they’ve lost more than 40% of their value in the past three months. Some could even be forced to dump assets at fire-sale prices. The upshot: “Big Oil could add high-quality acreage in the Permian or Bakken,” says Morningstar analyst Allen Good.

None of this will matter if valuations don’t look compelling, but the selloff has left most Big Oil companies at attractive prices. Nearly all are trading below fair value, according to Morningstar’s discounted-cash-flow analysis, while some look downright cheap. Good says BP looks particularly attractive: It trades at just 10.4 times 2015 earnings estimates, and near book value. The low valuation is partly deserved: BP owns 20% of Russia’s Rosneft, and has legal troubles of its own due to the Macondo oil spill—but most of that is reflected in its price,” he says. If BP avails itself of opportunities created by the drop in oil, all the better.

SOURCE: http://online.barrons.com/articles/cheaper-oil-could-be-a-gift-for-big-energy-companies-1417848121

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