The New Era of Austerity

According to the online version of the Merriam-Webster dictionary, the definition of “austerity” is “a situation in which there is not much money and it is spent only on things that are necessary.” For the oil and gas industry, what’s “necessary” has rapidly become delivering greater value to shareholders, even if that means sacrificing the historical objective of production growth.  

This shift follows from a growing revolt among shareholders against energy-company managements, who are perceived as being more focused on expanding their business franchise (and presumably their paychecks) than on creating shareholder wealth. However, it is unlikely that companies can both expand production and, at the same time, return more cash to shareholders in the form of higher dividends and increased share buybacks. 

Thus the question students of energy markets need to answer is this: Will the “unseen” impacts from this strategy shift outweigh the “seen” ones?  

The Shale Revolution

Since the middle of the last decade the American shale revolution has been powering the U.S. economy, and the country is enjoying a revival of its oil and gas business not seen since the 1970s. Domestic oil reserves at the end of 2012 (last year available) reached their highest level since 1979. Reserve levels during the 1970s were boosted by the then-recent inclusion of Alaska’s Prudhoe Bay oil field that was brought into production in the latter half of the decade as a direct response to the 1973 Arab oil embargo. From that point forward the industry struggled to increase reserves until the shale plays evolved. 

Natural gas reserves in 2012 were down from their 2011 record but largely due to abnormally low gas prices that discouraged drilling and development. Low gas prices have enabled gas demand to grow significantly over the past few years, but not as fast as supply. Increased environmental concerns are shutting down coal-fired power plants, which are being replaced with natural gas-fired units and renewable power.  

The upturn in U.S. oil production over the past five years has exceeded even the most optimistic expectations. We are now producing more than eight million barrels a day of crude oil, up three million barrels a day, or nearly 60 percent, from the low reached in 2007. Expectations are that we will see an additional one million barrels a day in output over the next several years and we may possibly reach 10 million barrels a day by 2020. 

The story for natural gas is similar as the U.S. consumed 26 trillion cubic feet last year, a new record. The gas boom has been carried on the shoulders of the shale revolution. Since January 2005, gas production in the Lower 48 has increased by 38 percent despite a sharp reduction in the number of drilling rigs targeting dry gas reserves. Experts predict that domestic gas production will continue rising – not only to supply increased utility and industrial consumption but also to enable nearly 10 billion cubic feet of natural gas a day to be exported in liquefied form. 

As these reserve and production trends appear set to continue, the U.S. is now being recognized as the new global energy powerhouse, a view unimaginable just a few years ago.  

This optimistic view of America’s energy future is based on the industry continuing to spend vast sums of money drilling new wells, developing new fields, and constructing the pipelines and treatment facilities to handle all this new output. Based on various capital spending surveys, the oil and gas industry anticipates spending $156 billion this year on exploration and development, up 8.5 percent from 2013. Since 2008 the industry has increased its spending by more than 50 percent, generating record growth in both production and reserves.  

Increase Spending or Reward Shareholders? 

These gains, however, are at risk as the industry adapts to the new “Era of Austerity” being dictated by shareholders. Allocating more of the industry’s cash flow to reward shareholders means that, unless oil and gas prices or output increase meaningfully in the near term, additional spending on exploration and development will be difficult. That is especially true given the rise in the cost of drilling and developing new discoveries.  

The Era of Austerity has emerged from the clash between higher finding and development costs that have contributed to falling energy company profitability and demands from the companies’ owners for a greater share of the profits. Shareholders are clamoring for higher dividends and more share buybacks rather than counting strictly on higher share prices because energy companies have underperformed the overall stock market for the past several years. 

Contributing to this underperformance is the shift of many investors away from commodity-related stocks in favor of companies in rapidly growing industries such as biotech, dotcoms and technology. Underlying this shift is the search by shareholders for higher returns from their equity holdings as low interest rates have washed away the historical strategy of funding retirements from bond interest income.  

So how are the large integrated oil companies responding to this new austerity? Collectively, they are taking a much harder look at the economics underlying major new projects. That means determining how to drive down the costs of these projects or, failing that, making more realistic cost estimates before proceeding. The best example of project cost escalation is Chevron’s Gorgon LNG project offshore Western Australia, whose estimated cost has ballooned from $37 billion in 2009 to $54 billion last year, a 46 percent increase in four years.  

To fight inflated costs and flagging financial returns, Royal Dutch Shell, under its new CEO, is reexamining every project and considering some radical restructuring of its operations in order to improve results. It has, for example, cancelled certain projects such as a planned massive gas-to-liquids plant on the U.S. Gulf Coast due to weakening economics. It has decided to segregate its shale resource business into a separate new company and sell some of its shale assets following a significant charge to earnings from having to write down the value of some of those assets. The most intriguing move was the company’s announcement that it will begin using Chinese-manufactured oilfield equipment because it is cheaper than American-made equipment and, in its view, on a par quality-wise.  

BP Ltd. is another company that has decided to separate its shale operations into a new company with the goal of embracing the more successful operating philosophies of independent shale operators. BP has also elected to increase its deepwater offshore exploration and development activities in an effort to find more “elephant” fields despite their greater costs and long timetables. The interesting question about BP’s strategy shift is whether an “elephant-hunting” culture can be transformed into the low-cost, incremental improvement, manufacturing-like operation necessary for developing shale resources.  

These shifts copy what are seen as successful transformations by ConocoPhillips and Marathon Oil from integrated oil companies into exploration-only operations. Neither Shell nor BP has made the radical shift of splitting itself into upstream, exploration-only operations and downstream refining, marketing and petrochemical businesses. Rather, their moves to establish separate, shale-focused units more closely follow the strategy of ExxonMobil after it purchased XTO Energy, a very successful, shale-oriented exploration company.  

In contrast with previous acquisitions, ExxonMobil left XTO as a stand-alone unit and transferred its existing shale operations to the new entity. So far, this has not been financially successful as evidenced by ExxonMobil’s upstream operations in the U.S. earning returns on average capital employed over the last two years of barely seven percent, while its international upstream business generated returns of 24 and 32 percent, respectively.  

Hard Choices

The Era of Austerity will force oil and gas companies to evolve their strategies. That process may prove somewhat uncomfortable as managements will need to more actively consider shareholders in their capital allocation decisions. Reducing operating costs to boost profits will necessitate passing on projects that might otherwise have been favored because confidence in the assumptions about their profitability may be low.  

Creating shareholder wealth should be the primary objective of company executives. If that wealth cannot be created by growing oil and gas reserves and production, then it will need to be achieved through other means. While shareholders may gain, the primary loser could be the general public as energy supplies may not keep up with global demand, signaling that oil and gas prices will be heading higher in the foreseeable future. 

Chevron’s CEO John Watson announced to his peers at a recent industry conference that $100 per barrel oil today is the equivalent of $20 a barrel in the past. One wonders whether the Era of Austerity will drive that metric to $150 or even $200 per barrel in the future.