Moody’s: Global integrated oil, gas business stabilizing

The global integrated oil and gas business is stabilizing and will likely improve modestly from recent historical lows over the next 12-18 months, says Moody’s Investors Service in a recent report. The report—“Integrated Oil & Gas: Global Oil Price Uptick, Accelerated Cost Cuts Put Upstream Activities on Road to Recovery”—says higher oil prices and lower operating costs are driving a steady improvement in companies’ earnings.

“Over the last year, integrated oil and gas companies have accelerated reductions in their operating costs to adjust to earlier oil-price declines. As a result, most companies’ upstream operations returned to positive net income generation in the second quarter of 2016, while also benefiting from an uptick in the price of crude,” said Elena Nadtotchi, a Moody’s vice-president, senior credit officer, and author of the report.

Moody’s expects recent capital investments should support a flat production profile by the industry in the next 3-5 years. A stronger recovery in oil prices beyond their estimates of an average Brent price of $45/bbl next year would be the main diver of a faster improvement in earnings and cash flows.

“Nevertheless, in the longer term, we think the sector will continue to face multiple challenges as we expect oil prices to remain in the range of $40-60/bbl. These include improving returns on capital and delivering long-term growth in production beyond 2020, as well as finding ways to enhance the replacement of reserves,” the report said.

Moody’s estimates that the industry will generate about $65 billion in negative-free cash flow in 2016-17, although several companies including are expected to generate positive-free cash flow next year. Moody’s also expects to see integrated companies continue to fund deficits through assets sales, new debt issuances, and cash balances over the next 12-18 months.

Drag factors

According to the report, the pace of upstream cost reduction is to slow after the industry delivered a 26% cut in average production costs per barrel of oil equivalent in 2015.

“We think the sector is likely to be approaching the limit of production cost reductions and the pace of improvement in cost positions is likely to slow in 2016 and 2017. Because we expect the sector’s production to be flat over the next 12-18 months, improvements in upstream cash margins and cash flow generation are likely to be driven mainly by the pace of the recovery in oil prices during this period.”

The business’ earnings recovery also will be slowed by weaker downstream performance in 2016 due to the oversupply of refined products in Europe and North America, weaker growth in gasoline demand, and sustained high operating rates. However, the decline is likely to be cushioned by contributions from most stable chemicals and marketing operations.

Most companies are still reducing capex to support dividend payments. Moody’s expects that the sector’s capex is likely to decline by 20% on aggregate in 2016 and by 10-15% in 2017, given the persistent low oil-price environment. However, Eni SPA, Chevron Corp., and Statoil ASA will buck this trend in 2016-17, as they pursue large-scale projects to bring on additional production volumes in 2018-19.

“While oil revenues and operating cash flows declined in 2015-16, the sector maintained a high level of dividend payments, even as European peers have opted for scrip dividend payouts as a temporary measure,” the report said.

Nevertheless, Moody’s still expects the industry’s cash flow to remain too low to fund dividends. This is based on Moody’s current price estimates of $40/bbl in 2016 and $45/bbl in 2017 and assumes current dividend policies.

“We expect that dividend payments will remain the key driver behind the projected negative free cash flow generation by the sector in 2016 and 2017,” Moody’s said.

“The high level of investment in 2008-15 and sustained, relatively high levels of shareholder payments have left the industry with a higher level of debt than in 2008-09, even as [earnings] and operating cash flows declined below the levels seen during the last trough. These more levered positions were reflected in the recent downgrade of the ratings of the integrated companies during the industry-wide credit review that we concluded in April 2016,” the report said.

Companies’ credit profiles will only recover gradually, the report said. The industry’s rising net debt load should stabilize as companies use the proceeds from targeted divestments to fund operations and to reduce debt after acquisitions.

“The industry’s balance sheet remains solid, with about $150 billion in cash balances, which is equivalent to almost 25% of the sector’s adjusted debt. Cash balances continue to provide an additional level of support to investment plans and dividend payments in 2016-17. Given the direct impact of higher oil prices on cash flow generation, a markedly higher oil price environment with oil prices sustained at above $45/bbl would result in a sooner return to free cash flow generation than we currently anticipate.”

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