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Oil companies dig deep

With an eye on shareholders' returns, oil companies are reining in costs and increasing internally generated cash flows

While investment activity in the upstream oil and gas sector has improved this year, financing conditions have tightened slightly. Investors in the widely-watched US oil patch have become somewhat wary of financing production volume at the expense of shareholder value. Burnt during the oil-price crash that took prices from over $100 a barrel in mid-2014 to less than $30/b in early 2016, equity investors have shown only moderate enthusiasm for financing new production—even in a climate of oil-price recovery, ending the year around $60/b.

Finance offerings in the US oil and gas sector, after a strong H1 2017, have slowed to a crawl. Total bond and equity offerings, including midstream and downstream, were down 26%, from $133.4bn to $98.3bn in the first three quarters, according to Houston-based analyst PLS. The firm also reported six upstream initial public offerings during the first nine months of the year, raising $2.7bn. Analysts point out that the volume of equity issuance in particular tightened during the third quarter. "Equity is not as open as it used to be," says Tom Ellacott, a corporate analyst with Wood Mackenzie.

Earlier this year, it was widely reported that the finance community had tired of supporting companies that weren't perceived to be creating shareholder value. The industry as a whole, since 2014, has had to tighten its belt. Cash-flow-neutral targets have been cut to around $50/b from the $95/b prevalent up to late 2014. Cost control must battle with higher charges in the oil-service sector.

This discipline is being imposed on the sector at a time when the outlook remains uncertain. The market is still not entirely convinced that Opec and non-Opec producers will continue to restrict output levels to reduce world oil inventories and rebalance the market. In addition, US interest rates seem set on a slowly rising path; the Federal Reserve is shrinking its balance sheet; and there's uncertainty about the effect of the tax reform plan now under discussion in Congress and whether it will pass. Finally, will there be enough external capital to finance the expected large increases in US oil output in a flat oil-price environment? All these elements push independents towards reliance on cash flows from operations rather than external financing.

Producers have, therefore, this year concentrated on consolidating their portfolios, especially in relatively low-cost, prolific areas like the Permian and Marcellus basins. These saw the largest mergers and acquisitions among independents this year. Short-cycle, flexible, efficient operations are seen as essential. Ellacott says that with the future potentially very volatile, drillers are asking: "How much of the sweet spot is left? As you drill out the sweet spots, what are the resources going to be?" Gas producers may also face the challenge of pricing pressure from large volumes of associated gas produced in tight oil basins.

Energy index falls

The sector's financial profile has improved this year, as oil prices have strengthened. According to the US Energy Information Administration's Financial Review of the Global Oil and Natural Gas Industry: Second-quarter 2017, return on equity for the 108 publicly listed companies it follows was the largest since the first quarter of 2015. But earnings in other industrial sectors outpaced those in the oil patch, and while the key US broad stock market gauge, the S&P500 Index, has risen 14% this year, the S&P500 Energy (Sector) Index is down 12%.

Company reactions to investors' desire for more attention to shareholder value and less to production volumes have indicated that they've got the message. Anadarko, for example, has announced that it expects its 2018 capital expenditure to be covered by discretionary cash flow, assuming an oil price of $50 a barrel, and natural gas prices of $3 per million British thermal units, and to return cash to shareholders via buying back shares. Competitor ConocoPhillips, meanwhile, has bought back nearly 30m shares, in part with proceeds from the sale of Canadian oil sands assets. Despite the two companies' announcements, Anadarko's share price is down 31% this year, compared with ConocoPhillips' 1.1% decline.

During the third quarter, US independents were joined by private-equity market participants, who paid particular attention to prospects outside the leading US plays in the Permian and Marcellus basins. Private equity is also expected to move further into the UK North Sea, where analysts see a changing of the guard, as international oil companies that once led the area's development now share it with independents.

Beyond the US oil patch, significant financings were completed for national oil companies, including a $1bn bank loan for Brazil's Petrobras, which is restructuring its finances following the "Car Wash" scandal, and ahead of a new round of oil licensing bids. Saudi Aramco issued a seven-year, $9bn Sukuk (Islamic bond) in a private placement to institutional investors, as the first tranche in a planned larger programme. In addition, leading oil trader Trafigura completed an innovative $470m non-recourse structured financing backed by a portfolio of hedged commodities.

These transactions show that while conventional sources of upstream financing may be marginally less open than they were before the oil-price crash, there are plenty of institutional investors willing to provide funds to all parts of the oil sector.

As 2017 winds down, the market appears to be settling in for a long haul of relatively stable oil prices. Upstream companies will try to maintain discipline by reining in costs and increasing internally generated cash flows. The coming year will reveal whether this outlook conforms to a market in which cash-strapped oil producers will restrain output and US oil production sustains its predicted climb. That outlook may also determine whether Saudi Aramco will successfully launch its long-awaited Aramco IPO.

This article is part of a report series on Oil and gas finance. Next article is: Oil firms back in the black

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