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The Times: Mirror, mirror on the wall, how can oil plan at all?

January 31, 2007
Carl Mortished: European Briefing
 
Every morning as he brushes his teeth, a European oil company chief is reminded of the big question: is his business more like a tube of toothpaste or a glass of water?

If the latter, his job is to make money by being efficient, to keep the tap flowing, the water clean and the glass adequately replenished. 
 
A glass half-empty or half-full is the conventional view of integrated oil companies. These are utilities: there is plenty of oil and gas about and the job is to invest adequately, not overfilling the glass, in order to maximise the amount of money that flows from the taps and pipes.

The other view is that the business of big oil is to capture scarce resources. It’s about squeezing as much as you can out of the wrinkly tube. Oil companies are custodians of wasting assets: it’s all about reserves, who owns the barrels and the price, monetary or political, to acquire more of them.

Suddenly the debate over what oil companies are about is becoming shrill — and not only because the supporters of peak oil theory are getting more noisy. Whether or not the global oil industry has reached maximum output at some 85-90 million barrels per day, the stock market seems to have lost its ability consistently to price risk in the oil sector.

On multiples of forecast earnings, the gap between the value of the European oil majors (Shell, BP and Total) and the leading American competitor ExxonMobil has widened dramatically. At the same time, the price-earnings multiples of the “risky” emerging market companies have, counter-intuitively, soared as well.

You might think that the market is getting Exxon right — it is a bit better at running the machinery of oil. Capital spending at Exxon is tighter, cashflow is stronger and, Exxon Valdez notwithstanding, it has had fewer operational hiccups and less evidence of slipshod management in recent years. If the market’s job is to value each company’s rigs and refineries in terms of their future cashflow, then arguably Exxon’s kit ought to fetch a valuation, say, 10 per cent higher than BP or Shell.

A much higher premium would be wrong — there is no reason why a company of the scale of Exxon should grow much faster than Shell. The two sell similar quantities of the same products at identical prices in a market where demand rises on average at between 1 and 2 per cent a year. If growth rates should, in the long term, even out, the valuation argument is about efficiency: which firm generates more cash from its bag of assets. At Deutsche Bank, analysts worry that the market’s valuation of Exxon’s asset base is soaring while that of Shell and BP is hammered. Adjusted for inflation, Deutsche says that the long-term asset multiple of Exxon is about 1.7 times, compared with BP’s 1.6. That sounds like a sensible premium for Exxon’s efficiency, but today it’s all gone loopy. The market values Exxon at 1.9 times its adjusted asset base, while BP is 1.4 times and Shell just 1.2 times.

Spending is an issue. Add a few billion dollars to the annual capex budget and a company’s return on capital shrinks. Exxon is spending proportionately less than its rivals, but should we really draw comfort from Exxon’s miserly way?

Further afield, investors are flirting with Rosneft and Gazprom, hardly models of capital efficiency. Their extravagant ratings are based not on cashflow but on growth potential. The market thinks that Russia’s tube of toothpaste is family size. BP and Shell struggle to squeeze the last smidgin from the North Sea and Exxon hopes no one notices that its toothpaste tube is miles offshore of Qatar in the Gulf, halfway to Iran.

Efficiency does matter, says the market to our bleary-eyed oil chief. But don’t fool yourself: barrels count, too. It’s not enough to be a disciplined process engineer and, since the massive Kashagan discovery in the Caspian Sea in 2001, legions of petroleum geologists armed with billions of dollars of exploratory wells have had paltry success. Diplomacy is the skill that matters, the silver-tongued art of opening doors. Unfortunately, the capital markets are uncertain how to value something so ephemeral. Will Exxon continue to thrive without a strong position in Russia? Will Total recover prewar licences in Iraq? Is TNK-BP secure and will the Kremlin throw Shell a meaty bone or two after seizing the carcass in Sakhalin?

It is many decades since the the future of the big oil companies has been so dependent on the art of speech and persuasion. In each of the giant companies, there has been a recent management transition or a changeover is imminent. No wonder the market is confused.
 
http://business.timesonline.co.uk/article/0,,8210-2575327,00.html

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