FUNDAMENTAL ANALYSIS DEPARTMENT OIL AND GAS INDUSTRY REPORT

Transcription

1 FUNDAMENTAL ANALYSIS DEPARTMENT OIL AND GAS INDUSTRY REPORT Done by: Chia Wesley Edwin Su Zengxin Leonard Goh Yee Tat

2 Contents Introduction... 3 Outlook... 4 Key Performance Indicators (KPI)... 5 Exploration Industry... 5 Production Industry... 5 Unique Characteristics of Oil & Gas Industry... 6 High Operational Capital... 6 Dominated by State-Owned Enterprises... 7 Oil to remain as a Staple Energy Source... 7 Case Study Royal Dutch Shell... 9 Stock Profile Royal Dutch Shell (NYSE: RDS.A) Conclusion of 14

3 Introduction In numerous ways, oil and natural gas have helped in the daily lives of people and it is an everyday necessity in almost every aspect our lives. More than 60% of the world s energy is supplied by oil and natural gas. As a result, the oil and gas industry plays significant role in the contribution of the world s economy. In terms of dollar value, the oil and gas industry is considered to be one of the biggest sectors. The oil and gas industry can be categorized into three main key areas: 1. Upstream The Upstream component, also known as Exploration and Production (E&P), encompasses the exploration for underwater, underground natural gas or crude oil fields and the drilling of exploration wells to recover oil and gas. 2. Midstream The Midstream involves the transportation and wholesale marketing of crude or refined petroleum products. This process helps in the delivery from production sites to refineries. 3. Downstream Downstream refers to the filtering of the raw materials obtained during the upstream phase. The industry itself is characterized by complex operations that range from scanning for potential wells to the actual drilling process, all of which may take up to years to complete. The oil and energy sector is not solely affected by its own operations but even more so by the macro-environment, from politics to changes in our technology as well as global energy requirements. This report will hence examine some of the unique aspects and characteristics of this industry that investors should first consider and understand prior to investing. 3 of 14

4 Outlook In the mid-2000s, global demand for oil was at its peak. Oil prices increased exponentially because of the insufficient oil production and supply was not able to keep up with the demand. Oil price fluctuated around US$100 per barrel from 2011 to During that period, energy companies saw the opportunity to make a profit and started extracting oil, even from places that were difficult to drill. Technologies for drilling were improved and this led to a boom in oil production. However, things changed in September Oil demand in Asia and Europe weakened, especially in China, Japan and Germany. Even so, oil companies continued in their oil exploration activities. Figure A: Oil price in 2014 With weakening demand and increasing supply due to the shale gas revolution, oil prices started to fall. This could also be seen from the negative market sentiment. From its peak at June, oil prices have dropped from USD $115 to $65-$70 per barrel. In a fight to protect market share, OPEC members refused to cut oil production. This led to the belief that oil prices will remain around $60 in the Despite the negative market sentiment about oil price, we believe that the oil and gas industry is still profitable. In the past couple of years, Source: NASDAQ investment and acquisitions in shale assets and oil sands were the main focus for oil and gas companies. Previously mentioned, upstream exploration and production was high and the midstream and downstream sector could not keep up with demands. Hence looking forward into 2015, investment will shift to midstream from upstream sector. This includes refinery operations and petrochemical facilities. This spending shift is already prevalent in the expenditure budgets of these oil and gas companies. According to the Oil and Gas Journal s 2013 projection, upstream E&P capital spending stayed flat over the past year. From 2012 to 2013, spending for upstream activities had only increased by 0.11%, from US$354.4 billion to US$354.8 billion. On the other hand, midstream spending increased from US$12.8 billion to US$46.4 billion from 2012 to 2013, an increase of 263%. Downstream spending had also increase by 11% to USD 24.7 billion in of 14

5 Key Performance Indicators (KPI) The key performance indicators for the oil and gas industry may be segregated into 2 forms one for the exploration industry and the other for the production industry. Exploration Industry For the exploration industry, it is imperative to assess the quantity and quality of seismic data produced and the time taken to obtain such data. Next, the quality of interpretation of such seismic data and the time taken to process the data is especially important in the exploration process because this would generate the field plan development which is the blueprint for all other exploration activities downstream. One other indicator which may not be used often is Down Time which is the number of man-hour losses as a result of equipment failure or stakeholder disturbances. Production Industry In the case of the production industry, some key performance indicators include that of production rate which is based on the number of barrels of oil produced per day, usually in millions, hence, commonly known as million barrels per day (mbpd). Next, the production cost for each barrel is also the key in assessing performance and efficiency. One common indicator that the production industry shares with the exploration industry is the Down Time as a result of equipment failure or stakeholder disturbances. Another indicator that is used at times, but not frequently, is the number of environmental issues such as oil leaks due to equipment failure, technical glitches or even the sinking of oil containers at sea. 5 of 14

6 Unique Characteristics of Oil & Gas Industry High Operational Capital The process of surveying for oil and gas, acquiring the necessary licenses and the actual drilling of wells makes the industry a highly capital intensive one, characterized by High Risks, Even Higher Rewards. The process of producing oil and gas starts with companies engaging Geological and Geophysical Surveys (G&G) which utilize seismic, sonic, and satellite imagery to pinpoint geographic profiles under the earth s surface known to produce oil. This typically accounts for 30% of the cost of producing oil, with the average ranging even higher for offshore surveying (40% of oil production costs). After potential wells are sourced, licenses are acquired from either the government or other companies who have yet to develop the concession. Drilling is then carried out, which accounts for 50% of the cost of oil production. This process can be executed in two methods, conventional vertical fracking or the more recently adopted horizontal fracking. Vertical fracking is responsible for extracting a bulk of the oil reserves; however, it leaves many of the peripheral fissures untouched. Horizontal fracking corrects this by allowing for sideways drilling at a specified angle, thereby allowing for more oil and gas to be extracted. It is horizontal fracking that is responsible for the recent shale gas booms that have dominated the Gas markets, as more gas-bearing shale is penetrated. The total cost of this process is difficult to predict as the process usually runs from 1 to 3 years for complete extraction and involves many variables. However, a company can expect millions to be pumped into the operation of any single well. However, should a well be successfully extracted, payoffs of up to an average of USD175 Million can be expected, subject to oil production. After oil is extracted, it is then sold to downstream companies who refine, sell and distribute the product. This accounts for up to 17% of the cost of producing usable oil products. The breakdown of the cost for each barrel of oil can be seen below. Figure B: Cost of Producing Crude Oil and Natural Gas from 2007 to 2009 Source: Other sources of energy have proven to be similarly capital intensive, from wind energy produced by largescale wind farms to nuclear energy from nuclear facilities. This is possibly due to their relatively low contribution to world energy production and hence is still not carried out in large scale, which can result in economies of scale and greater innovation to reduce cost of production. 6 of 14

7 The U.S. Energy Information Administration (EIA) calculates the levelized cost of new onshore wind turbine plants placed in service in 2018, capacity factor 0.34, 30-yr life, at $86.6/MWh, including transmission costs of $3.2/MWh. The average non-fuel O&M cost for a nuclear power plant in 2013 was $15.1/MWh. Since 2001, nuclear power plants have achieved the lowest production costs between coal, natural gas and oil. While these up-and-coming sources of energy are gaining in popularity, their large-scale production and use have still been uneconomical as compared to oil production. Dominated by State-Owned Enterprises Oil production and various upstream processes are largely dominated by State-Owned Enterprises (SOEs), with the top 5 producers being in order of Russia, Saudi Arabia, United States, Iran and China. Amongst the oil producers exists one of the most well-known cartels, the Oil and Petroleum Exporting Countries (OPEC) which control 88% of oil production with other SOEs. Outside of the SOEs exists the 6 Super majors, consisting of BP, Chevron, ExxonMobil, Royal Dutch Shell, Total and ConocoPhillips. Figure C: Distribution of Proved Reserves in 1993, 2003 and 2013 by Percentage Source: BP Statistical Review of World Energy June 2014 As most of the world s oil production is controlled by countries through the use of SOEs, political agendas have a strong influence and impact on the industry. Should countries wish to undercut each other s production, this may result in a surge in oil surplus, which depresses oil prices, thereby negatively affecting the entire chain of the industry, as capital costs are high and companies stand to lose large investments if the oil produced cannot recuperate the high startup costs. It is because of this facet of the oil and energy industry that has caused many fluctuations in oil and energy prices, which presents investors with a double-edged sword, which could mean high losses or even higher profits. Oil to remain as a Staple Energy Source While renewable energy has come a long way and has gained much popularity with increasing awareness for the need for sustainable development, oil still remains as a staple due to both its wide-scale use as well as its more economical cost of production. 7 of 14

8 To put this claim into actual numbers, according to Forbes: A. World oil production was 82 million barrels per day in At roughly 6 gigajoules per barrel, this equates to around 5.7 terawatts of power production. B. World wind power production in 2010 was 0.3 petawatt-hours. Averaged over a year, equates to around 34 gigawatts. C. World solar power production in 2010 was 0.03 petawatt-hours. Averaged over a year, equates to around 3.4 gigawatts. At the existing state of energy production, world energy production from oil alone is 2 orders of magnitude higher than wind power, and 3 orders of magnitude higher than solar power. With such a massive difference, it will still be a relatively long time before we can start to consider greater reliance on alternative forms of energy. Hence it is apparent that for the foreseeable future, oil will remain a mainstay for the energy sector. In recent years, there has been a shale gas revolution with the advent of hydraulic fracking and horizontal drilling that has given petroleum explorers access to previously impermeable gas (shale gas) trapped in low permeability shale rocks. With an estimated 7,299 trillion cubic feet of shale gas in global reserves, and its accompanying 345 billion barrels of Tight Oil, spread across 137 shale formations in 42 countries, Shale has gained large popularity for its seemingly untapped potential. At current estimates, the world has sufficient shale gas reserves to meet current demand for the next 230 years, with the largest reserve located in China, in its Tarim Basin, Ordos Basin and Sichuan Basin. However, shale brings along with it several disadvantages that may result in its eventual decline and prove it to merely a fad. Firstly, while shale gas costs significantly less to produce through cheaper upstream processes; it also generates significantly less revenue as compared to conventional petroleum, with the cost of extracting offshore shale gas in the UK estimated to be more than $200 per barrel of oil equivalent. Secondly, the production of shale gas carries with it significant environmental concerns, with higher photochemical smog and terrestrial toxicity than the other options, possible contamination of water and underground aquifers with heavy metals and hydraulic fracturing routinely producing micro seismic events used to map the horizontal and vertical extent of the fracturing, having reportedly caused earthquakes large enough to be felt by people in the United States on three occasions as of late Lastly, due to the high momentum at which shale gas is being produced and converted to usable Liquefied Natural Gas (LNG), there is a concern of oversupply which will further depress LNG prices. 8 of 14

9 Case Study Royal Dutch Shell Shell (NYSE:RDS.A, RDS.B, LSE:RDSA, RDSB) is currently the second largest of the oil Super majors in terms of market cap, standing at US$ billion. Its business model integrates the entire supply chain of the petroleum industry, from the upstream to the downstream, including both B2B and B2C sales of its products. The following case study will use Shell as an example to showcase what we have generalized of the prevailing Oil and Gas Industry. According to New York University s Stern School of Business, the upstream Oil and Gas Industry has an average CAPEX of $138,935.01m, while the average CAPEX of 96 different industries only yielded a value of US$9,403.90m. Shell alone, accrued US$426,007m in consolidated expenditure, with US$40,303m in upstream capital investment, US$153,792m in upstream capital employed, US$5,528m in downstream capital investment and US$64,507m in downstream capital employed. This staggering amount clearly identifies the oil and gas industry as being one of the most operationally capital intensive industries with high operational and start-up costs that must be considered when investing in such companies, as revenues must be carefully monitored to be sufficient in covering costs for profits to be made. However, for companies that are successful in its operations, payoffs are exceptionally appealing, as can be seen from Shell s US$16,371m in profits attributable to its shareholders. Figure D: Consolidated Financial Data of Shell Source: Shell 9 of 14

10 Figure E: Key Statistics of Upstream Overview Source: Shell Figure F: Key Statistics of Downstream Overview Source: Shell Shell, being one of the largest non-soe oil producing companies, is also to a certain degree vulnerable to political actions that have large impacts on the industry. For example, Shell attributes its fall in 2013 profit margins to the deteriorating security situation in Nigeria, which has hampered its African oil production, which is responsible for 10% of its total production. Furthermore, the recent fall in oil prices due to the overproduction of various oil producing SOEs have also had a detrimental impact on Shell s profit. However, Shell has taken steps to hedge against such price fluctuations through the increase in production of LNGs more so than other oil producers, which has helped to diversify its risks. While Shell has exerted large efforts dedicated to improve and increase its capacity to produce Gas, visible by the increase in its upstream earnings from sales including integrated gas, its mainstay is still liquid oil, which it has produced at a relatively steady amount over the last 5 years. However, unlike the other Super majors, Shell s business model heavily relies on integrated gas for hedging, as it reports integrated gas earnings having increased by around 400% since 2009 to some $9 billion in 2013 or about 60% of upstream earnings. This has prompted Shell to dedicate more resources to the increasing of production capacity of LNG, far outpacing its competitors. This is supported by its building of the Prelude, the world s first floating LNG project. 10 of 14

11 At Shell s operations in Pinedale, Wyoming alone, it produces around 350 million cubic feet of gas a day, enough to power 1.6 million US homes. Shell also produces enough tight gas in the Groundbirch area of British Columbia, Canada, to meet the needs of over 400,000 Canadian homes. Outside of its Americas Operations, Shell is also producing 117 billion cubic feet of tight gas a year at the Changbei field in China enough to power 12.5 million Chinese homes. Figure G: Upstream Earnings, Production and LNG Leadership Source: Shell In conclusion, Shell to a large extent exemplifies the oil and gas industry, in that it requires high operational expenditures, is affected by political changes and relies on liquid oil as a staple product. However, Shell is also unique in its efforts to develop its LNG production capacity as a method to hedge against foreseeable fluctuations in oil prices in the future, so as to diversify its risk and build upon the growing Gas Revolution, in hopes of growing sustainable profits. 11 of 14

12 Stock Profile Royal Dutch Shell (NYSE: RDS.A) Current Price: US$62.30 Given the current bearish outlook on the oil and gas industry, we place more emphasis on companies that have relatively low debt and high free cash flow as this would indicate that they have a better ability to ride out the falling oil prices. As mentioned earlier, there has been an increase in demand for the midstream and downstream stages of the oil and gas industry and thus we would also like a company with higher exposure to it. We recommend Royal Dutch Shell plc (ADR), which is currently trading on the NYSE at US$62.32 as of 12 th December Royal Dutch Shell is an oil and gas company that has achieved vertical integration in every aspect of the industry including but not limited to exploration, production, refining, distribution and marketing, petrochemicals, power generation and trading. They have operations in more than 70 countries worldwide, with a workforce of more than 92,000 people. They also produce close to 3.2 million barrels of oil every day. Over the past 5 years, Royal Dutch Shell s shares have nearly doubled on a total return basis, topped only by Chevron. At its current price-to-earnings ratio of 13.07, we believe that this is an attractive valuation given the fact that the NYSE is currently trading at a price-to-earnings ratio of Its debt-to-equity ratio stands at 23.75% which is considered In addition, its price-to-cash-flow ratio stands at 3.2x, which is considered relatively low for a capital-intensive industry. Royal Dutch Shell has done a good job in generating free cash flow and as of 2014; they have generated almost as much cash as in 2012 which had the highest free cash flow since the financial crisis. Figure H: Free Cash Flow Track Record of Shell Source: Shell This increase in cash flow can be attributed to its US$15 billion sell-off in underperforming assets, in addition to its reduction in capital budget. The management of Royal Dutch Shell has estimated that capital expenditure for FY14 will be 20% less than that of FY13. We are encouraged by this move and believe this will improve the financials of the company tremendously. 12 of 14

13 It has a free cash flow of nearly US$8.5 billion for Q3FY14 and US$14 billion (ttm). By sitting on such a large cash hoard, we believe that Royal Dutch Shell will be able to take advantage of oil prices, which has fallen to a 5 year low as of 12 th December 2014, with Brent Crude trading at US$61.46, a price not seen since We forecast that with a further fall in oil prices, newer and smaller firms will not be able to cope and may end up being acquired by Royal Dutch Shell. This is a very common practice in the oil and gas industry and with the large free cash flow that Royal Dutch Shell has, such acquisitions will not be a problem. These acquisitions will also bode well for Royal Dutch Shell in the long run as it will generate a positive effect on its NAV. Royal Dutch Shell also has a history of good dividend yields and share buybacks, having had a total for US$16 billion in shareholder distributions for FY13. Dividend yield for Q3FY14 stands at an attractive 5.31%, up 4% from a year ago. For FY14, they have had $8.9 billion worth of dividends declared and over US$3 billion worth of shares repurchased to date. Given its high free cash flow and attractive dividend yield, we recommend Royal Dutch Shell as an attractive stock pick for the forward-looking and defensive investor. We also prefer Royal Dutch Shell given its exposure to all stages of the oil and gas production, with an increased emphasis on its midstream assets. Shell Midstream Partners LP, a pipeline partnership, went public on 30 th October 2014 and became the largest master limited partnership initial public offering in more than a decade. It surged 46% in the best US trading debut performance by an energy company this year. The units climbed $10.55 to $33.55 at the close in New York, after being priced at $23 each. Shell Midstream raised $920 million by selling 40 million units, according to a statement yesterday, after offering 37.5 million for $19 to $21 apiece. What makes Royal Dutch Shell attractive is this it is the largest shareholder of Shell Midstream Partners LP, with a 71% stake and most of the money from the stock sale is being sent to Royal Dutch Shell. We estimate that this public offering will raise more than US$750 million for Royal Dutch Shell and thus improve its cash flow, reduce debt and better equip itself for further acquisitions in the spate of falling oil prices. For 2014, we have seen Royal Dutch Shell disposing of certain downstream assets in a bid to concentrate its downstream footprint on a smaller number assets and markets where it can be most competitive, as quoted by the company. Recent disposals include the sale of refineries in the U.K., Germany, France, Norway and the Czech Republic and downstream businesses in Egypt, Spain, Greece, Finland and Sweden as well as the establishment of a downstream joint venture across Africa. One notable transaction involves the sale of its Australia downstream business to Vitol for approximately US$2.6 billion. Although these actions taken by Royal Dutch Shell may seem contradictory given that there has been an increase in demand for downstream businesses, we believe these cost-cutting measures have increased profit margins and efficiency as a whole. This can be seen in the Q3FY2014 results where its downstream business posted a 77% rise in current-cost-of-supplies earnings to US$1.6 billion, even though there was a reduction in the volume of oil and products and chemicals sold. As such, with Royal Dutch Shell s improving cash flow, profit margins and increased emphasis on midstream assets, we place a BUY call on Royal Dutch Shell with a TP of US$69, given the negative outlook on the industry and its most recent technical support (now turned resistance). 13 of 14

14 Conclusion With slowing demand for oil, accompanied with the stronger US currency, oil prices are at a five-year low. Many oil companies are cutting spending with some already cutting exploration investment. While oil remained highly valued over the past few years, prices of other commodities fell by 30-40% from The recent drop in oil prices is a sign that the market is correcting oil prices. We believe that oil prices will remain above US$40 per barrel because many oil companies have already carried a lot of debt and a price below US$40 will be unprofitable for businesses. Hence, if oil price drop below US$40, there is high chance that oil prices will increase. In the short term, oil prices are likely to hover between US$60-US$70 but with supporting long term trends such as global population growth and urbanization, we strongly believe that oil prices will increase along with the increased oil consumption. This research material has been prepared by NUS Invest. NUS Invest specifically prohibits the redistribution of this material in whole or in part without the written permission of NUS Invest. The research officer(s) primarily responsible for the content of this research material, in whole or in part, certifies that their views are accurately expressed and they will not receive direct or indirect compensation in exchange for expressing specific recommendations or views in this research material. Whilst we have taken all reasonable care to ensure that the information contained in this publication is not untrue or misleading at the time of publication, we cannot guarantee its accuracy or completeness, and you should not act on it without first independently verifying its contents. Any opinion or estimate contained in this report is subject to change without notice. We have not given any consideration to and we have not made any investigation of the investment objectives, financial situation or particular needs of the recipient or any class of persons, and accordingly, no warranty whatsoever is given and no liability whatsoever is accepted for any loss arising whether directly or indirectly as a result of the recipient or any class of persons acting on such information or opinion or estimate. You may wish to seek advice from a financial adviser regarding the suitability of the securities mentioned herein, taking into consideration your investment objectives, financial situation or particular needs, before making a commitment to invest in the securities. This report is published solely for information purposes, it does not constitute an advertisement and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. No representation or warranty, either expressed or implied, is provided in relation to the accuracy, completeness or reliability of the information contained herein. The research material should not be regarded by recipients as a substitute for the exercise of their own judgment. Any opinions expressed in this research material are subject to change without notice NUS Invest 14 of 14