A Very Scary Graphic

For today’s column, I had intended to discuss the energy policy reform proposals of Senate Finance Committee Chairman Max Baucus (D-MT). But I am going to postpone that for another week to deal with a breaking story. Last week The Wall Street Journal published a story called Big Oil Companies Struggle to Justify Soaring Project Costs. That story contained a VERY SCARY GRAPHIC that has many people talking:

oil majors capex and output chart

Source: The Wall Street Journal

Much of the subsequent commentary treated this graphic as the face of peak oil: Oil companies spending more and more for modest production gains (or even declines). There is some truth to that narrative. As the easy oil is depleted the capital costs increase for the harder stuff (which is why high oil prices are here to stay). But there’s more to it than that, and I always strive to deliver the rest of the story (which hopefully is a benefit to readers).

What’s missing from the graphic? Revenues and profits. This is important, because if you miss this you can come to some inappropriate conclusions. Revenue is important because it was the huge surge in revenues as oil prices rose that fueled the capital expenditures. A decade ago, ExxonMobil’s (NYSE: XOM) revenue was under $300 billion. By 2008 it had surged to $477 billion, and after two years of weakness due to a collapse in oil prices (also aided by XOM’s ill-timed purchase of natural-gas producer XTO), revenues for 2011 and 2012 were above $480 billion. XOM’s net income showed a similar trend. It surged from $25 billion in 2004 to $45 billion in 2008, pulled back in 2009 and 2010, and then reached $48 billion in 2012.  

Big oil companies found themselves with very big piles of money, which they used to invest in new projects (and to buy back shares). Because of the size of these oil companies and the amount of revenue they generate, they either have to invest in a tremendous number of small projects, and/or a small number of megaprojects.

What you see in the WSJ graphic is largely a function of spending on megaprojects that in most cases turned out to be costlier than expected, but that also aren’t yet complete and producing.

As an example, in 2009 Chevron (NYSE: CVX), Shell (NYSE: RDS.A) and ExxonMobil teamed up on the Gorgon natural gas project in Australia. The Gorgon and Jansz-Io gas fields are estimated to contain 40 trillion cubic feet of natural gas, which will supply natural gas to the growing Asia Pacific market for decades. Chevron has invested more than $18 billion, and the total project cost has risen to $52 billion (40 percent over budget). That’s a lot of capital spent on something that hasn’t yet shown up as production, but once it does it will produce for many years.

The Kashagan oil field in Kazakhstan is another example, where ExxonMobil and Shell have each invested billions to produce the 13 billions of oil that are estimated to be economically recoverable. But this project has also suffered from cost overruns and delays, and the first oil just began to flow in Q4 2013.

So it’s important to keep in mind that there is often more to a story than meets the eye, and that is certainly the case here. Yes, projects are costing more these days for supermajors like ExxonMobil, but surging revenues are driving the project spending. When projects are delayed and costs escalate, there can be a short-term impact to earnings. We are seeing this impact now with earnings disappointments from many of the oil supermajors — but history has shown this to be a buying opportunity.

There is always a delay between spending on a project, and seeing that spending bear fruit. That delay can be three to five years, or even longer with some of the more complex projects. Recall that oil prices surged from 2005 until 2008, but oil production remained relatively flat during that time. This fueled much speculation that oil production had peaked. But the surge in oil prices spurred new projects, and as those projects came online they began to move the production needle. In the US, this has resulted in five straight years of increasing domestic oil production.

Remember, Warren Buffett isn’t a naive investor. In November, his Berkshire Hathaway (NYSE:BRK.B) disclosed that is had taken a $3.45 billion stake in ExxonMobil. He clearly believes that there is still life left in that supermajor. Many investors followed his lead, and bought into XOM as its share price rose throughout November and December. But with the recent pullback you can actually buy ExxonMobil for less than what Warren Buffett paid. You could do a lot worse than that.   

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