Size, costs of global projects become Big Oil's millstone

HOUSTON -- Are the supermajors too big for their own good?

That was the first question posed to Exxon Mobil Corp. CEO Rex Tillerson at a recent conference with equity analysts in New York. Not known for their willingness to ruffle a CEO's feathers, Wall Street's purveyors of opinion tuned in to listen.

Exxon succeeds by investing in a broad range of oil and gas ventures, Tillerson explained confidently.

"We try not to belabor risk management aspects of our business," he said. "We don't have any one project, there is no one country, there is no one thing that we live and die by. And that is part of the model that we offer to investors."

In other words, Exxon can gather up the capital and engineering talent needed to tackle complex and expensive energy projects. Smaller companies don't have the stomach for that.


Not surprisingly, Tillerson took issue with the premise underpinning the friendly interrogation: Why have shares in the world's largest privately held oil and gas companies underperformed in the broader markets for the past half-decade? Has Big Oil lost its competitive edge?

Big Oil, as it's referred to as both an accurate description and pejorative label, consists of companies with revenues bigger than the economies of some small nations: Exxon, Chevron Corp., Royal Dutch Shell PLC and BP PLC fall into this group. So do France's Total SA, Italy's Eni SpA and Spain's Repsol.

Increasingly, though, investors are voicing concern that multinational oil companies face hard times ahead. Cost overruns are rampant for megaprojects across the globe -- $15 billion to $50 billion oil and gas projects in Russia, Australia and the Arctic, for example, and the accumulated cost of drilling thousands of wells in North America's unconventional oil and gas fields. What's more, some of those projects won't produce enough oil to replace declining reserves in other areas of their portfolios.

Norwegian consulting group DNV GL recently noted that in Australia, there's an unforeseen willingness among competitive companies to work together to control costs as the raft of liquefied natural gas (LNG) terminals under construction there are completed.

Australia is one of the supermajors' frontiers. With the shores of China, Japan and South Korea a relatively straight shot by boat, Australia's offshore gas fields promised long-term reserve potential and a gold mine in oil-indexed gas sales. So they rushed to invest in the latest massively expensive opportunity, sending demand for construction equipment and labor through the roof.

Oil producers are struggling to balance longer-term projects that promise future returns with the desire among investors to see returns today. It's an age-old tension exacerbated by the size of the megaprojects.

In a February report, Credit Suisse predicted that next year could be a turning point for Big Oil, bringing that tension into better balance, but acknowledged deep skepticism among investors. Noting an 11 percent decline in cash flow for these companies, coupled with a 23 percent growth in capital expenditures since 2011, Credit Suisse analysts blithely noted that "no major has covered themselves with glory."

Stuck on a treadmill

If the old rules of investor relations hold true, the oil majors will continue scraping for access to new oil and gas pools. The challenge for the supermajors is maintaining high reserve replacement ratios.

In recent years, getting to those massive reserve figures -- so companies can make predictions about future production -- has run up against national oil companies (NOCs) that control most of the globe's oil and gas reserves.

It's a little like being stuck on a treadmill, according to energy analysts.

"The sheer size of the supermajors is, in my mind, and I think many others, an impediment," said Charles Dewhurst, a principal at the Houston office of global consulting firm BDO. "We're going through so many transitions in the energy industry with things like shale development [and] needing to react to a higher focus on safety and spills."

Much of the challenge has been in the companies' downstream refining and marketing businesses, where profits are squeezed when a refiner goes to buy globally traded oil at $100 a barrel.

Speaking at Rice University, International Energy Agency (IEA) chief economist Fatih Birol said there's too much spare refining capacity around the world. Still more is being built, he said, and he warned that refineries in Europe and the United States are "facing serious challenges to come."

Commodities pricing firm Platts spelled out the rest of Big Oil's problems in a February note. Put together, BP, Shell, Exxon, Chevron, Total, Eni and ConocoPhillips have seen their liquids production decline by 2.2 percent in 2013 from where it stood in 2012. Liquids output for the companies slid more than 12 percent between 2009 and 2013.

Platts' analysts pointed out that Shell experienced one of the smallest dips in liquids production from 2009 to 2013, a drop of 2.5 percent. On the other side of the ledger is France's Total, which saw output slide by more than 15 percent. Eni's slid by more than 17 percent.

Last year, ConocoPhillips split from the supermajor pack altogether. The company spun off all its downstream business to the newly independent Phillips 66. ConocoPhillips now calls itself the world's largest independent upstream exploration and production company.

Other supermajors also appear ready to make changes that a short time ago would have seemed like a dramatic response to a volatile oil market. BP is organizing its entire North American onshore portfolio into a separately managed unit. It's moving the team responsible for onshore unconventional developments out of its corporation campus on Interstate 10 in Houston to another office entirely. In theory, from BP's perspective, the company is better positioned to stay on its toes as smaller shale oil and gas companies compete for acreage and production gains.

Shell is arguably hurting the most. Facing an investor backlash over rising capital expenses in the face of flat or falling earnings, Shell's executive suite is promising a complete overhaul this year. Planned moves include a major retreat out of some U.S. and Canadian shale fields and a suspended Arctic drilling program. Investments in encouraging heavy trucking and fleet vehicle use of natural gas are also on hold.

"If you look at the reserve replacement ratios for some of the supermajors, some of them are quite alarming," said BDO's Dewhurst.

Many of these ratios are under 100 percent. On an annual basis, that means these companies are slowly depleting their reserves. "They're not adding new reserves to make up the production that they benefit of the current year, so they're shrinking in size," he said.

'Proved reserves' for cash

Tillerson's Exxon is faring the best among the group, according to some measures; Dewhurst estimated that the company managed to grow its reserves by around 15 percent over the past decade but that most of this reflects the company's shift to natural gas, a transition that has gone somewhat unnoticed because of Exxon's reliance on calculating reserve replacements in terms of barrels of oil equivalent, or BOE.

But the positive reserve replacement figures have been disputed for years, in part because Exxon doesn't stick to estimates of only proved oil reserves. Analysts at UBS have pointed out that the company's total resource base is 28 percent proved reserves, and the volumes of proved reserves are fairly flat year over year.

Still, Exxon exudes the most confidence among its peers, while acknowledging investor concerns. It plans to cut capital spending to $39.8 billion, down from $42.5 billion in 2013, which was a peak level for the firm. Tillerson said the cost overruns can be partly explained by how much capital spending is going on across the industry all at once.

Like CEOs at nearly all of the supermajors, Tillerson says capital spending and cost overruns are moderating. The company may be getting a handle on its production declines, as well.

Platts' data shows that Exxon Mobil's oil production fell by 4.5 percent in 2011 and by another 5.5 percent in 2012. But the company managed to grow crude output by nearly 1 percent last year. This year, production is set to start for a record number of Exxon projects scheduled to come online.

Exxon "expects to start production at a record 10 major projects in 2014, adding new capacity of approximately 300,000 net oil equivalent barrels per day and contributing to profitable production growth," the company boasts.

Meanwhile, Shell and BP will spend much of the year reorganizing as their megaprojects start coming online.

Analysts at Raymond James have noted a determination by Exxon's executives to court investors through dividends and aggressive share buybacks. But they've also acknowledged that Exxon has underperformed the Standard & Poor's 500 this year.

Christopher Ross, a professor at the University of Houston's Bauer School of Business, dismissed the idea that the supermajors are in trouble. He acknowledged the twin burdens of rising capital expenditures and massive reserve replacement expectations. Still, he said, the companies offer steady income and security, not a big blast of growth each quarter.

Yes, the companies are struggling with maturing, declining resources, and they have to run fast just to stay even, "but they make mountains of cash, which they can redistribute to shareholders as dividends or buybacks," Ross said.

The supermajors, he contends, are "not in the growth column; it's the returns and low risk."

Longtime horizons

"Their role in the energy world is, as Exxon puts it, to take on the world's toughest energy problems," Ross said.

Exxon executives argue this, too. At the recent analyst meeting in New York, Tillerson said Exxon is breaking new ground. Take its Papua New Guinea liquefied natural gas export project, dubbed PNG LNG, for example. It's extremely expensive and complex, but the project will be turned in on time, Tillerson said.

"Despite the many challenges, the project is actually progressing a few months ahead of schedule, with first cargo delivery in the middle of this year," Tillerson told analysts. Then there are Hebron and Sakhalin II, which are both challenging offshore projects off Newfoundland and the Russian Far East, respectively.

Ross criticized investors and analysts for being shortsighted.

"They have a longtime horizon, and this is why, I think, you run the risk of getting yourself into trouble when you start talking about quarterly earnings," Ross said. Exxon, he noted, is working on projects with 10- or 15-year time horizons before production.

Exxon is building a giant complex on the north side of Houston that will allow the company to consolidate all of its scattered offices in the city under one roof, including ExxonMobil Chemical and about 2,000 staff members being relocated from Virginia. The campus is so big that it has fueled speculation that Exxon may be preparing to move its corporate headquarters to Houston from the Dallas suburb of Irving. Company representatives have repeatedly denied this.

"That suggests to me a very hands-on management style where they can be much more efficient at decisionmaking because all of the key players are going to be here in Houston to execute those decisions," Dewhurst said.

But for the supermajors as a whole, Dewhurst said he remains unconvinced that the future is bright.

They've got competition from oil services companies. Companies like Baker Hughes Inc. and Schlumberger have become so specialized and skilled at equipping and managing complex drilling operations that they're taking the supermajors' business. National oil companies in Asia now have somebody else to turn to other than Shell, Exxon and Chevron.

Dewhurst predicts the supermajors will deal with reserves replacement issues through expensive mergers and acquisitions, purchasing companies already holding assets rather than finding new tracts of their own.

"I think they are very sensitive to these declining reserve replacement ratios, so I'm sure we'll see a lot more acquisitions by the supermajors to replenish those maturing assets," he said.

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