Macro Wrap – The Case Against Big Oil, $XOM, $CVX, $XLE

by Enis August 5, 2013 8:09 am • Commentary

The Economist had an in-depth article in this week’s issue with the subtitle, “The day of the huge integrated international oil company is drawing to a close.”

The article goes on to argue that the mega-cap oil majors like XOM, CVX, COP, BP, and RDS/A are being squeezed on all sides.  From a competitive standpoint, national oil companies like Saudi Aramco and Petrobras are increasingly hogging the reserve growth, leaving the developed market oil majors to compete for scraps in more expensive project locales.  Meanwhile, smaller companies are nimbly and ably developing new technologies (particularly in shale gas, but also in deepwater extraction and exploration techniques) that are forcing the majors to react rather than lead the industry from the front.

The oil majors are the classic slow-moving behemoths ridiculed for decades by business school jargon.  They’re massive corporations, with many little fiefdoms, probably better split up than consolidated.  Just last week, XOM and RDS/A, two of the largest energy companies in the world, both announced dismal earnings results.  XOM blamed poor refining results, while Royal Dutch Shell announced a more involved restructuring, as its shale investments in the U.S. look to be duds.  RDS/A essentially threw in the towel on its prior reserve growth strategy, instead deciding to focus on functioning as a utility, shrinking the business over the next 5 years but increasing cash flow returns to shareholders.

Investors do seem reluctant to commit capital to the mega-cap oil majors this year.  XLE is basically where it was in late May (red arrow), while WTI crude oil is more than 10% higher in price (green arrow):

1 year chart of XLE (black) vs. CL1 (orange), Courtesy of Bloomberg
1 year chart of XLE (black) vs. CL1 (orange), Courtesy of Bloomberg

But the real long-term crux for the oil majors is the rapidly changing global energy backdrop.  The Economist argues that we might be close to peak demand, citing improvements in automotive efficiency, increased reliance on natural gas as opposed to oil, and more stringent regulatory regimes.

I agree that oil’s importance in the energy supply chain will be reduced in the coming years.  Yet, the Economist omitted perhaps the one area with the largest long-term potential – renewable energy.  While I concede that the promise of renewable energy has not met expectations for decades, cost comparisons with fossil fuels are rapidly approaching parity.  Oil demand could contract if replacement technologies continue to improve, while oil supply continues to increase as extraction gets more nifty as well.

While energy is one of the cheapest sectors globally from a valuation perspective, good long-term reasons exist for that.  For the largest energy companies in the world, a brave new world is a reason for worry rather than cheer.  But that’s probably good reason for cheer for the rest of us.