Where have all the oil companies gone?

Adrian Jackson, energy analyst for Investec Asset Managements 4Factor equity team, looks at why oil company share prices are not profiting from the oil price boom

As an equity investor in the oil sector, despite the record highs of oil prices at over $86/bbl for benchmark WTI crude, one might expect that any company producing the black stuff would be a one-way bet.  Now, whilst share prices in the energy sector as a whole have moved up (as measured by the MSCI World Energy Index), the index has increased by only about half as much as the price of benchmark WTI crude oil.  It might seem logical that with operational leverage, companies' profits would move at least as much, possibly more than the oil price, as all the incremental revenue drops through to the company's bottom line, but clearly, at present this is not the case.  The question is, why?
 
The reality is that, despite average WTI oil prices of c.$73/bbl (some 10% higher than in 2006), many of the major oil and gas companies are struggling to grow their earnings above last years levels; and thats after a positive contribution from their downstream refining and petrochemical assets.  In spite of what looks on the surface like a perfect commodity price environment for them, they are actually facing a multitude of difficulties which, in some cases, mean that their earnings are forecast to be lower this year than last.  In trying to identify the winners in the sector it is quite instructive to look at why these companies are struggling to grow earnings.
 
Firstly, many of the majors gain a significant proportion of their production from gas developments which, although prices vary geographically, are consistently lower than oil prices on an energy equivalent basis.  US spot natural gas prices at Henry Hub are trading at c. $7/Mcf, which equates on an energy equivalent basis to about $42/bbl, or slightly less than half current oil prices. 
 
Secondly, many of the International Oil Companies (IOCs) are struggling to grow production.  Access to new reserves is becoming increasingly difficult because of gradual resource nationalisation either though reduced ownership (e.g. Venezuela, Ecuador, Bolivia, Russia) or through increasing fiscal take by host governments.  New development projects often also face delays caused by the well-publicised shortages of equipment and personnel within the industry.  So new production is difficult to come by, and meanwhile, oil companies are constantly having to replace declining production from their older more mature fields.  To add to their problems, if oil production is in countries where off-take is governed by Production Sharing Contracts (PSCs), as is the case for many IOCs, actual off-take declines with higher oil prices.  This so-called "PSC effect" results from the formula of the oil off-take split between the IOCs and the host government, through which the IOCs recover their original development costs.  As oil prices rise, the IOCs receive fewer barrels of oil to recover their costs, thus shrinking their overall production.
 
Thirdly, the surge in exploration and development activity that has occurred in response to high oil prices (from not only the IOCs but also from the National Oil Companies (NOCs), such as Saudi Aramco, Kuwait Petroleum and other OPEC state-run companies) has caused significant shortages of equipment and personnel.  These shortages have resulted in very significant industry cost inflation across a wide range of equipment and services.
 
So where can an equity investor find companies that are benefiting from the strong rise in oil prices?  One can do a lot worse than following the old adage from the days of the nineteenth century gold rushes: the only people who made any money were those selling picks and shovels.
 
In the oil world, the pick-and-shovel sellers benefiting in this case are the oilfield service sector companies focused on international exploration and development activities, particularly those with little or no exposure to the North American market, which is dominated by natural gas drilling and development.  Examples are:
 
1) Seismic surveying companies are experiencing strong demand for their services, resulting in a rise in margins and fleet utilisation, as the industry steps up its exploration expenditure to find new reserves.
 
2) Offshore drilling companies with a fleet focused on deepwater exploration and development are benefiting from effectively full utilisation and ever-increasing leading-edge day rates for new drilling contracts.
 
3) Equipment manufacturers who supply drilling and development equipment to the industry are seeing high demand, especially if their equipment is used for more hostile deepwater environments.
 
Finally there are indeed some 'oil prospectors' out there who have hit it lucky, although generally only if they are producing light crude in a country with a relatively benign fiscal regime. And, as we have seen, even western governments have not been averse to increasing their tax take from the oil companies.  This trend has been seen both in the UK and just recently in Canada.