Upstream cash machines

Upstream has never made so much money. The brutal cost-cutting in the downturn primed oil companies for the V-shaped recovery last year. Even higher oil and gas prices resulting from the Russia/Ukraine conflict are delivering undreamt-of cash generation in 2022. I asked Tom Ellacott, SVP Corporate Analysis, what the industry might choose to do with the money.

How much cash are we talking about?

The five supermajors – ExxonMobil, Chevron, Shell, TotalEnergies and BP – could generate over US$200 billion of free cash flow after investment from upstream alone this year at today’s oil and gas prices. That’s more than 50% up (in nominal terms) on both the 2008 super-cycle peak and the previous all time high in 2021; and three times the annual average for the first two decades of this century. The companies could buy back their entire share capital in just seven years with cash flow at this level. Much the same story is playing out across the wider industry.

What will they do with the money?

Corporate plans are already adjusting. Elevated oil and gas prices will lead to more investment, though we’re yet to see the big uplift in spend that characterised past upcycles. Global spend is set to increase by 20% this year and will go higher still.

The focus for the most part is on short-cycle, fast-payback conventional, deep water or shale projects. US Majors have increased budgets for the Permian by 50% compared with 2021, but US Independents so far have not responded in kind. The pressure is intensifying, not least from the Biden administration, for US Lower 48 operators to loosen their self-imposed constraint to drill more wells and bring more tight oil supply to the market. A stretched supply chain might limit how much and how quickly that can happen.

The crisis may be the catalyst for the shift towards higher exposure to gas that companies have flagged for some years but has never materialised. Certainly, Europe’s policy to cut dependence on Russian gas is a bullish signal to LNG developers in the US, Qatar, East Africa and beyond; and for pipe options such as Azerbaijan (BP), the East Mediterranean (including Eni, Chevron, BP) and Norway (Equinor).

Eni stated last week it intends to accelerate sales of gas into Europe, leveraging 14 tcf of equity and third-party gas in its portfolio. Shell’s re-assessment of its UK pre-FID Jackdaw gas field – a project shelved late last year – is another sign of rekindled appetite for gas.

Surplus cash flow will also be used to speed progress towards net zero ambitions. For example, Eni also announced it is bringing forward by five years its target date for net zero Scope 1 and 2 emissions.

However, we don’t expect substantive changes to the core corporate strategies that evolved before the crisis. The energy transition is unfolding, and oil and gas will be an important part of the mix for years to come. The thrust will still be to build a resilient upstream portfolio around low-cost, low-carbon assets.

Will companies change their approach to portfolio management?

The Russia/Ukraine conflict will trigger a reappraisal of portfolio risk and the ESG implications for individual country positions; and more broadly, the concentration of value, assets or, indeed, people in geopolitically higher risk countries.

Separately, the upcycle presents a great opportunity to clear out unwanted assets at better prices. The temptation may be to keep assets that are on the disposal list, but which now are suddenly gushing cash. It should be resisted.

The argument for high grading is still compelling. Companies need to reduce exposure to upstream over time in anticipation of demand falling with the transition. Getting the timing right is the tough part, but mature, higher cost, higher carbon-intensive assets will become liabilities at some point. Better to dispose of them when finance for buyers may be easier to come by.

What about more investment in low-carbon energy?

The crisis and high fossil fuel prices have lifted energy security and affordability to the very top of the agenda. Governments everywhere want to lessen dependence on imported fossil fuels and the price volatility that comes with them. Policy will incentivise domestic energy supply, with renewables high on the list for countries with solar and wind resources.

The Supermajors already have ambitious plans for new energy, doubling planned spend in the last two years. Current projections are for upwards of US$25 billion a year across the group by the end of this decade, around half of upstream spend in 2022. If oil and gas prices stay elevated, cash flow would easily support another doubling and annual spend on new energy could exceed upstream investment by 2030.

What could go wrong?

Lots of things. Cost inflation (including in the service sector), windfall taxes and lower oil and gas prices could all erode these cash flow projections.

The biggest risk is in the industry’s gift to manage. The Supermajors have painstakingly improved investor perception by building financial resilience through the downturn: through active portfolio rationalisation; cost-cutting and a flexible approach to investment; and developing an action plan for decarbonisation. We estimate the peer group can cover dividends down to a Brent price of US$40/bbl, and much lower for some.

Investor confidence in the sector is fragile and will quickly leak away if oil and gas companies fall into the trap of past upcycles by losing that discipline.