Putting a price on Big Oil – how to value oil stocks

The future of oil is uncertain, but some of the major oil companies are not being given the benefit of the doubt, says Cris Sholto Heaton.

Shares in Big Oil – BP, Chevron, ConocoPhillips, Eni, Exxon Mobil, Royal Dutch Shell and Total – collapsed at the start of the pandemic and have remained out of favour even as the market recovers. BP and Shell (both down 35% since the beginning of 2020) are especially weak, but Eni, Exxon, Chevron, Conoco and Total (down 15%-25%) are also lagging, despite oil rebounding to where it was three years ago. 

The evident fear among many investors is that these firms operate in a dying industry. The world will move away from oil and they will be out of a job. This is a very real uncertainty – but as profits rebound, it’s worth recalling how much cash these firms can generate and what their options are.

Running down the reserves

The seven oil majors had reserves to production (R/P) ratios that ranged between 8.3 years (Shell) and 15.5 (Exxon) at the end of the 2019 fiscal year (I’m using 2019 because the oil-price collapse in 2020 meant some of them wrote down reserves that should be viable with oil back at higher levels). Free cash flow (FCF) also varies greatly: Shell averaged almost $25bn per year across 2018 and 2019 (when oil was $65-$75 per barrel), while Exxon averaged almost $11bn. This isn’t because Exxon has weaker underlying cash flow: instead, Shell is reinvesting less cash in finding new reserves.

We can do a crude calculation for how much spare cash each firm might generate in just these booked years of reserves if oil stays around $70 (the average across 2018 and 2019). Assuming each firm pays off its net debt steadily over that time and using a discount rate of 5%, I’d estimate that the present value of future free cash flows is about 80% of Shell and BP’s market cap, about two-thirds for Total and Eni, but more like 40% for Chevron and Conoco, and 30% for Exxon. 

I stress this is very crude. Shell won’t shut down in seven years’ time, for example: the reserves won’t be used up evenly and there will be a long tail of production. All the majors – even the ones with low R/P ratios – are still investing in finding new resources. The split between oil and gas varies between companies, as does the cost and complexity of their projects. FCF in 2018 and 2019 may not be an ideal proxy for long-term cash flows. You could easily build a far better model.  

Still, it’s hard to avoid the sense that BP and Shell are almost priced as if they are in run-off, with the market putting little value on their long-term prospects in either oil and gas or renewables. Meanwhile, others – eg, Exxon – are priced to suggest their new oil and gas investments will have long-term value and not end up stranded. The difference at least partly reflects how much BP and Shell’s dividend cuts alienated income investors. With payouts starting to rise (up 38% at Shell and 4% at BP), then so long as the world doesn’t abandon oil faster than seems likely, both look extremely cheap plays in a cheap sector.  

The seven oil majors
 Market cap.Net debtR/P 2019Free cash flow avg. 2018/19
BP$62bn$33bn14$8.3bn
Chevron$199bn$35bn10$15bn
Conoco$76bn$11bn11$5.3bn
Eni$44bn$12bn11$4.5bn
Exxon$244bn$57bn16$10.9bn
Shell$115bn$66bn8$24.6bn
Total$100bn$25bn12$10.3bn
Sources: Bloomberg, Morningstar

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