Deutsche Bank Securities recently announced the release of a research report on the Oil Majors. The essential conclusions of the report appear to be that the business model for the oil majors is wrong and inconsistent with the realization of full value.
We do not have access to a full copy of the report. However, it has been summarized in a number of places. Our comments will be confined to a consideration of the key points that have been highlighted in these summaries.
The study's key observation seems to be that the financial markets are discounting major oil companies' valuations relative to other sub-sectors in the global energy business such as oil service, independent producers, or refiners. The current differences in the market's relative valuations in the oil and gas industry are taken to imply that the strategic focus of the large international oil companies is therefore wrong.
While this is an important result, it is certainly not something new. Moreover, this is not always true. Relative valuations of major integrated oil companies, independent producers and service companies have always been cyclical -- shifting with the oil and gas price cycles. These relative valuations are not constant over the cycles.
The authors attribute the discounting of major oil company shares to several factors. In broad terms these factors seem to be usefully summarized as (1) market wants, (2) a failure of the "traditional business model of international oil companies", and (3) external forces. We believe that Deutsche Bank is wrong on multiple levels.
What the Market Wants
The report asserts that:
The strategic approach of the majors -- low leverage, diversified investment goals, and long planning horizons -- are not consistent with what the market wants.
Instead, the markets, according to Deutsche Bank Securities, want high-risk exploration, high leverage, short-term growth plans, and break-up strategies.
Perhaps there is a reason why what Deutsche Bank believes the markets want of oil companies sounds like the strategy and rationale behind the housing bubble, derivatives and sub-prime lending. I suppose we should take some form of comfort in the remarkable consistency with which investment banks and their analysts view industries and markets in a way that benefits their transactions business.
Let's first be clear: There is not one market for shares in companies active in oil and natural gas. And, therefore, there is not just one set of market wants nor should managements of companies expect their shares will appeal equally in all market segments or at all times.
What the markets want when oil and/or natural gas prices are high and rising is a far cry from what these markets want and value when prices are low and falling.
Consider, for example, the market enthusiasm for Chesapeake Energy leading up to a share price of nearly $67 by June 2008 and how it was rapidly replaced with the disillusionment that, by December 2008, drove the share price down to only $11.32.
Or let's compare Chesapeake's 83% share price collapse to the 38% decline in ExxonMobil shares from December 2007 to July 2010. Or ExxonMobil's recovery back to $85 per share in February of this year (all the while paying substantial dividends to the portion of the market that chooses to invest in such companies) while Chesapeake has yet to get much past $35 per share since its bottom.
Chesapeake, Tullow, Santos or BG, to cite several examples across a large spectrum, may possess the potential for extraordinary gains to their shareholders over a short period of time. These gains are often due to one or more company-making discoveries or because they possess a material position in one or more emerging plays.
On the other hand, what the successful oil majors offer is a demonstrated capacity to repeat success over the long-term. This capacity is demonstrated by typical returns on capital employed that are in excess of costs of capital and that are sustained over a range of oil and gas market environments not just in a high price case.
There is a widespread misconception, explicit in the Deutsche Bank conclusions, that rapid (and unexpected) volumetric growth is an essential indicator of success and requirement of the financial market. Growth is neither a necessary nor a sufficient condition for success by the standard of sustainability. Indeed, as a company succeeds and evolves, as it grows and becomes more diverse in its asset base, a critical barrier to sustained success is often rooted in a continuing management preoccupation with volumetric growth. The source of the problem is that all too often the drive to grow sacrifices sustainable profitability.
The Traditional Business Model of International Oil Companies (IOCs) Doesn't Work
What, in fact, is the traditional business model of the IOCs? Deutsche Bank, at least according to available summaries, believes that this model involves a linear evolution from exploration success through project development and exploitation combined with downstream integration.
In most key respects Deutsche Bank's description of the consensus IOC model is inaccurate. It describes the consensus view as it existed until about 1986. It is not, however, an accurate description of the consensus strategy driving the IOCs in the period up to the shift that is now underway. After 1986 and through most of the 1990's, the more prevalent or dominant model emulated Total's focus on negotiated production agreements with host countries involving existing, proved reserves.
Until recently North America played little or no significant role in terms of upstream operations. In fact, the accepted strategy was to exit most major elements of North American upstream operations. These operations were seen as little more than sources of cash flow to invest elsewhere. At the same time integration generally fell out of favor. The driving forces behind recent shifts in strategy including the move back to North American upstream and the rising role of natural gas are two-fold. First, the one-dimensional strategy of the post-1986 era failed. Second, from both a practical and a public policy perspective, gas resources are likely to be a driver of future company success.
The reality is simply this. The goal of new business development, whether through the vehicle of exploration or through acquisitions or production agreements, and whether upstream, midstream or downstream, is to establish the basis for new core areas. The two unambiguous requirements for core area status are (1) return on capital employed in excess of the cost of capital and (2) the capacity to repeat success (to yield sustained success) over time.
External Forces Erode the Role of the Majors
The Deutsche Bank study reportedly argues that external factors have eroded the potential role of the majors. Their argument is not new.
Oil resources are concentrated in countries offering limited access. Gaining access to these resources is typically only through service contract types of tax and licensing systems and, therefore, upside for the oil major is limited. This, combined with competition from the national oil companies and limits on access to oil opportunities, drives the oil majors to gas which, according to the authors, is not consistent with the traditional oil major focus on scale and integration.
The argument is fundamentally flawed on three fronts.
First, tax and licensing terms and company access to resources is a dynamic, market process. The evolution of tax and licensing conditions and availability of new investment opportunities in countries throughout the world over the past 30 years is unambiguous evidence of this fact. Deutsche Bank is offering nothing more than another rehash of the over-used argument that the world's oil and gas resources are controlled by the national oil companies and governments. It ignores the fact that the degree to which these governments need industry capital resources varies substantially over the price cycles.
Second, service contract agreements may limit price-based upside available to the oil and gas companies. However, so long as the contract terms are compatible with return on capital needs, service contracts in areas with large resources can still be very much compatible with sustainability of profits.
Third, natural gas (both LNG and the unconventional gas plays that have risen to dominance in North America and Australia) is very consistent with sustainability, the necessity for a long view to succeed, the value of scale and the importance of integrated investment strategies. The fact that the majors have opted to expand into this segment is not surprising. The fact that it took them so long to change course is a testament to the inertia that builds within consensus strategies even as the conditions driving these strategies are changing. The potential for unconventional gas opportunities on a more global scale (CBM in Indonesia, shale gas in Europe, etc) could become a major next phase for the majors.
The Coming Dilemma for Market Wants
There is an emerging dilemma for the market and its wants as seen by Deutsche Bank. The pool of "majors" is growing, not shrinking.
Broad spectrums of companies (including national oil companies) aspire to major status and are rapidly evolving to this status. In a number of cases this evolution is the result of companies' investment decisions (particularly their acquisition programs). In other cases the evolution to major status is being driven by companies' new business development programs worldwide and recent exploration successes.
The maturation of the Chinese companies' international programs is a clear example. The future impact of exploration results in Brazil's pre-salt play and African deepwater is another case affecting Petrobras, BG, Anadarko and others. The rise of unconventional oil and gas will also play a major role in redefining the nature of a wide range of companies.