Energy Industry Struggling to Generate Free Cash Flow
In my previous column, Energy Industry Capital Spending Reaching New Highs, we looked at how the industry continues to ramp up spending across its sectors. As I noted, this is no surprise given the enormous capital requirements to sustain its business models.
However, what is surprising is that despite the significant tailwind of high crude prices since 2010 to current, net free cash flows (operating cash flow less cash capital spending) have actually declined for the industry overall. Operating costs are increasing crimping margins, and investment spending is rising faster than top-line revenue growth. To put things into perspective, although total industry operating cash flow (OCF) dropped only 1% in 2012 from 2011, from 2007 to 2012 spending grew at a per annum rate of nearly 10% while OCF increased at a 5% per annum rate.
The worst offender has been the U.S. E&P sub-sector heavily weighted to natural gas production at low prices; the sector has seen its deficit cash flow grow. In 2012, despite spending decreasing 2% from 2011, OCF dropped a whopping 17%. From 2007 to 2012, capital spending grew at nearly a 7% per annum rate, while OCF increased only 3% per annum.
Seeking to build infrastructure to meet growing production from unconventional oil & gas shale plays primarily in the Northeast U.S., North Dakota, and Texas for transport to markets, the midstream sector has focused on capacity growth with only one year –2011– from 2007 to 2012 posting positive FCF. Although OCF nearly kept pace with spending growth rates on a per annum basis from 2007 to 2012, 0% to 9%, respectively, the total dollar outlays exceeded cash inflows.
Likewise the utility sub-sector has focused on building natural gas fired generation to replace retiring coal fired plants. Utilities’ spending have grown roughly 11% per annum from 2007 to 2012, while OCF grew at a per annum rate of under 9%.
Seeing the pullback in spending by the U.S. E&Ps and a moderate increase by the western multinationals in spending, the Oil Service sub-sector pulled back in spending in 2012 from 2011 by 3%, and improved cost control helped improve OCF to increase by 4% 2012 from 2011. Indeed, good bottom line management enabled the sector to record only one deficit year from 2007 to 2012; from 2007 to 2012 spending did increase at a 9% per annum rate, while OCF increased only 2.4% per annum.
Not surprisingly, despite capital spending growing at a per annum rate of 10% from 2007 to 2012, and OCF growing 3% over the comparable period, the Western Majors (IOC) with their consistent emphasis on financial performance only had one deficit year in 2009, at the height of the global economic collapse. In 2012, their FCF fell 5% from the year before, but remained positive.
Although the U.S. refiners recorded FCF deficits in 2008 and 2009, the widening of the WTI-Brent differential provided a significant tailwind to their margins, as their feedstock costs are recorded at WTI prices and their refined products are based on Brent prices. The best of both worlds, as their OCF jumped 33% in 2012 from 2011, and rocketed 188% in 2011 from 2010. From 2007 to 2012, spending increased 18% per annum, while OCF grew at an impressive 28% per annum.
The WTI-Brent differential has collapsed to under $13 per barrel, and for the 1Q 2013 average, WTI and Brent prices are below 2012 comparable levels by 8% and 5%, respectively. The lower prices and spread coupled with costs that in general will remain stubbornly high, will most likely contribute to lower earnings for the energy sector in the 1Q 2013 compared to the 1Q 2012. With weak energy demand driven by an overall anemic economy in the U.S. and globally, expect free cash flows to remain challenged into 2013 for the energy sector.