Big Oil’s big spending shouldn’t freak investors

January 31, 2011

By Christopher Swann
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Big Oil firms have become big spenders. Together, the top three U.S. giants say they plan capital spending of about $60 billion — well above the year of peak crude prices in 2008 — despite showing only tepid cash flow growth. At first blush, this looks like desperation, as Western oil groups increasingly struggle to replace crude reserves. But patient investors will find higher returns are on the way.

Investments in a host of mega-projects, along with higher prices for services and parts, have compelled Exxon Mobil, Chevron and ConocoPhillips to open their wallets ever wider. Exxon disclosed on Monday that full-year spending was up by a fifth in 2010 while Chevron’s outlays are on track to reach close to three times the level of 2005. Collectively, spending at the Big Oil triumvirate will be roughly 20 percent higher than in 2008.

In return for these monumental investments, oil firms expect meager production growth of less than 2 percent a year between 2010 and 2013. And free cash flow for the big three — after capital outlays — is actually lower now than it was in 2005, falling from $45 billion to $34 billion. With spending gobbling so much of the spoils, the return on capital deployed — one of the main criteria by which oil companies are judged — is under pressure. As a result, the top three trade at just 11.5 times 2011 earnings, a discount to the broader equity market.

This may be the dark before the dawn, though. In the coming years, cash flow should ramp up faster than production. Huge liquefied natural gas projects, such as Chevron’s Gorgon in Australia, will be prolific cash generators. A shift towards fiscally friendly rich nations will also help. And cash margins on crude from the Gulf of Mexico and Canadian oil sands are fatter than energy firms have become used to.

Of course, it will take time for these to kick in. But as they do, Big Oil could see cash flows rise 6 percent a year to 2017, Credit Suisse estimates. In the meantime, oil chiefs would be unwise to simply wait. To get better multiples now, bolder steps are needed — dumping less desirable assets or, better still, spinning off refineries.

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