Insight: How the Lost Decade for Oil Was the Golden Decade for the Majors
After the 1986 collapse, oil prices stayed stable for a decade. Still, European Majors outperformed strongly during those years, with low volatility. In this note, we investigate whether this can happen again. The Majors face many near-term headwinds, but this scenario is worth exploring.
1987-97: A lost decade for oil but a golden decade for the Majors. Oil prices collapsed from ~$30 to ~$10/bbl in 1985/86, but by May 1987 they had recovered to ~$18/bbl. They would stay close to that level over the next 10 years. Still, the European Majors performed strongly during that decade, returning ~17% per year, well ahead of the market at 12.5%.
Key to this strong performance was a high dividend yield at the start of this period. By mid-1987, the Majors were yielding 1.8x the wider market's yield, implying low investor confidence in the sustainability of these dividends. As that confidence was restored, yields contracted. The high starting yield and its contraction over time drove this strong 10-year outperformance.
Full dividend cover remained elusive for a decade; yet no Major cut the dividend. Surprisingly, the Majors covered their dividends with organic FCF in only three out of the 11 years from 1987-97. On average, organic FCF funded just 79% of dividends, with the balance coming from disposals. Clearly, full cover is not required for the Majors to perform strongly over a long period.
Despite flat oil prices, cash flow grew supported by constant cost improvements. After initial sharp cost savings in response to the 1986 downturn, another wave of more structural cost savings followed. Throughout 1987-97, upstream operating cost fell on average 5-6% per year in real terms, for a total real-term decline of >50% between 1985 and 1997. Combined with 3% production growth p.a., this allowed cash flow to grow despite flat oil prices, supporting the Majors' dividends.
Could this happen again? Some key factor are in place again. Dividend yields are similarly elevated, there is substantial scope for cost cutting once again, a healthy project pipeline is likely to drive modest growth, and room to fund 20% of dividends through disposals appears to exist as well.
Although there are also reasons to be sceptical too. The downstream was a tailwind which may not be repeated, oil prices do not yet show the modest recovery they did in late 1986, and 'energy transition' means the future may not look like the past.
Outlook 2016 – stay 'Attractive'. We are agnostic about the next decade but see an attractive outlook for 2016. Rising prices and falling costs are likely to drive FCF recovery and yield contraction. Top picks Total and Statoil.