Demand for energy never goes down, but it is fairly elastic to changing prices. The oil shocks of the 1970s finally led to demand peaking out in 1979 and according to this article, entered a period of stagflation.

On a global basis, that demand level was again seen only 10 years later, in 1989. Significantly, European oil consumption is still 5% below its historic high of 1979.

In their Vision for European Oil and Gas for 2014, Citi analysts Alastair R Syme, Michael J Alsford, Ryan W Kauppila, Mukhtar Garadaghi, David A Byrne and Nikhil Gupta say that the outlook for both earnings and returns “look challenging.”

European Oil: Deflationary pricing

Since the beginning of 2012, European oil stocks have under-performed the broad market by 24%, and the scenario going into 2014 is not very encouraging. After nearly three years of Brent oil trading about flat in the $103 range, the principal risk now is weaker pricing with Citi forecasting sub-$100 Brent.

“The simple point is that we think prices are deflationary to some degree. Oil refining looks very challenged as overcapacity grows, while we see a continued weak outlook for gas in US and Europe. Deflationary pricing = earnings risk,” says the Citi team.

Cutting back on capex not the solution

European companies have taken their foot off the capex accelerator and many are responding to pressure from shareholders to strike a balance between splurging cash on their huge capital spending programs and returning some to their shareholders.

French oil company Total has announced that it will taper its capex 2014 onwards, while Italy’s Eni SpA (BIT:ENI) announced a buyback. The BG Group plc (ADR) (OTCMKTS:BRGYY) (LON:BG) has also said it would provide a return to shareholders in 2015 and lower its capital spending.

But Citi has a different view. “Cutting high cost growth is not the same as capital efficiency. Ultimately, in an environment of flat to deflationary pricing, it will be greater capital efficiency that adds value to an asset, lowering the relative cost-curve position of the portfolio and boosting what remain anaemic returns for Big Oil,” they say.

To a large degree, this is also a legacy problem. Breakneck investing at high costs after 2007 is now affecting the ability to deliver returns, and thereby dividends. More seriously, new full-cycle projects have not delivered the returns envisaged. “Spending rocketed over the last decade – sector capital employed +180% (11% CAGR) since 2003 – but delivered very little in the way of operational growth. Growth in earnings/cash flow ended up simply being a function of rising oil prices,” say the analysts. This is brought out well in the chart below.

1-capex-vs-returns European Oil

European Oil: Exploration has potential, refining weak

A pessimistic market has devalued Exploration and Producing (E&P) companies to the extent that they now trade at their “core values” with no value being recognised for growth expectations or exploration opportunity. This is a sector that “still has capacity for out-sized returns,” says Citi.

On the other hand, a whole range of problems assail European refining:

  • Global gasoline oversupply, particularly in NW Europe and the Mediterranean, will pressure margins.
  • Due to political considerations, refiners have been slow to bite the bullet on labor rationalization and cost control; as a result 15% of European capacity is unprofitable. “In Russia and [the] Middle East, we are expecting continued additions of high complexity refining capacity, benefitting from cheaper feedstock and more favorable tax regimes, which will push European refiners yet further down the global refining cost curve,” warn Citi. (See chart below)
  • European refining margins were down 40% in 2013, and the decline could continue into 2014.

According to Citi, “We see rationalization as the industry’s only viable long-term solution in light of Europe’s stagnating demand and increasing inflows of cost competitive supply.”

2-cost-pressures European Oil

European Oil: Investment recommendation

All things taken, Citi analysts recommend investing only in those European Big Oil companies that have good growth and low cost resource/margin expansion. These are companies that have exposure to Brazilian oil assets and it is likely that their price multiples could fall in the future:

  • BG Group plc (ADR) (OTCMKTS:BRGYY) (LON:BG)
  • Galp Energia SGPS SA (OTCMKTS:GLPEF) (ELI:GALP)
  • Repsol SA (ADR) (OTCMKTS:REPYY) (MCE:REP)