IOCs Adapt Capital Spending Patterns as Competition Hots Up

This Article was originally written as a piece for the April Edition of the Oil Council‘s Drillers & Dealers Magazine.

Major changes in the pattern of capital spending by Independent Oil Companies (IOCs) are emerging as these companies adapt to a fast-changing geo-political and economic environment. [1] Some of the key trends include

• Rapidly rising capital expenditures by IOCs in recent years, both in absolute and relative terms, with capital spending eating more and more into free cash flow
• A marked shift towards upstream expenditure and away from refining, marketing and chemicals where maintenance capital expenditure is the order of the day
• A shift towards acquisitions and mega-project development away from exploration spending (despite lower finding costs via exploration).
• Pure upstream companies appear to be overtaking the larger companies in terms of the efficiency of exploration spend.

Overall levels of capital spending by IOCs have been rising rapidly in recent years, reflecting higher capital intensities as energy, labour and material costs rise and a shift in emphasis towards exploration and development in deeper water and unconventional plays. Virtually all of the growth in IOC capital spending has been upstream, reflecting both shrinking margins downstream and the lure of much better returns upstream as oil, if not natural gas, prices have strengthened.

At the same time, capital spending has been taking a larger chunk out of IOCs’ available cash flow (see Figure 1), leaving less for dividends, and share buybacks, despite huge growth in cash flow generated from operations for these companies. Operating cash flow for the IOC group as a whole soared to $414 billion in 2010 from just $169 billion in 2000, but capital spending grew at a faster rate. Share buybacks by the Majors peaked at $63 billion in 2006, but fell to just under $14 billion last year with ExxonMobil accounting for virtually all of that number. This freed up funds for capital projects.

Figure 1 – Graph of Capital expenditure as % of operating cash flow

While upstream capex as a whole has been growing strongly, proportionately more is being spent on developing mega projects than on exploration. Though exploration expenditure as a % of total upstream capital spending has not changed greatly in the past 10 years there are big differences between companies. Generally, firms whose operations are weighted towards the upstream have tended to spend a greater proportion of their upstream capex on exploration compared with the bigger, more integrated players. One notable exception is Shell which has boosted its exploration spend substantially in recent years. Statoil has also been increasing its exploration spend while Chevron has reduced the proportion it spends on exploration in the past few years, partly due to its relatively high cost of reserve replacement through exploration.

Figure 2– graph comparing exploration capex as % of total upstream

One of the key choices open to IOCs is whether to acquire rather than replace reserves organically and here IOC strategies differ depending on their success in replacing reserves through the drillbit. Finding costs for proved reserves for the Majors have been higher than most other companies in recent years, making acquisitions a more attractive route for reserve replacement in some cases compared with pure upstream players who have demonstrated better proved reserve replacement through the drillbit. The graph shows the trend in finding costs for the Majors, Integrated and pure Upstream companies in the Evaluate Energy group and indicates that pure upstream players have successfully contained per barrel finding costs in recent years while per barrel finding costs for the Majors has risen sharply. The graph refers to proved reserves only. Many companies will include probable or even possible reserves when announcing their finding costs but such reports are rarely on a consistent or easily comparable basis.

Figure 3 Independents outperforming bigger companies in efficiency of exploration spend

An in-depth analysis of 20 deals done by the Evaluate Energy group of IOCs in 2010 reveals that companies within the group acquired 4.4 billion barrels of oil equivalent of proved reserves at an average cost of $6.34 per boe, compared with finding costs of $7.75 per boe for 2010 and a 3 year average of just over $7.00. If we widen the population of companies to include IOCs that are not in our group, the total cost of acquiring 10.8 billion barrels of proved oil equivalent reserves was $6.04 in 2010. In 2011 so far, the cost of acquiring barrels has jumped by 50% to an average of $9.89, prompting some companies, BP for one, to switch more spending into exploration in 2011. All acquisition costs are normalised. Evaluate Energy adjusts acquisition costs for assets included in the deal, such as non-upstream assets, probable, possible and contingent reserves, that may otherwise skew the per barrel calculation.

Indications for 2011 are that capital spending among the IOCs will continue to rise strongly and that upstream development will be the prime target for spending growth. BP plans to increase organic capex to $20 bln in 2011 from $18 bln in 2010 with more than half being spent on development projects. Chevron is planning capital expenditures of $26 bln in 2011. 87% or $22.6 bln of that total will be upstream, with still lower exploration expenditures, higher maintenance capex and the bulk of the growth going on major capital projects. Shell is planning to spend $25-27 bln 2011-2014, mainly on high potential exploration wells, new projects including the Prelude Floating LNG project in Australia, debottlenecking of the AOSP oil sands project in Canada and deep water oil and gas developments at the Cardamon discovery in the Gulf of Mexico and at Malikai in Malaysia. ExxonMobil announced capital spending of $34 bln in 2011 and between $33-37 bln through 2015. ExxonMobil is planning to bring onstream 11 major upstream projects between 2011 and 2013. Meanwhile, Total is planning to spend $16 bln in 2011 compared with $14.8 bln in 2010, based on Brent at $80 and 60% of its spend will be on 15 major upstream projects including Kashagan, Ekofisk,, Pazflor, Surmont, Anguille/Mandji, GLNG and CLOV.

But while IOC capital expenditure has and will continue to rise, the growth in spending by the National Oil Companies (NOCs) is far outstripping that of the IOCs. Part of this reflects the relentless push by China to secure oil supplies and part reflects the geological fact that most of the lower cost oil lies in countries where IOCs do not have direct access. As new patterns of political and economic power emerge in the Middle East – a phenomenon Dan Yergin recently described as a “sea change” – the IOCs are broadly powerless to influence the outcome. They find themselves between a rock and a hard place. A flight to reduce country and political risk for the benefit of their shareholders will only serve to raise their costs of reserve replacement as they compete for corporate acquisition targets or reserve plays or push the technical boundaries into more unconventional sources of supply.

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