In a recent posting, I looked at the break-even price for many of the world's key oil projects. In that posting, I quoted from a report by Carbon Tracker Initiative, a U.K.-based think tank that examines the relationship between investing in fossil fuels and the climate, and attached this graphic that shows how the capital expenditures by several of the world's largest oil companies are being impacted by a low-price environment:
With low oil prices come declining cash flow which makes it difficult for companies to do two things; maintain dividends (which investors love) and maintain capital spending. This dilemma has been solved using debt, however, in the current environment, increasing debt becomes less and less palatable to both management and shareholders, particularly in a market where interest rates may rise. Companies will be forced to cut projects that are at the high end of the cost curve which creates another problem, failing to meet production targets, an issue that often results in significant trimming of share prices.
It is important to keep in mind that projects that have a high front-end capital cost are riskier to investors as are the companies that have a stable of these projects. The risk of a low return on investment increases as the cost component of a project rises; for example, drilling in a hostile environment like ultra-deep water is far more expensive and has a far greater risk of economic failure than what are now relatively rare, onshore projects. In the case of the Canadian oil sands, the greatest risk is the massive capital cost required to produce crude. For example, Canadian Natural Resources, operator of the relatively new Horizon oil sands project in Northern Alberta, spent $9.7 billion on Phase 1 of Horizon which had a production capacity of 110,000 BOPD. This resulted in a capital cost of $88,000 per flowing barrel. Keep in mind that this does not include operating costs which, according to CNRL run around $1.4 billion per year for Phase 1 alone.
In this posting, I'd like to dive more deeply into CTI's report, looking at the impact of lower prices on the world's largest oil companies. Here is a graphic showing potential capital expenditures by company from 2014 to 2025 and what oil price is required to make the company's stable of projects economic:
In the case of Total, 40 percent of their potential projects require a price in excess of $95 per barrel. In second place we find Exxon Mobil at 39 percent, Shell at 37 percent and Chevron at 36 percent. In the case of Exxon Mobil, 68 percent of the company's potential projects require a price of at least $75 per barrel. On the opposite side of the spectrum, only 25 percent of BP's potential projects require a price in excess of $95 per barrel.
Now, let's look at undeveloped projects, those projects where a discovery has been made but is not on production and undiscovered projects where, obviously, no discovery has been made:
When considering undeveloped projects that require a price of $95 per barrel or more, the authors found that 27 percent of Total's potential capital expenditures between 2014 and 2025 are slated for high-cost, undeveloped projects. Shell follows with 26 percent of its potential capital expenditures and ConocoPhillips trails the pack, requiring only 17 percent of its potential capital expenditures for high-cost, undeveloped projects.
Here is a chart showing the detailed exposure of each of the companies to high-cost undeveloped projects by type:
In the cases of both Shell and ConocoPhillips, oil sands projects account for just over one-quarter of the total that will be allocated to high-cost, undeveloped projects. ConocoPhillips also has significant exposure to high-cost Arctic projects. In the cases of BP and Total, a major part of their capital exposure to high-cost projects over the next decade are in deep and ultra-deep water, swallowing up a combined 77 percent and 73 percent of capital expenditures respectively. Exxon Mobil, Eni (an Italy-based multi-national) and Chevron have significant exposure to high-cost deep water projects which will consume 45 percent, 41 percent and 43 percent of capital expenditures respectively.
The world's major oil companies will be looking through their projects over the coming days, looking to cut those that are the most expensive, highest risk and have the lowest return on investment. We've already seen Total and Suncor shelve their Joslyn oil sands project and Royal Dutch Shell postpone its 200,000 BOPD Pierre River oil sands project. As a result, in all likelihood, we will see a combination of companies not meeting their production targets and taking write-downs on the value of their assets, particularly if the period of what are now considered to be low oil prices looks to be long-term. All of this will result in declining profitability, one of the things that investors and the stock market really, really hate.