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BP And Shell Optimistic The Market Is Turning

BP and Royal Dutch Shell reported their latest financial figures for the third quarter and both companies showed some improvement, a sign that the oil markets are starting to find their footing.

A few days ago, some of the other oil majors released third quarter earnings, revealing the ongoing damage being done to the balance sheets of even the largest oil companies. But BP and Shell offered some reasons for optimism for the industry.

Shell said that its current cost of supplies – similar to net income – jumped to $1.4 billion, compared to a massive $6.1 billion loss in the same quarter in 2015. Much of that was due to some factors unique to Shell, namely, the integration of BG Group, which allowed the combined company to post higher oil and gas production under one roof. With the costs of acquisition increasingly behind Shell, the benefits are starting to be realized. Total liquids production for Shell climbed to 1.87 million barrels of oil equivalent per day in the third quarter due to the inclusion of BG, up from just 1.528 mb/d a year earlier. Additionally, Shell benefited from not having to write-down assets the way it did in 2015.

BP’s replacement cost profit was $930 million, about half of what it was a year ago, but up 30 percent from the second quarter of 2016. As mentioned in a previous article, earnings took a hit this year because of lower refining margins, the one source of strength that the majors had been relying upon since the downturn began in 2014.

Both companies believe that things are turning a corner. BP said that it expects cash flow to improve by $2 billion to $4 billion in 2017 because of higher oil prices. The British oil giant also expects “to see the full cumulative benefits of our cash cost reductions” next year.

But there are some very worrying signs for Shell and BP, which are similar to the problems that the other oil majors face. Shell’s gearing – a ratio of net debt to total equity – jumped from 12.7 percent in the third quarter of 2015 to 29.2 percent by the end of September 2016. A higher gearing ratio is problematic because it points to a more indebted company that could have trouble paying back debt if market conditions remain poor, which also represents a threat to equity holders. BP’s gearing ratio rose to 25.9 percent this past quarter, compared to 20.0 percent a year ago.

Since there is little to no chance of an issue with meeting debt payments, the likely casualty if oil prices remain low would be even deeper capex cuts, more layoffs, and deferred projects. After that, the next thing to be axed would be dividends.

Related: Oil Tanks After API Reports Biggest Build To U.S. Crude Stocks Since March

“I’m always deeply suspicious about companies that are paying uncovered dividends and effectively paying today and not investing for tomorrow, which appears to be what is going on here,” Charles Newsome, divisional director at Investec Wealth, told CNBC. “We invest for the long-term. That’s what we look at, long-term quality businesses that are paying sustainable dividends. And clearly Royal Dutch isn’t here; maybe less so BP. But overpaying dividends, I believe, is dangerous.”

Jefferies Equities analyst Jason Gammel was more upbeat, citing Shell’s “dramatic improvement in cash generation.” Gammel said that with capex declining Shell has “a lot more potential for cover on the dividend” in 2017.

But much of that depends on oil prices continuing to rise. And on that front, the oil majors are not out of the woods yet. Despite their cost savings over the past two years, the companies cannot maintain such generous dividend payouts if oil prices fall much further than current levels.

Related: Brazil To Boost Oil Output, Regardless Of OPEC’s Deal

Oil is facing a pretty significant downside risk should OPEC fail to come to an agreement at the end of the month. The inability of OPEC to make any discernable progress at its latest technical meeting in Vienna dimmed hopes of a substantial production cut deal, which has been hyped since the group met in Algiers a little more than a month ago.

“The lack of progress on implementing production quotas and the growing discord between OPEC producers suggests a declining probability of reaching a deal on November 30,” Goldman Sachs wrote in a note to clients on October 31. Goldman says that oil prices could plunged to the low-$40s per barrel if the OPEC deal falls apart.

That would erase the little bit of optimism that the top oil executives have exhibited in recent days, and it would call into question the sustainability of their dividend payments.

By Nick Cunningham of Oilprice.com

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