Betting against Big Oil companies like Total (TOT +0.00%) is an awfully bold risk. Sure, they might not always perform up to the standards of the S&P 500 over extended periods of time, but Total and its peers also have the luxury of being some of the biggest players in an industry where demand will remain strong for decades to come. This, as well as some of the things coming down the pipe at Total suggest that good times may lie ahead for the company.
Just because there is promise for a company does not mean that it is exempt from issues that could cause share prices to fall, though. To help better understand what could prevent shares from doing what we want them to do, let's take a look at three major issues that Total has to deal with and how investors can keep track of these issues.
1.) Beholden to other operational masters for many of its projects
Looking up and down the project portfolio for Total looks pretty impressive. It represents more than 750,000 barrels of oil equivalent per day of production, several of which will be decades long cash generators such as heavy oil prodiuction in Canada as well as LNG. The one downside to many of these projects, though, is that Total is the operating partner in very few of these projects, and the ones where Total has the operator stake are mostly smaller projects that won't have a significant impact on the production portfolio.
Source: Total Investor Presentation
This is not 100% a bad thing; being involved in projects with multiple stakeholders helps to spread the costs -- and the risks -- around so no one company gets burned. The one drawback to this approach, though, is the companies that have the operational control of these projects could decide to ultimately not invest in the project, or operators could decide to continue with a project that may not be in the best interest of Total. This could keep Total involved in projects that may not look as promising as they once were -- ahem, Kashagan -- or be forced to sell out of their stake. Ultimately, this could lead to the company not meeting its production targets, which would eventually make its way to the bottom line of the company.
2) High exposure to geopolitical and operational risks
Looking up and down Total's production portfolio, one thing stands out. A lot of its production comes from either developing nations or from deep offshore regions. Also, looking at its new project portfolio, that dynamic isn't going to change anytime soon.
Source: Total Investor Presentation
Many of these regions will undoubtedly hold promise. The pre-salt formation off the coast of Brazil, for example, is estimated to hold several billion barrels of oil, and many believe that similar geological formations are just waiting to be found off the coast of West Sub-Saharan Africa. The one issue with having so much exposure to offshore and developing nations is the higher operational and political risks associated with them.
Operational risks for offshore exploration and production can be explained with one simple name: Deepwater Horizon. This isn't in any way an indictment of Total's operations in offshore exploration, in fact over the past 10 years their operational safety record has been strong and improving. But by the simple virtue of doing so much work in the offshore region means that it has a higher risk of an offshore incident.
Political risks are relatively self-explanatory as well, but one place in particular is worth highlighting: Nigeria. Total has seven major projects slated to come online in the next couple of years in the country, but for quite a while oil and gas companies have struggled with operations there. According to Royal Dutch Shell, one of the largest operators in Nigeria, it lost close to $1 billion because of issues involving theft, sabotage, and embargoes on its LNG export facility. Issues like this could permeate to other operators such as Total, and losing up to $1 billion could be pretty costly and could have a serious impact on both share price and dividends -- after all, Total's dividend is based on a payout ratio rather than a fixed dollar amount.
3) Masking weak free cash flow from operations with asset sales
Over the past three years, Total has spent a lot of money on new projects. Last year alone capital spending was at an all-time high of $30 billion. This big spending habit has basically wiped out any free cash flow generation from its continuing operations. Since 2011 the company generated 3% more cash from operations than what it spent on capital expenditures. The only reason that Total's returns look better over this period is that it has been propped up with close to $7 billion in asset sales.
As part of a program to improve profitability, Total estimates that it will sell between $8 billion and $12 billion in assets. Hopefully by then the company has put itself on a path that involves generating more cash from operations while spending less. Total does appear to have a plan in place that will lead to this, but if it can't then these meager free cash results will become that much more glaring on the balance sheet and could lead to a serious decline in returns.
What a Fool Believes
Don't get any delusions of grandeur if you are looking at Total as a potential investment. As an integrated oil and gas company with hundreds of billions of dollars of assets in a very capital intense industry, this isn't one of those high-flying stocks. Instead, investing in Total is more of a lesson in patience as you hold on for the long term and use the magic of dividend reinvestment to do the heavy lifting for you. However, things such as political risks and operational accidents can send shares plummeting at the drop of a hat without much warning (as BP shareholders know all too well).
From an investors standpoint, there isn't much we can do to foresee those kinds of issues. Instead, it's better to focus on the ones we can track and monitor. For Total, a metric that people should watch going forward is the company's ability to generate free cash from continuing operations, if cash generation remains weak compared to capital expenditures, then it's likely to lead to share prices going the wrong way.
