Forget Oil Prices, This is the Number that Matters to Oil Companies

Source: Anadarko Petroleum Corporation.

There has been a lot of attention on the price of oil, which has been under a lot of pressure over the past year. Long gone are the days of triple digit oil with a new normal setting in that its price will be lower for longer. That said, many oil companies are now beginning to look past a particular oil price and instead are focusing on the margin they can earn from producing oil. It's a margin that was high when oil was over $100, but has taken a hit along with the price of oil. However, margins have been improving because of cost cutting measures, which is leading oil companies to refocus their attention on margin instead of the oil price.

Margin matters
Anadarko Petroleum (APC) was one of the companies that really highlighted the importance of margin over price as CEO Al Walker highlighted it on the company's second-quarter conference call. In answering a question on the call about the company's outlook on the oil price, he said, "it's really more about the margin and not about the hydrocarbon price." He then went into a bit more detail as to why margin matters more than price by saying,

We still see some improvement from the service sector in terms of our abilities to improve margins. I think there is a lot of things we've done that are permanent, as it relates to the efficiencies that we've put in place. So it's not just price reductions from various service vendors that in a different hydrocarbon price environment would come back to us as a higher price, these are actually sustainable improvements that will weather the storm of higher prices when we have those.

In other words, a lot of what Anadarko Petroleum has done to improve its margins are permanent improvements. It has become more efficient, which has the potential to save the company money not only in a low oil price environment, but is something that will stay with it when prices improve. Further, those efficiencies, when combined with lower costs from service providers, have really improved its overall margins during the current environment so that it isn't focused on an oil price, but instead on the margin it is earning on oil.

Source: Anadarko Petroleum Corporation

Still a ways to go
Having said that, Anadarko Petroleum still has some work to do on the cost side to improve its margins. It needs to become even more efficient and wring out even more costs before it will be prepared to resume growth focused drilling. Unfortunately, Walker doesn't see that on the near horizon as he said,

So it's really looking at the margins that we anticipate from our major asset plays through the balance of the year, looking exactly what we think we can achieve with those. And it just seems unlikely...that we're going to have the kind of margins that we have seen historically, that would encourage us to go back into a growth mode.

In other words, despite the cost savings from service companies and the efficiency gains, margins are not yet back to the historic levels at the current oil price that would incentivize the company to go back into growth mode at this time. Instead, it will need some combination of additional cost reduction from service companies, further efficiency gains, and/or a higher oil price to improve margins back up to that historic level it's seeking. In other words, it doesn't necessarily need a return of $100 oil, but it needs the margin it was earning at that level, which can be attained through a combination of higher price and lower costs. That said, he doesn't yet believe that, "we as an industry are anywhere close to the types of margin improvement that's needed before we go back into a growth mode" that would deliver strong returns that investors expect. 

Investor takeaway
There has been a lot of emphasis placed on the price of oil, however, the price isn't as important as the margins companies can earn from production and drilling. That margin has improved over the past few months thanks to efficiency gains and service cost reduction. However, it still is well off of the historic level that Anadarko Petroleum and its peers need to resume growth drilling. Given the current oil price prediction and cost estimates, it's not something the company's CEO sees in the near future. That said, investors do need to realize that margins matter much more these days than a particular oil price to drive Anadarko's growth going forward.