Oil Majors Struggling; Best Value in Small-Cap E&Ps

In a world where energy and transportation fuel demand continues to rise, and where oil prices have hovered at an unprecedentedly high $100 per barrel price range for years, an observer might expect the oil majors to thrive. Their primary products are increasingly in demand, prices are sustainably high, and geopolitics and potential inflation threaten to reduce supply and further increase prices. It would seem like the perfect setup for some of the largest, most profitable companies in the world.

However, one after another, the oil super majors have announced disappointing results. Costs are rising, production targets are being missed, reserves are not being replaced, and stock buybacks and dividends are insufficient. The causes vary, from depleting older fields, to massive failed projects, to cost inflation in potential growth areas, to an inability to economically tap unconventional shale reserves.

The scale of the problem is immense from a market capitalization perspective. The three largest oil majors, Exxon, Shell and Chevron, represent almost $1 trillion of stock market value. Adding in other majors brings the total closer to $1.5 trillion. If even a small percentage of that money were redeployed, it could move markets significantly. Before considering where this investment could go, it is worth examining a few of the specific problems these companies face.

“What the Hell, Shell”:
Shell’s problems have been highly publicized. A Forbes article earlier this year, titled “What The Hell, Shell”, highlighted some of the issues Shell has been facing, beyond disappointing financial results. These include geopolitical driven production issues in places like Nigeria and higher than expected maintenance and service costs. And the article pointed out that Shell’s biggest hit to earnings was a huge write-down of unconventional shale assets. Shell bought a ranch in 2010 prospective for Eagle Ford shale for $1 billion, and four years later had to write down $700 million in value. To put this in perspective, smaller companies like EOG spent similar amounts on land in the same shale “play” only slightly before Shell and have created tens of billions of dollars in value from such investments.

Key differences between Shell’s unconventional shale efforts and EOG’s, for example, include:

*A focus on different resource. EOG went for oil, Shell went for natural gas. This reflects EOG’s better understanding of local market dynamics.
*Cost structure differences. EOG was able to drive down cost per well dramatically, while Shell’s cost per well remained well above average.
*Acquisition approach. EOG was able to acquire its properties directly from mineral rights holders, giving it more favorable terms and lower entry costs. Shell bought an asset that was likely marketed by investment bankers and represented a substantial upfront investment.

Opportunity In Small E&Ps:
Fortunately for investors, there is a large set of publicly traded oil and gas companies. Some, like Exxon, are well known. But there are hundreds of others, traded in the US, Canada, and elsewhere, that operate under the radar. In such a fragmented market, particularly with the limited analyst coverage of smaller companies, there is substantial valuation dispersion, which opens up interesting opportunities for savvy investors willing to dig in and do the work.

It is possible to be more like EOG than like Shell – targeting the right resource based on local market dynamics, focusing on low cost operators to ensure higher margins and profits, and buying at low valuations to reduce probability of loss and increase potential upside. Due to the fragmented nature of the industry and the market, it is often possible to buy assets cheaper in the public market by buying undervalued stock than it would be in a private market transaction.

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