Energy Newsletter: Super-Majorly Cheap

 

‘Super-majors’, the world’s largest, non-state-owned oil companies, make up approximately 35% of our all-cap energy funds today. We have made large investments in Chevron, Exxon and Shell as we think they offer great value at today’s share prices and because they are well-positioned for the current oil market environment.

 

 

It is not hard to find people that disagree though. The Economist magazine even went so far last August as to proclaim that ‘the day of the huge integrated international oil company is drawing to a close’.

It is often argued that the super-majors are not good investments because they are too large to grow and they are spending more and more money on capital expenditure just to stand still. We think that these are misconceptions.

 

Growing

It is certainly true that super-majors have not grown their production over the past few years. Between 2007 and 2012 Shell’s production actually dropped by 1.6% and Exxon’s only grew by 1.4%.

However, overall production growth is not what shareholders should focus on. Instead, the important indicator is how much the company will earn per share from that production. Or better still, how much profit each share will distribute to its owner through dividends.

For example, in the last three years Exxon’s production has remained flat and so have oil prices. At the same time, dividends per share have grown rapidly, rising by 43% from US$1.76 to US$2.52 per share. This was achieved in part by Exxon buying back its own shares, which effectively left each remaining share with a larger piece of the company’s free cash flow.

The trends around dividend growth over the last three years have not been unique. In fact, Exxon has raised its dividend every year since 1986, in spite of the oil price moving up and down through economic cycles. Chevron has matched that record.

 

Capital expenditure

So when it comes to what is important – dividends per share – the super-majors have been offering growth. Growth, however, that the critics claim is not sustainable. The super-majors are having to spend more and more on capital expenditure.

It certainly seems that way. In 2012, Exxon, Chevron and Shell combined spent US$81bn on net capital expenditure (spending on new developments less the proceeds from disposals) – nearly double the accounting depreciation charge for the same year of US$44bn. It is costing the companies a lot more to maintain production than their profit and loss statements would suggest.

This was not always the case. In 2003, combined spend on net capital expenditure of US$25bn, was about the same as the depreciation charge of US$26bn.

The reason today’s capital expenditures are so high compared to depreciation is cost inflation. IHS, an oil and gas consultancy, calculates that an oil project developed today would cost nearly 2.3 times what an identical project would have cost in 2003. While capital expenditure reflects today’s costs, depreciation reflects historic costs.

However, cost inflation was itself caused by rising oil prices. Project costs have increased dramatically in the last 10 years but so has the oil price. On balance, the majors are still generating healthy returns on new capital invested and have iron-clad balance sheets. Exxon is one of only four companies in the world still to retain a AAA credit rating.

 

Now’s the time

The current market environment, with balanced demand and supply growth and oil prices trading in a narrow range, is a favourable one for the super-majors. Most oil companies do well when oil prices rise. In the current environment having low-cost assets, capital discipline and shareholder focus are all key. Historic shareholder returns for the super-majors are just as strong in periods of flat and even declining oil prices as they have been over the past decade of rising oil prices.

We also believe that current share prices are under-valuing the super-majors. It certainly looks that way when you compare their price-to-book ratios to the broader market (see earlier chart).

The super-majors have certainly made mistakes, highlighted last year by Shell’s US$2bn write-down on its US shale investments. What we believe is overlooked are very strong business models able to generate growing dividends for their shareholders and very attractive current valuations.