Last week the major integrated oil companies reported earnings for the second quarter of 2013, and all in all, the investment world was not pleased with their performances. First, people should understand that the largest oil companies in the world, Exxon, Shell, BP, and Chevron are dominant companies which generate large amounts of revenues, cash flow, and in absolute dollars, net profits. However, the costs for large integrated majors have been going up and are enormous. In order to explore for oil, both in the sea and on land, they have to pay millions for the licenses and the acreage to develop. Once they have the land or rights to sea areas, they have to lay out hundreds of millions of dollars to drill for the oil with rigs or sea platforms. Projects take years to develop, so the payback time can be extended. The chances of discovering oil are typically about one in every four wells that are drilled. One final potential problem is the volatility of oil prices. In this quarter, as oil prices retreated a bit, their profits were hurt some. Obviously, the way technology has developed the capabilities of seismic imaging and the use of sensors and nanotechnology, more precision in locating oil is constantly improving. Still, the largest problem for investors in the oil sector is the amount of capital expenditure which constantly needs to be made.
Another problem for big oil is much of the new possible discovery is located in areas which are very dangerous, either weather wise or in politically unstable regions. Making things even more difficult for the majors is the high volume of oil that they deal with, and the expectations of Wall Street. The investment world is constantly concerned with growth. The big oil majors produce an average of anywhere from 2-5 millions of barrels of oil per day. In order to move the needle on those production numbers, the oil majors have to invest not hundreds of millions of dollars in new projects, but billions of dollars. Big oil is a high stakes game with major financial and political consequences as many countries depend on their oil revenue for nearly all of their budget revenues for a fiscal year. I would expect you will see a much sharper focus placed on developing existing acreage versus looking for new territories, especially if those areas are dangerous, in tough to access regions, or under the control of governments which might be considered questionable to deal with.
In looking at the major's results, Exxon, BP, Shell, and Chevron all had results which were below what the market expected. Speaking specifically to BP and Shell, the former was hurt by a high tax rate and some tax lag on their investment in Rosneft and how Russian duties are calculated. Certainly, the fact they had to set aside a bit more money for the ongoing legal situation from the Macondo oil spill did not help either. Operationally, things went pretty much as expected as their upstream division performed well and their downstream (refining) was solid.
Shell was disappointing because their investments in non conventional avenues for oil development, meaning shale and tight oil, proved very disappointing. Shell also withdrew their guidance for cash flow growth in the future. Shell is the second largest oil company in the world, and their announcement shows that regardless of how promising an area is, if you pay too much for land or access to development, there certainly is no guarantee you can recover the resources to make the return on investment worthwhile. This is the fundamental issue with the big oil companies right now, which is how much return will be realized based on the amount of capital spent. Shock of shock to anyone investing capital, but this is the same question one has to consider for any opportunity you might evaluate. I would expect Shell will return to the fundamentals of upstream exploration and refining to get those operational areas straightened out. Once they do so, they will then revisit the unconventional resource question, but probably with a heightened focus on return on investment. One final note on the big oil companies is they remain dominant in an industry which will be with us for quite a long time. In that light, Wall Street ignoring them, or even worse punishing them, might not be the wisest action. In fact, a few of the major are buying back their own shares. Hmm, what does that tell you?
Regarding my own thoughts on lawyers, certainly what BP is having to deal with regarding the settlement with the Macondo Oil Spill has an affect on how I see things. It appears BP is now taking the step of either having a favorable ruling from the district court on how claims are processed, or they will opt out of the settlement. The trail lawyer profession is one where for many years, they have targeted any industry they can think of to extract massive damages. I am not saying enterprises are not responsible for industries when they make errors, and many families deserve compensation for injuries, illnesses, or even worse, loss of life of family members. What is at issue is the conduct of the trial lawyer profession in their various efforts in many different situations. One of the largest trial firms was Millberg-Weiss, which was investigated for all kinds of illegal activities and eventually had to be broken up. They are not the only class action law firm which has engaged in, what I will call, questionable ethical behavior.
In the situation with BP, the company agreed to a class action settlement, has payed out $20 billion of claims, and when the claims administrator was switched, all of sudden law firms and other businesses have been getting paid out on claims which BP say have no merit because a different interpretation of revenues and expenses is being applied. Can you say, bait and switch? In fact, BP says over 50% of all the claims amounts have been going to law firms. The judge in the case is an ex head of a class action lawyers law firm. Can you believe he has always sided with the class action lawyers- what a shock. Now, BP will take a different tact and we will see what happens. (Full disclosure- I own BP, the firm Y H & C Investments owns BP and Shell for clients).
The media space is really starting to heat up as far as possible merger and acquisition talk. If you read the cover story of Barron's this week (http://goo.gl/tkYWhG), the possibilities are literally endless. The companies who could be involved are the biggest providers of content and access in the world- Google, Amazon, Comcast, Apple, Netflix, Time Warner, Time Warner Cable, Yahoo, Facebook, etc.
It has been a long summer, and it is time to vacation. You know I will be watching what goes on in the investment world, but now is a time for me to recharge the battery. If you have any comments, or thoughts on the blog, or any questions, please post them! I hope you enjoy your week.
Y H &C Investments, Yale Bock, and the family of Yale Bock own positions in securities mentioned in the blog post. Investing in stocks can lead to the complete loss of your capital. As always, on any company mentioned here, past performance is not a guarantee of future returns. Investing involves risk of losses on invested capital. One should research any investment and make sure it is suitable with your objectives, risk tolerance, risk profile liquidity considerations, tax situation, and anything else pertinent to your financial situation. Also, the CFA credential in no way implies investment returns will be superior for any charter holder.