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Upstream Margins Squeezed as Costs Escalate, Profits Decline, Says IHS

The global upstream industry's capital expenditures totaled $720 billion in 2013, 18% higher than a year before, but margins were squeezed as costs escalated and profits declined, an IHS Inc. analysis has found.

"Margin squeeze remains a significant challenge for upstream energy companies because capital spending continues to rise rapidly, despite the recent weakening in per-unit profitability and the longer-term trend of deteriorating returns," said IHS Research Director Daniel Pratt, who leads energy company transactions. Pratt co-authored the 2014 IHS Herold Global “Upstream Performance Review.”

"If it persists, the recent price drop in global crude prices will only add to these financial challenges for operators."

The latest review, which looked at data from a peer group, individual company and regional perspective, assessed three key areas of upstream performance: capital investment, reserve replacement rates/costs and profitability.

Accelerated spending caused the underlying net capitalized costs of upstream assets to more than triple in the last decade, researchers said. The uptick in spending, coupled with lower per-unit profitability, has caused the return on net cumulative capitalized costs to decline since 2005. In fact, returns over the last five years have been "markedly lower than what the industry achieved for much of the past decade," IHS researchers found.

Fourteen years ago, the IHS company study universe earned a 23% net income return on net cumulative capital costs, when realized costs were slightly higher than $22.00/boe. Between 2000 and 2013, realized prices nearly tripled to $63.00/boe, but the study universe earned only an 11% return on net cumulative capital cost.

"History shows that it will take a significant reduction in organic capital spending before costs are meaningfully reduced," Pratt said. The recent decline in oil prices, if sustained, could be a catalyst.

"We were previously expecting a 2% decline in exploration and development spending in 2014, based on an IHS survey of 50 of the largest global upstream companies. However, if this recent drop in oil prices continues for any length of time, we would expect to see weaker capital spending this year and into 2015."

Besides the increasing challenges of containing costs, operators also are facing headwinds on finding new growth opportunities.

The "viable growth opportunities appear to be shrinking because Russia was the only region outside of the highly competitive landscape of North America to show any meaningful reserve growth during the past decade," Pratt said.

Between 2004 and 2013, upstream companies reviewed by IHS were able to grow reserves only in the United States, Canada, Russia and the Asia Pacific. Compound annual growth rates were highest over the 10-year period in Canada (9%), followed by the United States and Russia (5% each) and the Asia Pacific (3%).

"The unconventional revolution, coupled with the large resources associated with oilsands, has made North America a growth region once again," the researchers said.

And there's another hurdle facing upstream companies: available cash flow to invest in organic growth. After reaching a peak of more than $136 billion in 2008, free cash flow available for organic growth in general has been declining.

In the first half of the last decade, operators consistently invested around 75% of their cash from upstream operations into organic finding and development activities, including unproven reserve acquisitions, and exploration/development drilling. During the last half of the decade, allocations have ballooned to an average of 91% of cash flow, and to nearly 100% in 2013, according to IHS.

"As a result, organic finding and development activities generated essentially no free cash flow in 2013, which will have an immediate impact on broader capital strategies and could have longer-term impact on the regional growth outlooks as less capital is available for future growth investments," Pratt said. "In terms of shareholder satisfaction, the decline in cash flow also has implications on non-upstream uses of capital, such as share repurchases and dividend distribution to shareholders, which are often major elements of a company's capital strategy and its ability to return value to shareholders."

Russia's OAO Rosneft led all upstream operators studied with $86 billion of investments in 2013, including $74 billion in proved and unproved acquisition spending. The China National Offshore Oil Co. Ltd. (CNOOC) followed, with $40 billion invested, including acquisition spending of $25 billion, primarily for Canada's Nexen Inc. IHS's other 2013 top 10 capital spending leaders in order were Royal Dutch Shell plc, PetroChina Co. Ltd., ExxonMobil Corp., Chevron Corp., Total SA, Petroleo Brasileiro (Petrobras), BP plc and Statoil ASA.

"Chevron increased its spending more than 30% in 2013 by $8 billion to $33.5 billion, virtually all of it development spending," IHS said. The biggest increase was in the Asia Pacific region, where Chevron is developing the Gorgon and Wheatstone liquefied natural gas (LNG) export projects. Total also increased its spending more than 30% to $30.8 billion, with heavy investments in Europe and the Asia-Pacific region. Among the exploration and production (E&P) peers, Japan's Inpex more than doubled its capital spending to $6.4 billion by investing $2 billion in unproved property purchases, IHS said.

U.S. onshore operators Oasis Petroleum Inc., a big player in the Williston Basin, and Permian Basin heavy hitter Rosetta Resources Inc. more than doubled their capital investments in 2013, mostly on acquisitions. Rosetta spent nearly $1 billion, while Oasis invested almost $2 billion in acquisitions, IHS said.

"On a regional basis, U.S. capital spending declined in 2013 to $177 billion because acquisition expenditures were $33 billion lower than in 2012," researchers noted. "Exploration and development spending in the region was essentially flat at $146 billion. Without CNOOC’s acquisition of Nexen, Canadian investment would have decreased because exploration and development spending was down and the overall market was weak."

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