Adapting to lower for longer oil prices

Pascal Menges, portfolio manager of the Lombard Odier Global Energy fund gives his outlook on the oil market.

At current oil prices, investors have every reason to wonder whether the major oil companies can generate profits. In reality, the majors can barely generate free cash flow and so they have to rely on debt to cover their dividend obligations. Some have chosen to pay dividends in shares which, de facto, correspond to a regular capital increase.

In the near term, for some of them, the brunt of the fall in the oil price has been smoothed by strong refining margins and trading profit thanks to the prevailing contango in the oil price future curve.

If this reverses in the last quarter of this year, the majors’ weakness will be even more glaring. With lower-for-longer oil prices dividends are unlikely to be sustainable. Large corporations must then, we think, cut costs and defer projects even more aggressively than the most recent announcements. Several companies, we believe, have inappropriate project portfolios with too-high breakeven costs, such as oil sands, ultra-deepwater and Arctic drilling.

That means that such portfolios will have to be re-tooled, either through lower cost solutions and/or Mergers & Acquisitions.

The picture from the US shale sector is patchy. Some shale sector companies have very attractive geologies while others are in marginal geological trends. In addition, corporate structures may pose challenges with growing financial debt.

In general, we would expect those with the best geologies and solid balance sheets to come out stronger from this downturn. We have seen massive improvements in cost and efficiencies. Contrary to long cash-cycle projects such as deepwater or oil sands for example, cost deflation in US shale has been as large as 30% (source). These dynamics illustrate the manufacturing nature of the US shale and how costs can be driven down thanks to the learning curve. This is in stark contrast with conventional fields.

This said, the very best of US onshore companies have managed to rapidly drive down costs and reach cash flow neutrality. This is very different from oil majors where such a rebalancing is likely to take years… if ever. We believe this means that investors should focus on short-cycle business models, like US onshore companies.