Oil price crash could be a blessing in disguise

By cutting costs and focusing on capital efficiency, these firms could start to improve their sub-par returns on capital employed and thus drive improved share price performance.

The common wisdom that prevails today is that oil majors’ operating performance is inextricably linked to the oil price.

One argument is that this current oil price environment is helping to accelerate a cultural change that was already becoming evident; a more cost and capital-efficient industry that is striving for sustainably improved business performance.

Over the past 12 months, we have witnessed more than a 50 per cent correction in the oil price. A look back to see what evidence history can provide us with can help explain the relationship between oil prices and oil majors’ capital efficiency.

Between 1980 and 1986, the oil price more than halved from its peak of $115 per barrel. Redburn Partners have produced analysis to show the long-term relationship between oil prices and BP and Shell’s capital costs from 1980.

The analysis shows that between 1980 and 1994, capex per barrel more than halved. It clearly illustrates that the industry has the capacity to improve capital efficiency when it needs to.

Unfortunately, history also shows that this industry has failed to hold on to capital efficiency improvements in times of recovering oil prices. The industry has also tended to invest most at the top of the oil cycle and least at the bottom of the cycle.

This combination has led to a woeful track record of industry returns on capital employed and weak long-term share price performance for the sector over a five-year period.

The stockmarkets’ current scepticism of this industry is thus understandable.

It would be unfair to suggest that the whole sector had refused to acknowledge the need for efficiency improvement prior to the recent oil price fall. Statoil, for example, stated at the beginning of 2014 that it would reduce investment costs by 8 per cent.

This, combined with a number of asset divestments, put it firmly at the forefront of the ‘value over volume’ industry change that has been taking place.

But many oil companies are no longer chasing incremental volume growth in barrels of oil; instead, they are trying to generate higher returns on capital and hence better returns for shareholders. This is a significant change for the industry after many years of ill-disciplined capital spend.

The question as to whether they are able to hold on to these efficiency improvements and sustainably improve returns on capital remains an open one.

But a sustained lower oil price environment could provide the necessary impetus for companies to follow through with their promise to reform and even speed up the rate of change.

The investment case for the oil sector is not predicated on rising oil prices. In fact, a quick recovery in the oil price could undermine the pace of industry change that is taking place. The ‘oil majors’ are enormous companies with complicated structures and it will take time to deliver the necessary reform.

The hope is that this very challenging backdrop will lead to simplification and standardisation of business processes and an improvement in industry returns on capital. Sector valuations currently discount little potential improvement, providing a ‘cheap’ option on successful industry change.

Andrew Hall is global equities manager at Invesco Perpetual