Anness and Hall argue that, while historically oil companies have been poor at allocating capital in a profitable manner and even though there is little evidence to suggest that this will change in aggregate, “we currently find ourselves at or around a cyclical low-point for industry return on capital employed (ROCE)”.
And, importantly, they say, this is happening at a time when management teams are very focused on improving their returns.
“We expect to see a reduction in capital intensity combined with improved cost efficiency driving an improvement in return on capital employed.”
Duncan Goodwin, head of global resources at Baring Asset Management agrees that the fall in oil prices has forced managements’ hand in a number of instances. Indeed, he says, companies across the commodities sector have focused increasingly on cost control in a bid not only to tackle lower prices, but also growing demands for better capital management from shareholders.
“We are a way through the cost cutting part of that cycle,” he said, “and we are now entering the next phase where we expect growing merger and acquisition activity.”
“The second aspect to this,” Goodwin adds, the other driver for the continued focus on cost control is the belief in the continued deflation of commodity prices, which increases the pressure to improve costs.”
“We are now in a period where managers are looking to improve returns in a benign commodities environment irrespective of whether prices will actually stay benign or not. I don’t think, for example, the Shell/BG would have happened had prices stayed above $100 a barrel.”
Finding value
So, if managers are looking through the lower oil price, where are they finding value?
According to Goodwin, Barings is forecasting a long term oil price of around $75 per barrel, but unlike Anness and Hall, at those prices he doesn’t really see a great deal of value in the integrated majors.
He is more constructive on the exploration and production sector, but he says here too it is very company specific, but there remains some expectation of further price increases.
In the oil services, however, he says there is a bit more valuation potential.
“If we are right and the exploration and production companies are ready to spend more, there is potential for upside in the oil services,” he said.
