The De-Emphasizing of Oil & Gas Megaprojects—A Telltale Sign for Investors

February 23, 2017

In the wake of the 2010s oil glut, Big Oil has changed their tactics on how they replenish their oil reserves. In an effort for less volatile earnings, the industry giants are making fewer bets on multibillion dollar projects. This cautious strategy, however, could make Big Oil less appealing to investors in the long run.

In the 2000s, Big Oil companies increased their exploration budgets amidst high oil prices and a rising demand in emerging markets. These companies spent escalating amounts of money in their attempt to find vast oil reserves in unconventional locations. In search for new areas to drill, these companies explored the ocean depths and under Arctic ice, as output from easy accessible oil fields declined. As spending increased, however, these multibillion dollar projects often came up short. In fact, leaving aside unconventional resources (oil shale, oil sands, extra heavy oil, and natural bitumen), the annual volumes of oil and gas discoveries have been successively declining since 2010.[1] As major finds became more scarce and as the price of oil plummeted in 2014, these companies decided to cut costs and stay clear of costly, high-risk exploration projects.

As the price of oil has doubled since its cyclical bottom a year ago, many believe that the oil glut is over.[2] In June of last year, Saudi Arabia’s Energy Minister, Khalid al-Falih, declared that the oil glut was over and that the industry should see a gradual climb in the price of oil.[3] Moreover, the world’s two largest oil-field services companies, Schlumberger and Halliburton, both declared in July that the worst was over in the two-year oil market crash.[4] This turnaround in the oil and gas industry is especially evident in the United States where Baker-Hughes, one of the world’s largest oil field services company, has reported this week that the oil-rig count in the United States is now at its highest level since October 2015.[5] Despite this unmistakable turnabout in the oil and gas industry, the spending budgets of Big Oil companies do not reflect the upward trends in the price of oil and the optimism in the market.

According to Edinburgh-based consultancy group Wood Mackenzie, global spending on oil exploration is projected to fall this year to the lowest level in 12 years as the industry giants look to cut costs and avoid high-risk and expensive areas such as the Arctic.[6] The consultants at Wood Mackenzie have reported that Big Oil companies have allocated $37 billion this year to exploration projects, marking the lowest level of exploration investment since 2005.[7] In 2017, the share of exploration in overall oil and gas production investment is expected to dip to a new all-time low of just 8 percent.[8] Before the 2010s oil glut, global spending on oil and gas exploration hit a peak in 2014 when it reached $95 billion.[9]

Some in the oil and gas industry argue that the decline in exploration spending will eventually lead to an oil drought, which in turn will prompt a spiking in oil prices.[10] At an oil conference in London this last October, Khalid al-Falih, warned that the underinvestment in exploration will result in a “period of shortage of supply.”[11]

Others in the oil and gas industry argue tha­­t a reduction in exploration is the new normal, “in which giants like BP and Royal Dutch Shell PLC will increasingly focus their exploration on less risky and more easily accessible reserves—and spend some of the money they used to commit to exploration to buy already discovered resources from smaller companies.”[12]

Shell, for example, refilled its oil reserves last year through its $50 billion acquisition of BG Group.[13] Shell also cut its exploration budget in half this year as it implements its new strategy of pursuing less risky and more easily accessible reserves.[14] As the company has retreated from the Artic after drilling one of the most expensive dry holes of 2015, Shell’s Chief Financial Officer Simon Henry explained that the company now relies “less on exploration.”[15] Although Shell is one of the largest and most financially stable energy company in the world, the industry giant is lowering its sights to more secure but potentially much less profitable projects as it implements its more risk-averse exploration strategy.

While there have been several large finds in recent years, as seen through Eni’s (an Italian multinational oil and gas company) 2015 discovery of vast gas reserves off Egypt and Exxon’s finding of oil off Guyana, these discoveries are more outliers than the norm, as Big Oil companies have increasingly opted for smaller, less risky projects.[16] According to Wood Mackenzie, Big Oil companies are currently more interested in “drilling more efficient wells aimed at more modest, low-risk gains, rather than big risky ones in new provinces.”[17] Moreover, the purported “major finds” are no longer as major as they once were. In June 2016, oil titan BP PLC announced that they had discovered an “important” gas discovery in the East Nile Delta of Egypt.[18] This discovery turned out to be a modest natural-gas find that did not even make it to the list of the top 50 oil and gas exploration discoveries since 2012.[19] The fact that BP hailed the discovery as a great success is illustrative of the new normal in the oil and gas industry as Big Oil is starting to scale back the magnitude of their projects.

By implementing a more risk-averse strategy and thus deemphasizing megaprojects, Big Oil is retreating from a sector where they enjoy a nice competitive advantage and are surrounded by almost unnavigable barriers of entry. Although these industry giants can still compete with smaller players in oil and gas’s unconventional frontier, Big Oil risks diminishing returns for their investors in the long run as they now allocate a lower budget to the colossal fields where only they can play.

One of the principles of corporate finance holds that managers are deemed to perform poorly when they “play it safe” and avoid risks that are necessary to create value for their shareholders. According to Todd Gormley, a finance professor at the Wharton School of Business, managers may not take certain risks because they have a lot tied up in their company: “If [business] goes south, their career could be adversely affected, and their personal wealth could be affected much more so than a diversified shareholder, so they’re going to want to take fewer risks.”[20] This is at odds with the goal of a diversified investor, who has already accounted for such risk through diversifying his or her assets through a broad array of investments. Since a typical investor’s foremost objective is to maximize their return, investors in the oil and gas industry should be asking themselves whether shares of less ambitious Big Oil companies are still worth owning.


[1] Sarah Kent, Oil Companies Shift Exploration Tactics, Curb Spending, Wall St. J. (Oct. 26, 2016), https://www.wsj.com/articles/oil-companies-shift-exploration-tactics-curb-spending-1477474206.

[2] Spencer Jakab, Big Oil Loses Its Mojo, Wall St. J. (Feb. 7, 2017), https://www.wsj.com/articles/big-oil-loses-its-mojo-1486491706.

[3] Collin Eaton, Saudi Energy Minister Says Oil Glut Has Vanished, Houston Chronicle (June 22, 2016), http://www.houstonchronicle.com/business/article/Saudi-energy-minister-says-oil-glut-has-vanished-8317909.php.

[4] David Wethe, Schlumberger Joins Halliburton in Calling Oil Cycle’s Bottom, Bloomberg (July 22, 2016), https://www.bloomberg.com/news/articles/2016-07-21/schlumberger-posts-surprise-2-2-billion-loss-cuts-more-jobs.

[5]Rig Count Overview & Summary Count, Baker Hughes http://phx.corporate-ir.net/phoenix.zhtml?c=79687&p=irol-rigcountsoverview (last visited Feb. 11, 2017).

[6] Angelina Rascouet, Oil, Gas Exploration Spend to Fall to 12-Year Low as Prices Bite, Bloomberg (Dec. 8, 2016), https://www.bloomberg.com/news/articles/2016-12-09/oil-gas-exploration-spend-to-fall-to-12-year-low-as-prices-bite.

[7] Id.

[8] Ron Bousso, Oil Exploration Spending May Drop Further Next Year: WoodMac, Reuters, (Dec. 9, 2016), http://www.reuters.com/article/us-oil-exploration-idUSKBN13Y0B7.

[9] Id.

[10] Kent, supra note 1.

[11] Id.

[12] Id.

[13] Will Connors & Sarah Kent, Shell Completes Acquisition of BG Group, Giving Energy Giant a Large Footprint in Brazil, Wall St. J. (Feb. 15, 2016), https://www.wsj.com/articles/shell-completes-buy-of-bg-group-1455541779.

[14] Kent, supra note 1.

[15] Id.

[16] Id.

[17] Id.

[18] BP Announces Latest Gas Discovery in Egypt’s East Mediterranean, BP (June 9, 2016), http://www.bp.com/en/global/corporate/press/press-releases/bp-announces-latest-gas-discovery-in-egypts-east-mediterranean.html.

[19] Kent, supra note 1.

[20] Todd Gormley, Why Avoiding Risk Can Be Good for Managers but Bad for Shareholders (Dec. 9, 2014), Wharton School of the University of Pennsylvania, http://knowledge.wharton.upenn.edu/article/avoiding-risks-is-good-for-managers-but-bad-for-shareholders/.

About

Clint Farha is a second-year law student at The University of Texas School of Law. He graduated from Texas Christian University in 2014 with a Bachelor of Business Administration in Finance and Real Estate, and a minor in Energy Management. This summer, Clint will be joining the Corporate group in Locke Lord’s Dallas office.