Another source of woe for oil majors

In the slew of second quarter losses announced by oil companies this week, lower oil prices has been universally cited as the key problem for oil majors. As long they are able to weather the downturn in demand and prices, and adequately replace their reserves, they stand to reap huge profits again when prices rise.

However as some of the big, easily accessible oil reserves begin to ebb, much of this reserve replacement is being done in areas of more marginal production – meaning the cost of replacing oil reserves is gradually rising.

But will higher oil prices necessarily mean more profits for years to come?

A note from Bernstein Research this week argues that reserve replacement percentage tells very little of the story for oil majors. So how should it be viewed? First the recycle ratio. They write:

If the cash generated from producing a single barrel of oil matches the cost to find and develop a new barrel of reserves, the company should be able to recycle its cash earned back into the business and maintain the status quo (a recycle ratio of 100%). If however the company wishes to grow production and reserves at all, it needs a recycle ratio in excess of 100%, and when adding dividends as well, the recycle ratio would be better to be closer to 200%.

This is how the ratio has actually performed across the top 10 listed oil companies:

But even this tells only part of the story. If the profitability of those replacement barrels is factored in, it looks even worse. Bernstein says the compound annual growth rate over the past 10 years for finding and developing has averaged 18 per cent, but the cashflow per barrel has only grown at 15 per cent.

They analyse this further by looking at the discounted future value of their proved reserves (NPV10) that oil companies file to the SEC each year. Dividing this amount by the barrels of oil equivalent and comparing it to the crude blend price per barrel shows a tale of woe:

Replacing high-margin oil with expensive oil means the companies losing value for shareholders in the long-term, they write. Tax regimes also figure in the equation.

So what can be done about this? Bernstein argue that the majors’ increasing focus on acquisitions, rather than exploration, to increase their reserves is part of the problem. They are also too reliant on improved recovery and revisions (which accounted for a third of the top 10 oil companies’ reserve additions over the past five years):

In summary, our view is that companies sourcing a large part of their reserve adds from revisions and improved recovery might be being too conservative in their approach to high risk exploration, and adding potentially marginal barrels, therefore potentially missing the boat on new and exciting plays. Also, as project economics change as a result of changing oil prices, reserves will be adjusted through revisions. What this means is that if the oil price drops again, these marginal barrels may be the first to go.

Exciting new oil finds, they say, have been left to the likes of Anadarko, Tullow, DNO and other smaller players. At the same time, both the new reserves and the production from OECD countries is falling, meaning oil companies are increasingly reliant on countries “in less accommodating corners of the world”, with lower margins and higher tax regimes.

Related links:

Chevron profit tumbles 71% (FT, 31/07/09)
Eni results drop on falling oil prices (FT, 31/07/09)
Profits and otuput fall at Total (FT, 31/07/09)
Shell and Exxon profits tumble (FT, 30/07/09)
BP chief warns of ‘drawn out’ recovery (FT, 29/07/09)

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