Higher Production Costs Sink Major Energy Stocks Exxon, Shell

by Aaron Levitt | August 2, 2013 11:06 am

Despite being two of the largest integrated energy companies on the planet, both Royal Dutch Shell (RDS.A[1], RDS.B[2]) and Exxon Mobil (XOM[3]) and their shareholders are feeling the sting as some troubling “issues” have presented themselves during their recent earnings announcements.

Namely,  costs are rising in the face of dwindling production. This story shouldn’t come as a shock for investors as many of the integrated majors have faced this problem for quarter after quarter.

However, the story is really beginning to hurt profits at the two giants and could signal rough waters ahead for the rest of the majors still on deck to report earnings. For investors, the question remains just exactly how long this can go on before the stocks seriously begin to suffer and perhaps fall into the dreaded “value trap”[4] category.

What Went Wrong?

Both Shell and Exxon seemed to disappoint investors this week when both companies reported abysmal profits for the latest quarter. Europe’s largest integrated energy concern reported a 60% fall in profit for the second quarter, while America’s energy golden boy reported a 57% drop in profits versus the year-ago period.

The reason isn’t pretty, as higher costs and poor production numbers continue to plague havoc with profits.

At Exxon, oil and natural gas production fell about 1.9%[5], to a little more than 4 million barrels per day. This decrease in daily production is now the eighth consecutive quarter of year-over-year production drops for the energy giant. Much of the large production declines can be attributed to lower European natural gas demand as well as volume decreases across the Middle East and Asia Pacific regions.

On top of this, Exxon had to deal with rising costs associated with deepwater and shale drilling. We here at InvestorPlace have documented just how expensive it is getting to drill[6] for new oil/natural gas deposits, and Exxon — despite its massive size and economies of scale — is really beginning to feel the pinch. Exxon’s unit production costs have tripled since 2003 and have climbed 23.5% since 2010.

These rising costs, coupled with dwindling production at XOM, echo what’s going down at rival Royal Dutch Shell[7]. The Anglo-Dutch giant saw production of oil and gas decline 1.3% from a year ago.

As with its American rival, declining production was meet with higher overall drilling costs. The company’s Nigerian assets pose the biggest headache for RDS — Shell is the largest foreign oil producer in Nigeria and has suffered several attacks on its pipelines in the country’s eastern delta region in recent months. Those attacks and shutdowns have cost it about $250 million during the quarter and continue to rack up expenses for the integrated giant.

Perhaps even worse, Shell was forced to take pretax charge of about $3 billion on the $24 billion worth of North American shale assets[8] it owns as result of disappointing drilling results to strike shale oil. Outgoing CEO Peter Voser noted that the charge reflects the greater risks and costs involved in exploring some shale formations.

Is It Time to Move On?

Given that this is the umpteenth quarter of production declines while facing rising costs for the two majors, you have to wonder just how long they can keep this up.

A recent survey by Sanford C. Bernstein & Co. — which looked at 50 of the world’s biggest energy producers — found that as a group, their production costs are rising fast while profit margins shrink considerably. Generally, when E&P firms can’t find oil quickly enough, they’re stuck with aging fields where overall output is declining. That’s a bad thing. And as we’ve seen, it results in falling profits, which are beginning to hurt shareholders.

While Exxon has managed to generate $138 billion in cash flow after capex during the past five years, the company’s current $6.6 billion in cash is its lowest amount in more than a decade. More shockingly, XOM is curtailing its lucrative stock buyback program for the first time in several years, even as the pace of dividend increases continues to fall. XOM raised its dividend by 21% in 2012, but only increased it by 11% this year. The story is similar at Royal Dutch Shell.

At the same time, smaller and nimbler producers — like Range Resources (RRC[9]) and Whiting Petroleum (WLL[10]) — have managed to steadily increase cash flows, production and earnings while the majors have floundered. That has resulted in substantial share price gains for these smaller firms. Meanwhile, XOM has been one of the worst-performing energy stocks in the S&P 500.

Investors might want to shift the bulk of their focus away from the majors and toward these smaller independents. I wouldn’t abandon Exxon, Shell or Chevron (CVX[11]) completely, though; they still offer plenty of stability and dividends for a portfolio.

But the sun could be setting[12] on the integrated giants as a real growth element in the energy sector. More misses and production declines might just seal their fates.

As of this writing, Aaron Levitt did not hold a position in the aforementioned securities.

Endnotes:
  1. RDS.A: http://studio-5.financialcontent.com/investplace/quote?Symbol=RDS.A
  2. RDS.B: http://studio-5.financialcontent.com/investplace/quote?Symbol=RDS.B
  3. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  4. “value trap”: http://slant.investorplace.com/2013/08/blackberry-stock-bankruptcy-breakup-bbry-aapl/
  5. fell about 1.9%: http://online.wsj.com/article/SB10001424127887324136204578641682906395220.html
  6. just how expensive it is getting to drill: http://investorplace.com/2013/07/welcome-back-west-texas-intermediate-that-is-black-gold/
  7. what’s going down at rival Royal Dutch Shell: http://online.wsj.com/article/SB10001424127887323681904578641183049294110.html
  8. North American shale assets: http://investorplace.com/2013/07/israel-gassy-opportunity/
  9. RRC: http://studio-5.financialcontent.com/investplace/quote?Symbol=RRC
  10. WLL: http://studio-5.financialcontent.com/investplace/quote?Symbol=WLL
  11. CVX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVX
  12. sun could be setting: http://investorplace.com/2013/07/take-the-money-and-run-from-linn-energy/

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