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Rapid fall in oil prices brings majors to their pain threshold

Times Online
The Times
October 25, 2008

This week’s slide in oil prices to a 17-month low is set to confirm what has long been suspected: that the third-quarter results season from Britain’s oil majors – which will be opened on Tuesday by BP – will be as good as it gets for now.

Quarterly earnings for BG Group are forecast to show a 92 per cent rise on the year. Those from BP should be up by around 65 per cent.

But what is likely to be more closely followed than the strength of recent profits is the sector’s pronouncements on its capital expenditure plans – nowhere more so than in the oil services sector, those companies that provide everything from contractors for petrochemical plants to high-tech deep-sea exploration technology, where share prices have nearly halved since early September amid a combination of tumbling commodity prices and the expectation of weakening demand.

The omens are not good. TNK-BP, the Anglo-Russian joint venture, has already indicated a potential $1 billion (£630 million) cutback in capital spending next year, and others are expected to follow suit. This week, shares in Baker Hughes, the Anerican oil services giant, fell by 22 per cent after it complained of a “less certain” outlook, echoing recent more cautionary comments from the likes of Halliburton and Schlumberger. Closer to home, Aker Solutions, the Norwegian offshore engineering specialist, rattled nerves on Thursday by missing third-quarter profit forecasts.

The immediate problem is that the rapid fall in oil prices has very quickly taken oil majors back to their “pain threshold” – the point where new investment becomes uneconomic.

Merrill Lynch estimates that capital expenditure by the global oil exploration and production sector will still rise by 5 per cent next year to around $320 billion. This is partly a reflection of the fact that spending on long-term projects can’t easily be reversed. However, the US broker concedes that if average oil prices remain below $80 a barrel for a protracted periods, either capital costs will have to come down or projects will be delayed or scrapped altogether. At around $50 a barrel, capital costs will need to fall by 40 per cent, it calculates.

There must be some encouragement from the fact persistently strong cost inflation in raw materials, such as steel and cement, have started to reverse.

Cazenove takes a more bearish view. It predicts that capital expenditure by the oil majors next year will be flat at best, or down 10 per cent at worst; although it does not expect greater clarity until year-end budgeting rounds have been completed. The consolation is that, even if Cazenove’s worst-case scenario prevailed, this would still be better than the oil price nadir of the late 1990s, when the likes of BP, Royal Dutch Shell and Exxon Mobil cut their upstream capital expenditure by roughly a quarter. The other reassurance is that oil prices have to fall to $25 a barrel for the profits of upstream oil producers to be extinguished completely.

So which projects are most at risk? The most immediate pressure will be felt by the smaller explorers, who do not enjoy the balance sheet strength of the majors, and where the availability of credit will be a more pressing problem than the near-term oil price. The other obvious casualties are the sort of big-ticket projects that typically take five years to complete and at least seven more years to produce an economic return.

These include deeper water offshore ventures, such as those off the coast of Brazil and West Africa, start-up liquified natural gas schemes, such as Exxon Mobil’s Gorgon venture in Western Australia, and possibly some of the new refineries in Saudia Arabia. But top of the list must be the proposed investments in Canada’s oil sands.

The synthetic crude extracted from the bitumen-soaked sands beneath Alberta’s peat bogs ranks among the world’s dirtiest oil and among the costliest to produce. This week Petro-Canada delayed its Fort Hills oil sands project indefinitely, citing a rise in its estimated project costs from C$19 billion (£9.5 billion) to C$28 billion in a year. It is no coincidence that London-listed oil services companies with exposure to Canada’s heavy oil have come under some of the most sustained share price pressure.

Aberdeen’s Wood Group, which last year bought Canada’s IMV, fell 9 per cent alone yesterday, meaning that its value has halved in the space of a month. Amec, its FTSE 100 peer, has suffered, too. For the oil services sector as a whole, the most visible indicator is likely to be a shrinking of its persistently high order backlog, which for its European constituents currently sits at around a record $70 billion (see chart).

An equally powerful barometer will be the willingness of the oil majors to maintain their dividends: if capital expenditure is not reduced in 2009, dividend payments will not be covered by cashflows at a price of $65 a barrel, assuming a 5 per cent increase in the payout, according to Cazenove.

Next week BP is expected to raise its third-quarter dividend by 50 per cent to 8.3p a share, an increase that few UK companies can match. The bigger question for an industry that preferred to cut spending rather than dividends in the last period of oil-price falls is whether that thinking will change.

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