Our research into a sample set of companies showed strong operating cash flows, but earnings lagged.
This article is a part of the Oil and gas Quarterly Trends series.
The profit picture for our sample of oil and gas companies in Q3 was disappointing. Combined net income was down 19% from Q2 and down 43% from Q3 a year ago. This financial performance was reflected in the equity markets. The market capitalization of our sample declined 3.3% during the quarter and 18.5% year over year at a time when the broader equity markets were up 1.9% during the quarter and 12% year over year.
Unsurprisingly, those results mirrored what was going on in the commodity markets. Oil prices were down slightly (2.4%) while gasoline prices were down more (6.8%) and refining spreads were off significantly (22.2%). Liquid natural gas (LNG) prices in Asian markets were slightly below the previous quarter but about half of what they were in the third quarter of 2018.
Continued growth in oil production combined with slowing oil demand growth of major energy consumers led to a decline in price. Relentless growth in US shale oil output, geopolitical shocks and the US-China trade war are largely determining oil market dynamics. LNG markets — facing a long-running oversupply— continued to search for a sustainable equilibrium.
Financial matters – particularly the ability of companies to return cash to shareholders in the form of increased dividends and buybacks – featured on top of analyst minds in Q319 as companies reported weak earnings and some even explicitly stated plans to delay share buyback programs.
Analysts sought specific details on how companies intend to pay for fattening dividends and share buyback programs given that the market headwinds may continue. Not surprisingly, companies were asked questions on any risks that might keep them from meeting their cash flow targets and the potential impact of asset divestiture programs and the ramping up of new projects on their future cash flows. Over the past few years, cost-cutting and productivity gains have driven cash flow breakeven significantly down; however, the current macro reality is leading analysts to question some companies’ cash return targets as overly optimistic.
Capital spending was also on the radar for several analysts, with some specific questions on capital spending flexibility in adverse macro conditions. Amid growing climate backlash against fossil fuel expansion, analysts had a keen interest in the allocation of capital to alternative energy business and the returns expected from those investments. The market’s focus on decarbonization is accelerating. Pressure is mounting from investors, capital markets, government and the general public, and there is a growing acceptance of the need for change. Although oil majors’ investment in alternative energy businesses is climbing, it still accounts for a marginal share of total spend.
Downstream performance also garnered significant attention from analysts this quarter, as they sought to understand the company-specific factors that helped lead to a sequential decline. Analysts also were keen to hear about the potential for reviving companies’ downstream business in upcoming quarters.
From an operational standpoint, analysts are intensely focused on progress on major capital projects and potential delays in project ramp-up schedules. A multiparty-owned Eurasian project facing cost overruns and significant delays got a lot of attention. Analysts asked straightforward and difficult questions on learnings from the project’s execution to fine-tune the entire project life cycle. Several questions were asked on production guidance for 2019 and 2020 to gauge companies’ confidence in meeting their targets.
Companies’ display of commitment to improvements in operational efficiencies and excellence gave some confidence to investors. Analysts were keen to get a view of companies’ ongoing operations and future plans in the US Permian and the likely impact on companies’ production growth. With the upcoming US election, companies’ capabilities to manage regulatory and political risk also emerged as a key concern.
On the strategic front, portfolio optimization, M&A opportunities and potential implications of government policy and regulation topped the list of issues. Analysts wanted to understand the primary factors that drove divestment decisions for upstream and LNG assets, and also to gain clarity on key milestones.
A profound strategic shift is clearly visible with companies building resilience into their portfolios. When it came to M&A, analysts were clearly interested to know the type of assets and geographies that are expected to see heightened levels of activity in the upcoming quarters. More specifically, analysts tried to gauge companies’ interest in the upcoming Brazil transfer of rights auction by seeking their opinion on the auction terms laid down by the Brazilian Government.
With some new regulations coming into force including IMO2020 and the Canadian Government’s announcement of a crude-by-rail policy, there is interest in understanding the preparedness of the sector in adapting to these regulations and their potential implications on companies. Analysts expect the market volatility to continue in the next few quarters amid protracted trade disputes. These uncertainties may continue to pose challenges to oil and gas companies. As uncertainty abounds in the upstream and new energies businesses, analysts’ longer-term concerns will focus on reinvestment risks with free cash flow.