Imagine the life of a Premiership footballer: however much money you spend, cash just keeps pouring in.
It’s been a bit like that for big FTSE-listed oil producers like Royal Dutch Shell (LSE: RDSB), BP (LSE: BP) (NYSE: BP.US) and Tullow Oil (LSE: TLW) in recent years.
However wild and extravagant their expenditure — Shell has spent nearly $6bn on its failed Arctic drilling programme — the cash just kept pouring in, thanks to oil’s long run above $100 per barrel.
I reckon that the oil industry got too comfortable at $100 per barrel. After all, it was easy money. Soaring costs weren’t a huge problem, except for shareholders, who saw their firms’ profits fall, despite stable revenues.
That era of easy money is now over — and despite press attempts to engineer a panic, I think the falling oil price could be good news for investors.
Costs vs. profit
Oil firms’ costs have gone through the roof in recent years, thanks to a booming rig market and contractors who knew they could demand top pay rates.
Those days are now over: in June, John Wood Group, Petrofac and Amec Foster Wheeler all cut contractor rates by 10%, and Wood Group announced a second 10% cut last week, as well as freezing the salaries of most of its onshore staff.
Drilling rig costs have also been falling over the last year; according to recent press reports, daily rates for ultra-deepwater rigs have fallen from a peak of $650,000 per day last year to less than $500,000 per day, while similar falls have been seen for cheaper jack-up rigs, which are used in shallower water.
Projects won’t all be cancelled
Recent reports have suggested that around $150bn of projects planned for next year may be cancelled.
I’m sure some will be cancelled — but many won’t be. Instead, the project planners responsible for costing the projects will have been sent away by their bosses and told to cut costs — or else.
The end result, in my view, will be that many oil firms become leaner, more efficient organisations. Contracts will be renegotiated to cut costs, and projects that required $80 per barrel to break even might now become profitable at $65 per barrel.
Such cost savings now should mean that when the price of oil starts to recover, profits and free cash flow will rise at firms such as Shell, Tullow and BP.
In turn, this should lead to rising dividends and a re-rating of these firms’ share prices.
