According to Cazenove’s Darren Winder and Robert Griffiths, UK companies are expected to pay £55bn in dividends this year with the biggest contribution (£14.6bn, or 26 per cent) coming from the oil & gas sector.
However, in a report published on Thursday, Sanford Bernstein has warned clients that something has got to give at the big integrated oil companies.
The Majors may need to revisit their shareholder distribution strategies in the short term if they want to sustain modest production growth in the longer term, as reserves replacement ratios and recycle ratios have reached dangerously low levels. In aggregate, it is only thanks to acquisitions that these companies are able to support 2% production growth, and based on organic replacement alone, they have barely kept their combined heads above water.
In order to internally fund 100% reserves replacement in any given year, Bernstein says a company’s recycle ratio needs to average 100% – i.e. cashflow per barrel of production must match finding and developing costs per barrel of reserves added.
Excluding all shareholder returns, we believe the Majors need a recycle ratio in excess of 120% in 2009 (equating to a blended oil and gas price of around $63 a barrel of oil to support 2% production growth; however, when adding dividends, the figure jumps to over 150%, requiring a 2010 blended oil and gas price in excess of $80 a barrel.
Therefore if current commodity price levels persist, something will have to give, and although we are forecasting oil at $80/bbl and gas at $9/mcf in 2010, this still does not provide the cashflow required to fund both reserve replacement and dividends in 2010. Unless the Majors manage to improve their Upstream profitability through cost efficiencies over the next year, things could get ugly, although mounting evidence exists to suggest that the companies are taking this in hand.
The evidence is cost cutting, something Bernstein says will be the key feature of the sector’s reporting season, which gets underway with second quarter results from BP on July 28.
Our analysis shows that given the recent cost climate present day commodity price levels simply do not allow the Majors to continue to grow the business and pay substantial shareholder returns, and therefore this quarter looks set to be a competition of who can cut costs the best, with many of the Majors having tabled cost cutting programs at the start of the year. Hence those wishing to stand any chance of paying healthy dividends and supporting production growth through exploration (or acquisition) will need to be publishing strong progress on cost efficiency programs in Q2.
BP, of course, has made much of its cost cutting plans - 5,000 job losses, freezing pay for many staff, including most managers, and pushing for price cuts from its suppliers. However, Bernstein is wary of taking the headline figures from BP and others at face value.
Despite some impressive numbers on cost cutting being announced in Q1, a large part of the cost reductions achieved by the Majors were down to decreased energy input costs, and therefore may not have been repeated in Q2. Specifically BP announced a $2Bn year-on-year cost reduction program, of which $1Bn was achieved in Q1. However from the Q1 transcript it seems that in fact around 40% of that was attributable to the lack of repairs that had to be paid for last year, and foreign exchange impacts accounted for 30% of the $1Bn, leaving only $400Mn as pure controllable cost reductions.