Big Oil: Toughen It Out, or Business Model Reboot?

The last several years have not been kind to the world’s oil majors¹. Production has fallen steadily despite a surge in investment, cost inflation has been rife, and labour productivity has declined

Even before the recent collapse in the oil price, return on capital had come under pressure and organic FCF was no longer sufficient to fund dividends. Many are now questioning the sustainability of the integrated business model.
We tackle this issue in this report, by combining Morgan Stanley’s analysis of the industry with the expertise of BCG, mapping out how Big Oil can reboot its business model to restore returns, and the consequent impact on share prices. We conclude that the days of Big Oil are by no means over.
Big Oil’s unique blend of technical capability, financial strength, risk capacity and global reach will remain relevant in the years ahead – and will not be entirely displaced by either service companies or smaller independents. But the model must evolve.

The Big Oil model needs to change
First, Big Oil needs to undergo a dramatic cost reset. Most firms are well advanced on rebasing costs with their suppliers in the current slowdown. But the changes must go far deeper, and companies must drive fundamental change internally, embracing technical standards, operating efficiency and co-operation with other operators as well as more traditional cost levers. Our experience is that most operators have in reality only just begun on this journey. We believe that the prize is considerable for those brave enough to fundamentally reset costs.
Second, Big Oil’s operating model needs to evolve. The model of the broad generalist is under pressure, and specialization is on the rise. An upstream world that is fragmenting into multiple niche oil and gas sources no longer suits a “one size fits all” model. Big Oil must better connect a portfolio of focused businesses in a network that harnesses their collective scale – rather than trammeling them with complexity and overhead.
Third, to be sustainable, these changes must be underpinned by genuine cultural change. Big Oil still lacks a truly cost-conscious culture – the focus has long been skewed towards safety, volumes and reliability. Without some rebalance, efficiency programs are likely to fail to deliver their potential – and Big Oil can no longer afford a period of incremental cost adjustment. The challenges are far greater, and 2015 may present the best opportunity for some firms to shape a competitive future.

It has been done before
These changes are not only necessary, they are also possible, in our view. There is a clear historical precedent: in the aftermath of the 1986 oil price collapse, the majors dramatically lowered cost and improved efficiency, which allowed strong earnings and share performance in subsequent years, despite an extended period of oil price weakness.

The size of the prize is large
If these changes are successfully implemented, the ‘size of the prize’ is considerable. The shares in major oil companies are yielding ~2 times the dividend yield available in the wider stock market. This reflects investor concerns that current distributions are unsustainable. However, these concerns will likely dissipate when organic FCF exceeds dividends once again. History suggests that under those circumstance, the majors’ dividend yield will likely contract towards its long-run median of ~1.3 times the market yield – implying upside of up to 50%.
In summary, the days of Big Oil are not over. We believe there is potential for the sector to emerge from the current cycle fitter, more resilient and more valuable than before.

¹ BP, Chevron, Eni, ExxonMobil, Royal Dutch Shell, Statoil and Total

Martijn Rats, Evan Calio, Haythem Rashed, Sasikanth Chilukuru – Morgan Stanley & Co. International plc+