Integrated oil company stocks have been beaten down by years of declining returns and the collapse of oil prices starting in late 2014. These companies currently trade at their lowest relative book value multiple to the market in nearly 50 years, and also trade at meaningful discounts to their peer energy companies.
Preproductive capital in focus
Over the past decade, the return on capital of the supermajor energy companies1 has fallen significantly even as the commodity price quadrupled. At face value, this would seem to indicate a deficiency in the operating model of the super majors; however, we believe an explanation can be unearthed in preproductive capital.
This type of capital is dedicated to projects whose construction time and anticipated production life are materially longer than in prior cycles. We have witnessed growth of preproductive capital since 2000; the supermajors are building liquefied natural gas projects, ultra-deepwater platforms, and Canadian oil sands developments, all of which take years to complete but have very stable production rates, generate high free cash flow, and require very little sustaining capital thereafter.
The capital allocated to these preproduction projects represents nearly 40% of the balance sheets of supermajors today and currently produces no revenue, depressing returns on capital and cash generation, and should come online at various intervals over the next few years.
Added value of proved reserves
Proved reserves—those reserves claimed to have a reasonable certainty of being recoverable under existing economic and political conditions, with existing technology—are governed by accounting standards and third-party verification, whereas unproved reserves—those not meeting the standard to be classified as proved reserves—are ungoverned and unverified. We believe that at $50 per barrel for oil, 80% of the value of supermajors is represented by proved reserves, which demonstrates their lower risk profile. Moreover, even the risky part of the target valuation of supermajors, the unproved reserves, trades at book value. Contrast this to exploration and production companies, whose unproved reserves at $50 a barrel constitute 43% of their valuation and that trade at a significant multiple-to-book value2 based on their increased risk profile.
Could be at a turning point
We are at a point in the capital investment cycle where supermajors should demonstrate significant growth in free cash flow as preproductive capital projects come online and capital intensity falls. As supermajor production grows and capital intensity declines, even if oil prices don't go up, the valuation of the supermajors should improve. In addition, these companies are offering historically high dividend yields as we wait for the cycle to play out.
We're just beginning to see these dynamics play out in the announced 2016 and 2017 capital budgets and production guidance of the supermajors. Production is forecast to continue to grow through 2018 while spending continues to fall. Going forward, we expect that the supermajors can further reduce spending beyond announced levels without significantly impacting their near-term production profile.
1 Supermajor energy companies are the six largest oil companies and include ExxonMobil, Royal Dutch Shell, BP, Chevron Corp., ConocoPhillips, and Total S.A.
2 A multiple-to-book value is a measure of a stock price relative to the accounting book value of the company's net assets as expressed on its balance sheet.