At first glance, the future may look pretty bright for the large Western integrated oil companies like ExxonMobil, BP, Royal Dutch Shell, and Chevron – collectively known as Big Oil. Oil prices have risen dramatically over the past decade and continue to hover just above $100 per barrel, while US natural gas prices have rebounded nicely since hitting a low of under $2 per Mcf in the spring of 2012.
But despite relatively high commodity prices, there are some very serious threats facing Big Oil companies – challenges that could meaningfully constrain their long-term earnings power, ability to grow their dividends, and share price performance. Let's take a look at three of the biggest ones.
Slowing production growth
The first major challenge is that of slowing production growth. Due to a combination of legacy declines from maturing wells and the paucity of new supply sources, virtually all the Big Oil companies have seen a dramatic decline in their production growth over the past few years, with many reporting several consecutive quarters of falling year-over-year oil and gas output.
Indeed, ExxonMobil said its second-quarter 2014 production sank 5.7% year-over-year to the lowest level since 2009. Not surprisingly, most Big Oil companies have lowered their previous production growth forecasts and are now guiding for roughly 1%-3% annual growth through the remainder of this decade. Chevron, which expects to deliver 4% annual growth through 2017, has the best prospects of the bunch due to its focus on higher-growth regions like the Gulf of Mexico and onshore US shale. Still, the general trend for Big Oil's production growth is decidedly bearish.
High costs of development
The second huge challenge for these companies is high and rising costs of production. As the world's so-called reserves of 'easy oil' have been depleted over the course of decades of intensive drilling, Big Oil companies have increasingly ventured into remote and uncharted territories around the world in search of hydrocarbons.
These so-called 'unconventional' plays, which include US shale, Canada's oil sands, and deepwater, feature higher costs of production than conventional methods due to the need for more specialized drilling equipment and highly skilled personnel. While costs in many US shale plays have fallen considerably over the past couple of years as companies have made incremental efficiency improvements, wells in these plays still require an oil price of roughly $65-$80 per barrel to break even.
Average break-even costs are even higher in some deepwater regions and for certain types of oil sands projects. For instance, the typical new mining and upgrading project in Canada's oil sands requires an oil price of $100 per barrel to turn a profit, according to estimates by Canada's Scotiabank. If the price of oil falls by just $10 a barrel, these and other high-cost projects could quickly become uneconomical.
The third – and perhaps most controversial – challenge facing Big Oil companies and the upstream oil and gas industry in general is the potential cost of complying with new regulations aimed to limit climate change. It's generally accepted that we need to limit the rise in global temperature by 2 degrees Celsius above pre-industrial levels before 2050 in order to avoid potentially catastrophic damage to the Earth's environment.
But in order to achieve that goal, we have to seriously curtail greenhouse gas emissions caused primarily by the burning of coal, oil, and natural gas. According to a report by Carbon Tracker, a London-based think tank, the goal of limiting the global temperature increase by no more than 2 degrees Celsius can only be achieved by drastically reducing our consumption of these fossil fuels.
This means that a huge percentage of the reserves owned by Big Oil companies cannot be burned, potentially rendering them useless. While improbable, if that turns out to be the case, these companies may have to take an unprecedented writedown on the value of their reserves, which would likely slash their market values and send their share prices tumbling.
The bottom line
Big Oil companies may be well known for monster profits but serious challenges to their business models loom. Slowing production growth, high and rising development costs, and the threat of policies aimed to curb global warming are some of the biggest challenges these companies need to surmount. Cautious investors would be wise to carefully consider these risks before investing.