Moody’s predicts lower margins from higher upstream opex in 2023

Sopuruchi Onwuka

Global upstream operating expenditure in the petroleum industry is set to jump in 2023 but investors would expect decreasing marginal returns from reinvestments in the industry which would be ruled by unstable market outlook in the midst of diversified energy options.

According to research notes from Moddy’s investor services, aggregate global upstream spending is expected to rise sequentially by up to 15 percent in 2023, even though overall spending will still fall below pre-pandemic levels.

Figures used in the research notes are not immediately available to The Oracle Today but the advisory firm made it clear that higher investments, operations and dividend expenditures expected in 2023 would be funded from cash flows while efficiencies of scale are also expected to tame cost and boost earnings.

Moody’s said the upstream petroleum industry would in the year enjoy favourable demand and supply fundamentals even in a lower and more volatile price situation as the industry continues to navigate policy changes associated with the risks of the prevailing energy transition.

The firm holds that prices would hover below the 2022 levels but would remain strong enough for most producers to generate solid cash flow and muster the financial capacity to propel growth.

The reports stated that companies with large portfolios would earn enough revenues to enable them reduce leverage, make returns on shareholders investments, and drive organic and inorganic growth. It said that larger E&P companies and large integrated oil companies would deliver the strongest free cash flow and have the most flexibility.

Vice-President at Moody’s, Sajjad Alam, stated in the report that although prices would remain above the midrange in the year, volatility and delicate balance would shape the market. He also pointed at constraints to supplies, wavering demand, and sharp price swings as factors that would rule the market in 2023.

According to Alam, “While we expect average prices to stay above mid-cycle levels in 2023, we also anticipate a high degree of price volatility in a delicately balanced global energy market. Various factors will constrain oil and natural gas supplies, while demand growth will waver because of increased recession risks and shifting policies in the largest energy-consuming nations. Sharp price swings will remain a norm, making large or long-term capital investment decisions difficult for companies.”

Moody’s noted that companies would take measures to cope with emerging issues in the industry, including higher taxes and stricter ESG regulations. The company added that producers would also grapple with prevailing global inflation, higher cost of oilfield services and tight labour markets in the year. The situation, the company stated, would push up aggregate upstream spending by about 10-15 percent while overall spending would fall below 2016-19 levels.

“Higher taxes on oil and gas profits in a growing number of countries will also discourage incremental investments. Most producers will try to follow the same playbook in 2023 that yielded strong financial results in 2022,” the company stated.

It added that over 50 percent of the incremental spending in 2023 would be propelled by cost inflation, leaving relatively little capital for volume growth. It listed cost sources to include oilfield services, a tight labor market in the US, and lingering supply-chain delays.

These would all limit any E&P company efforts to expand production capacity quickly in 2023, the firm stated in the report.

The situation, according to Moody’s would require that operating companies be more strategic in investments, cost management and portfolio alignment in order to achieve strong financial results and position for sustainable production.

“Companies will look to exercise capital discipline, invest strategically, and maximize free cash flow to strengthen balance sheets, maintain high levels of shareholder distributions, and better position their asset portfolios and production levels for long-term energy transition risks. While energy security has taken center stage for many nations following Russia’s invasion of Ukraine, companies will continue to take incremental measures to reduce their emission intensity as policymakers globally press forward with their goals to transition to cleaner energy sources,” Alam said.

The company also warned that funds reinvested in existing operations would record decreasing marginal returns, leading to higher breakeven and longer recovery period. Risk aversion would mean that operating companies would prefer inorganic growth to riskier exploration drilling programmes.

“Each dollar reinvested will generate fewer volumes, lower margins, and less return on invested capital in 2023. Breakeven costs have been rising across all geographies, and producers focused on US shale basins are gradually exhausting their top drilling locations over time. Yet, reinvestment rates will remain low by historical standards with most companies planning to dedicate only 50-70% of their operating cash flow to maintain productive capacity.

“Stronger companies will likely favor acquisition and consolidation opportunities over increasing their drilling programs, to minimize the risks of cost inflation, excess supply and shareholder backlash,” said Sajjad Alam.

The year will also see operating companies flowing funds back into the hands of creditors and investors in terms of debt repayments and share buybacks, thus improving credit rating of many players in the industry.

According to the report, upstream companies will have greater capacity to return capital to investors in 2023, after repairing balance sheets in 2021-22. Moody’s stated that most large companies have signaled that they would pay up to 75 percent of free cash flow to shareholders through additional variable dividends and share buybacks.

The report noted that 2023 price outlook would allow companies sustain substantial debt reduction that happened in 2022, improving the sector’s overall credit quality while rewarding shareholders with high dividends and record levels of share buybacks.

According to Alam, “While high shareholder returns are sustainable during periods of high commodity prices, companies will have to pare these activities quickly or lever up if prices fall precipitously, which may not be welcomed by equity investors after getting accustomed to recent high returns. But the likelihood of a sustained steep price collapse is low, that should allow companies to sustain their elevated distributions.”