Managing Director & Partner
Restoring Value Creation Through Business Model Revolution
Historically, Big Oil has been a structurally strong value creator, favored by investors for growing and preserving long-term wealth1. Global in reach, massive in scale, and able to manage complexity and mitigate risk, leading oil and gas companies have generated superior shareholder returns across the business cycle. From 1999 through 2004, Big Oil created an annual total shareholder return (TSR) of 6.7%, compared with –2.3% for the broad market. Similarly, from 2004 through 2009, which includes the 2008–2009 oil-price collapse, Big Oil yielded 7.3% yearly to its owners while the S&P 500 returned a mere 0.4%. Since 2009, however, the pattern of returns has eroded. From 2009 through October 2015, Big Oil generated an annual return of 2.9% while the S&P 500 yielded 13.6%. Even before the 2014 oil-price drop in the post-2009 market recovery, Big Oil’s returns trailed the total return of the S&P by more than 10 percentage points annually. (See Exhibit 1.)
The primary source of Big Oil’s declining shareholder value is deteriorating fundamentals brought on by the growing complexity of its operating model. (See “Killing the Complexity Monster in E&P: Eight Critical Actions for Upstream Oil and Gas Companies,” BCG article, January 2015.) In examining the major oil companies’ operations, we have found evidence of three kinds of intrinsic complexity:
This rising complexity and its escalating effect on costs are fundamental to any extraction industry. In 1859, Edwin Drake struck oil at 16 feet in Pennsylvania, but today, companies drill wells as deep as 40,000 feet and as far as 10,000 feet below the ocean’s surface. But the growing complexity of extracting less accessible resources is not the sole cause of Big Oil’s declining value. Rather, it is the combination of increasing resource, project, and industry complexity that has constrained Big Oil’s performance in ways unseen in previous decades.
As industry fundamentals deteriorate, investors expect lower profitability and call Big Oil’s business model into question. The model has suffered in three key areas:
As a result, even with high oil prices, company margins eroded. From 2012 through 2014, the average annual net profit margin for Big Oil shrank to 5.2% from 8%, and by October 2015, it had fallen to 0.5% for the preceding 12 months.
For a long time, investors rewarded Big Oil’s focus on reserve replacement and its role as a refuge for reliable long-term returns in turbulent markets. Value was driven by operators’ ability to add barrels that would at least maintain, if not increase, their reserve-to-production ratios. Operators with strong exploration capabilities, good discovery rates, and volume growth created value.
From 1999 through 2015, $0.97 of every new cash-flow dollar was plowed into capital expenditures and used to replenish reserves. At the same time, keeping up with depletion rates has become more difficult. From 2009 through 2014, every dollar’s worth of depleted assets required $1.80 of investment to maintain the reserve base, compared with $1.60 from 2008 through 2010.
In the new era of declining profitability and increasing complexity, investors have shifted their focus to cash flow generation. They have lost faith in the ability of Big Oil to invest its free cash flow efficiently, and they recognize that returns will be driven mostly by operators’ ability to return cash to them. Investors have essentially shifted their focus from volume to value. (See Exhibit 2.)
From 1999 through 2004, Big Oil’s annual TSR was 6.7%, with 5.9% from capital gains and 0.7% from cash flow. From 2009 through October 2015, annual TSR fell to 2.9%, with capital gains accounting for –1.5% and cash flow generating 4.5%.
As difficult as this change has been for Big Oil, it has hit independent producers even harder. Because they do not benefit from the natural price hedge inherent in downstream operations, they were more exposed than many of the majors when oil prices dropped in 2014 and 2015. Also, having traditionally focused more on exploration and growth than the majors, they were more exposed to declining value, and total TSR fell from 20.3% to –2.1%. Their traditional business model is effectively challenged. (See “Total Shareholder Return.”)
Total shareholder return (TSR) is the most effective measure of the value of a particular company’s stock to investors. TSR comprises a company’s stock price appreciation as well as any dividends paid. In simple terms, if a company’s shares are trading at $10, the stock rises by $1 during the holding period, and the company pays a $0.20 per share dividend, then the TSR is 12% ($1 plus $0.20 divided by $10).
As a result, TSR is a preferred method of valuation used by funds and other institutional investors in assessing their equity investments.
TSR is delivered through capital gains and cash flow contributions. Capital gains reflect profit growth, which management can influence through increases in revenues and profit margin, as well as changes in the valuation multiple, which is affected by such factors as growth and profitability expectations, performance consistency, investors’ confidence in management, financial policies, and risk factors. Cash flow contributions can be affected by capital expenditures, working-capital needs and dividends, share repurchases, debt, and cash.
While increasing complexity and declining profitability are structural issues that emerged when oil prices exceeded $100 per barrel, the current price level has exacerbated the industry’s challenges. For Big Oil, cash flow came under pressure long before oil prices started to fall. From 2009 through 2011, cash flow per barrel dropped as low as $2 from as high as $9 per barrel. Now, with oil prices well below $50 per barrel, the numbers have gone negative. Free-cash-flow yield, or free cash flow relative to market value, averaged 5.9% from 2004 through 2009, 0.8% from 2009 through 2014, and –5.3% for the 12 months that ended in October 2015.
In fact, Big Oil’s combined-enterprise free cash flow—defined as operating cash flow minus expenses, taxes, and changes in investments and net working capital—fell to –$30 billion in 2013 from $30 billion three years earlier, even though oil prices remained above $100 per barrel. (See Exhibit 3.)
Conscious of investor focus on cash generation, all but two of the majors have maintained their dividends, although they have been forced to sell assets to keep making payments. From 2010 through 2014, Big Oil sold about $30 billion in assets annually—three times as much as it sold during the first ten years of this century.
Clearly, this situation is not sustainable, and the majors may be forced to change their dividend policies if oil prices remain at their current level for a prolonged period.
For the next three years, companies will be cash neutral if oil prices are between $50 and $80 per barrel, well above their current level. Most companies are planning capital expenses on the basis of $40- to $60-per-barrel oil prices in 2017, which do not reflect stock buybacks and dividends equaling $10 to $15 per barrel. (See Exhibit 4.)
To protect their profitability and maintain cash returns to shareholders, Big Oil companies have drastically cut costs and made other adjustments to their business models in hopes of easing the current cash-flow squeeze. The initiatives that started even before the oil price crisis include the following:
Some companies undertook these measures before the 2014 price collapse. Statoil and Total, for example, adopted comprehensive rationalization efforts when the oil price was more than $100 per barrel. Nevertheless, the scope and depth of change have not been sufficient. To restore value creation, bolder moves are needed.
Large international oil companies must structurally and fundamentally redefine their business model. They need a revolution. Breaking free of the current situation requires a radical shift in Big Oil’s culture, operating strategy, and approach to competition. To restore value creation to historic levels, Big Oil needs five revolutions.
Big Oil faces daunting challenges: as complexity and costs increase and value creation erodes, the sustainability of its traditional business model is under pressure. Companies are reacting, making cuts to capital and operating expenses and adjustments to their portfolios. But we believe that a more fundamental, ambitious, and faster-paced revolution of Big Oil’s business is needed. Such a revolution requires oil executives to aggressively transform the fundamentals of their business model. It requires them to set new expectations for their employees and to change the way they operate and engage with contractors and governments.