Financial Times: Commodity bosses’ dilemma

Published: May 16 2007 12:39 | Last updated: May 16 2007 12:39

They run some of the world’s largest listed companies. Their products are indispensable in modern society. They hob-nob with world leaders on a regular basis, discussing geopolitics and climate change. Sadly, this is not enough to get their share prices moving.

Energy and mining chief executives have a problem. Despite high commodities prices and record cash flows, their stocks have suffered the worst de-rating of earnings multiples of any sector barring technology since 2003. It is a particular problem for the sector’s big boys – those with market capitalisations above $100bn, such as BP, Royal Dutch Shell and Rio Tinto. Maintaining growth is a struggle. Meanwhile, an equity market hungry for mergers and acquisitions is focused on mid-cap stocks and investors seem unwilling to buy into the notion of a commodities supercycle.

On balance, the miners have it easier. When it comes to gaining access to new resources, they do not have to contend with the Organisation of the Petroleum Exporting Countries. Consolidation has a certain logic in an industry where investment and pricing indiscipline have fuelled boom-bust cycles. China’s increasing role as both top consumer and swing exporter for several metals and minerals is one fly in this particular ointment, but investors seem unperturbed. BHP Billiton’s stock barely moved after it announced a blockbuster $10bn buyback in February, but talk of a bid for Rio prompted a jump in BHP’s shares. M&A activity is likely to intensify.

The oil sector’s problems are more existential. Cost inflation is eroding the benefits of high oil prices – one reason for the outperformance of oil services providers relative to the majors. Political barriers and the rise of state-controlled competitors severely constrain profitable opportunities for organic growth. No amount of consolidation will strengthen pricing power in a global oil market where Opec’s share of production is set to rise.

Why should investors own the majors, if capital and technology can be provided by others, and they are too big, or too heavily protected, to be bid targets? One reason is valuation. Both Morgan Stanley and JP Morgan reckon that the market currently values the upstream businesses of the likes of BP, Shell and Total at around $10 per barrel of oil equivalent of reserves. That is roughly half the multiple paid in recent asset deals or the average finding and development unit costs. That may reflect a conglomerate discount: majors’ upstream businesses lump in growth areas like liquefied natural gas with declining, but cash-generative, mature oil fields. Morgan Stanley suggests, sensibly, that the majors should break this out for investors.

There is also the potential for more radical action. Mega-mergers or splitting upstream from downstream operations are obvious tools, but may be too blunt. Mergers facilitate diversification, but create bigger conglomerates which still struggle to replace reserves. The integration of refining and marketing assets, meanwhile, is valuable, as demonstrated by Shell’s last set of quarterly results.

Asset swaps, carve-outs or mergers involving true like-for-like businesses – say, combining LNG assets – could make sense. Smaller, more focused companies may then be more obviously appealing to different types of investors, including private equity. They might also be more willing to embrace different business models. They could, for example, sacrifice ownership of barrels in the ground in favour of better service contract terms with host governments. Conceivably, unlike the majors, they could offer equity stakes to state-controlled companies in exchange for access, without raising political hackles.

The industry is undergoing its biggest realignment since the 1970s. By coincidence, the three largest western oil majors and three big diversified miners have all either recently installed new chief executives, or will do so within the next two years. That presents an opportunity to move beyond business as usual.

Copyright The Financial Times Limited 2007

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