Wood Mackenzie: Higher oil prices may spell trouble for upstream discipline

Operators were cautioned to exercise caution as oil prices trend higher this year, which will likely lead to higher cash flow for producers.

“While prices over $60/bbl will always be better for operators than $40/bbl, it’s not all one-way travel,” said Greig Aitken, a Director with the corporate analysis team at Wood Mackenzie. “There are the perennial issues of cost inflation and fiscal disruption. Also, changing circumstances will make strategy execution more challenging, particularly as it relates to doing deals. And there’s the hubris that comes in every upswing, when stakeholders begin to regard hard-learned lessons as outdated views. This often leads to over-capitalization and under-performance.”

Mr Aitken said operators should remain pragmatic. The blueprints for success at $40/bbl are still the blueprints for success when prices are higher, but there are a number of issues operators should keep in mind. For one, supply chain cost inflation is inevitable. Wood Mackenzie said the supply chain has been hollowed out, and a rush of activity would very quickly tighten markets causing costs to rise swiftly.

Secondly, fiscal terms are likely to tighten. Rising oil prices are a key trigger for fiscal disruption. Several fiscal systems are progressive and set up to raise government share at higher prices automatically, but many are not.

“Demands for a ‘fair share’ become louder at higher prices, and strengthening prices won’t have gone unnoticed,” Mr Aitken said. “While oil companies resist changes to fiscal terms with threats of lower investment and fewer jobs,  this could be weakened by plans to wind down or harvest assets in certain regions. Higher tax rates, new windfall profits taxes, even carbon taxes could be waiting in the wings.”

Rising prices could stall portfolio restructuring, as well. While many assets are up for sale, even in a $60/bbl world, buyers would still be scarce. Mr Aitken said the solutions to a lack of liquidity are unchanged. Would-be sellers have can either accept the market price, sell better-quality assets, include contingencies in the deal, or hold on.

“The higher oil climbs, the more emphasis shifts to holding on to assets,” he said. “Taking the prevailing market price was an easier decision when prices and confidence were low. It becomes more difficult to sell assets at a lower valuation in a rising price environment. The assets are generating cash and operators have less pressure to sell due to their increasing cash flow and greater flexibility.”

However, strategically high-grading portfolios is essential. Mr Aitken said: “It will get harder to hold the line at higher prices. Companies have talked a lot about discipline, focusing on debt reduction and increasing shareholder distributions. These are easier arguments to make when oil is $50/bbl. This resolve will be tested by rebounding share prices, increasing cash generation and improving sentiment towards the oil and gas sector.”

If prices hold above $60/bbl, many IOCs may head back toward their financial comfort zones more quickly than if prices are $50/bbl. This provides greater scope for opportunistic moves into new energies or decarbonization. But this could also be applied to reinvesting in upstream development.

The independents may see growth quickly return to their agendas: most US independents have self-imposed reinvestment rate constraints of 70-80% of operating cash flow. Deleveraging is the primary target for many highly-indebted US companies, but Mr Aitken said this still leaves space for measured growth within rising cashflow. Moreover, few international independents have made the same type of transformational commitments as the majors. They have no such reason to divert cash flow out of oil and gas.

“Could the sector get carried away yet again? At the very least, the focus on resilience would give way to a discussion about price leverage. If the market were to start rewarding growth again, it is possible. It could take several quarters’ worth of strong earnings results to materialize, but the oil sector has a history of being its own worst enemy,” Mr Aitken said.