Revisiting Our Price Estimates For Big Oil Amid Lower Crude Prices

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We recently revisited our price estimates for the integrated oil and gas companies we cover to account for the change in our long-term forecast for crude oil prices. We now believe that the recent decline in oil prices could sustain for a longer period amid a slower demand growth scenario and the weakened price controlling power of OPEC. According to our estimates, annual average crude oil prices (Brent) could bottom out around $80-85 per barrel by 2017 and rise back to $100 per barrel by 2020. (See: Where Are Crude Oil Prices Headed In The Long Run)

The key fundamental value drivers that are expected to be impacted the most because of the recent change in the oil price environment – apart from average price realizations – are exploration and production margins and downstream margins. Since the big oil companies take up relatively longer-term projects, compared to the smaller independent players, and have downstream operations that provide a relatively stable source of cash flows even during commodity down cycles, we do not expect to see as big an impact from the recent decline in oil prices on their upstream capital expenditure plans for now. Below, we briefly discuss how the two margin drivers could trend going forward.

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Thinner Upstream Margins

Despite the volatility in crude oil prices, costs associated with the exploration and production of hydrocarbons have risen consistently over the last few years. This is primarily because of the fact that it has gotten increasingly difficult to find and develop hydrocarbon reserves. According to the latest oil and gas reserves study published by EY, finding and development costs that include costs associated with unproved property acquisition, exploration, and development of proved reserves, increased at more than 14% CAGR between 2009 and 2013 to $22 per barrel of oil equivalent (BOE). Similarly, production costs, which include production taxes, transportation costs, and production-related general and administrative expenses, also increased at more than 14% CAGR between 2009 and 2013 to $19.60 per BOE. We expect this trend to continue in the long run, primarily because most of the growth in future crude oil production is expected to come from higher marginal cost areas like tight oil in the U.S., oil sands in Canada, and pre-salt reserves in Brazil. Therefore, lower crude oil prices are expected to weigh significantly on upstream EBITDA margins. [1]

Thicker Downstream Margins

The recent decline in global crude oil prices can be largely attributed to the sharp increase in tight oil production in the U.S., because of which, imports by the world’s largest oil consuming nation have been declining sharply over the past few years. As a result, oil exporting countries like Saudi Arabia are now increasingly looking for buyers elsewhere in the world and even offering discounts to benchmark prices in order to retain their market share. This oversupply scenario is benefiting refineries in Europe and Asia significantly because of which, downstream margins of the players operating in these regions are expanding. During the third quarter of this year, Exxon’s international downstream earnings increased by more than 100% year-on-year, while Chevron reported more a 340% increase in its international downstream earnings. We expect a similar situation to play out in the short to medium term because a significant reduction in the U.S. tight oil production growth as a result of lower oil prices is not expected to happen immediately. [2]

However, in the long run, we expect global refining margins to continue to remain under pressure due to industry overcapacity, which stems from the fact that governments in different parts of the world are willing to run uncompetitive crude refineries at very low or no returns to sustain employment and reduce their reliance on imported fuels. We currently forecast Exxon’s adjusted downstream EBITDA margin to improve marginally to around 2.2% in the long run, which is more than 20 basis points below the historical average by our estimates. (See: Key Trends Impacting Global Refining Margins)

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Notes:
  1. Global Oil and Gas Reserves Study, ey.com []
  2. Exxon Mobil Corporation 3Q14 Press Release, exxonmobil.com []