Statoil ASA's Focus on Returns and Higher-Grade Assets Should Pay Off

This year has already started off on a much better foot for Statoil (NYSE: STO  ) than its recent stock market experience. Maligned for its high finding and development costs, its dependence on high oil prices, and its weaker near-term production growth, Statoil investors had to endure a frustrating stretch where the short term-obsessed market wasn't willing to give the company its due.

Now, though, the market appears to be taking a more optimistic view. The turbulence in Ukraine has drawn attention back to Statoil's position as the largest supplier of gas to Europe outside of Russia. At the same time, management has openly turned to a more returns-oriented approach and has spent the last year upgrading its portfolio and making some major oil and gas discoveries. Valuation for oil and gas companies may be frustratingly imprecise, but Statoil seems to be offering a good mix of improving returns, capital appreciation, and a solid yield.

Leaner and smarter
Statoil's February analyst day highlighted a lot of the key changes that the company has been making. The company lowered guidance for capex spending through 2016 by about 8%, choosing to push out its prior target for 2020 production in exchange for higher targeted returns on capital employed.

A greater focus on returns (as opposed to growth) is central to the Statoil story today. Unlike rivals like BP (NYSE: BP  ) and ExxonMobil (NYSE: XOM  ) with expansive global operations, Statoil is choosing instead to focus on core areas like Norway (the North Sea), the U.S. (Gulf of Mexico and unconventionals), offshore Brazil, and offshore Angola. Along the way, Statoil was also active in divesting assets throughout 2013, selling assets with high capex demands and less impressive long-term return prospects. This ultimately had the impact of upgrading the quality of Statoil's portfolio, if at some expense to overall growth.

On the growth front, Statoil is still most likely going to lag BP, Exxon, Chevron (NYSE: CVX  ) , and Total (NYSE: TOT  ) in the coming years, as it takes years to bring major projects into production, and these other majors will be taking advantage of investments started years ago. Looking out to 2016 or 2017, though, the picture changes and Statoil's relative growth prospects start to improve with the contributions of projects in North America, Brazil, and Africa.

These are all welcome developments for Statoil investors. Examining one quarter (or even one year) can be misleading, but Statoil's 4% production decline in the fourth quarter didn't compare well to Exxon's 2% decline, Chevron's 3% decline, BP's 2% decline, or Total's flat performance. Likewise, the company's profitability was quite poor (around $9.50/bbl, versus an industry average of $13.50), and the rolling return on average equity in upstream operations was below the industry average (around 13% versus better than 14%), and well below the likes of Chevron (20%-plus) and Exxon (18%-plus).

Showing its operating skill
By virtue of getting its start in the difficult North Sea, Statoil has built up some significant expertise in harsh and difficult environments, as well as identifying promising assets. For 2013, Statoil generated an organic reserve replacement rate of 147% and discovered 1.25 billion new barrels of oil (equivalent), with two of the 10 largest discoveries of the year.

By way of comparison, BP posted a reserve replacement rate of 129%, Total saw 109%, Exxon saw 106%, and Chevron saw an 85% reserve replacement rate. Chevron's low replacement rate in 2013 is basically a fluke, but Chevron may well be the only major oil company that will challenge Statoil's production growth over the next decade (remembering, again, that Statoil will most likely trail the group over the next three years or so).

Statoil is also stepping up its game when it comes to enhanced oil recovery methods. Looking ahead, this will be a key factor if Statoil is to hit its return targets and close the valuation and performance gap with Exxon, Chevron, BP, and Total. Statoil is devoting about half of its R&D budget to enhanced recovery technologies, and the company has already increased recovery on the Norwegian Continental Shelf from around 30% to 50%, with a not-so-distant goal of 60%. If Statoil can transfer this success to its U.S. unconventional shales, Brazil, Angola, and other North Sea development projects, it will provide a significant boost to production, profits, and returns.

So what is it all worth?
Statoil has long traded at a significant discount to its major oil and gas peers, at least in terms of short-term metrics like EV/EBITDA and EV/DACF. This discount was explained in large part by the company's poor near-term production growth prospects, its higher finding and development costs, and its weaker profitability (whether measured by profits per barrel or returns on capital employed).

It may be time for that change, given the company's significantly upgraded growth, profit, and return prospects. Translating my NAV calculation into a discounted cash flow approach, long-term production growth of around 3% and improvements to just industry-average returns leads to a fair value of over $28. Looking at more short term-oriented measures like EV/EBITDA, Statoil could continue to trade at a sharp discount to the industry (a 3x multiple versus an industry average closer to 7x), and still merit a fair value above $33.

The bottom line
Statoil management seems to have learned from years of relative undervaluation and investor disgruntlement. Instead of growth for growth's sake, or diversification for its own sake, management seems to be much more focused today on profitable growth and quality over quantity. It will take a few years for this strategy to really bear fruit, but investors still have an opportunity to benefit from Wall Street's skepticism that Statoil's expertise in finding oil and operating in difficult environments will lead to strong real results.

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