Oil prices up - will oil company EPS rise too?
Oil prices are soaring. Does this mean that we are going to see sector upgrades to levels seen in 2008? It might seem counter-intuitive, but I say no, even with the Brent price approaching the highs of 2008.
Four years ago, strategists from the big investment houses got it wrong: they believed the oil price level was sustainable. Their estimates for EPS increased sharply for the years 2008-2010, see chart 1 below.
Those estimates almost followed the oil price level in tandem, and then a dramatic decline in oil prices changed the whole picture. Earnings ended at depressing levels compared to the hyped expectations.
This time around, I think the strategists and analysts are more reluctant to incorporate higher oil prices into their EPS estimates. Instead, I suspect they will corporate the higher oil prices in an incremental fashion. As time passes, the revenue and profits are booked, and subsequently the EPS will be revised up. There is not much “forward looking” in this, but this is what I expect at the moment. A stronger for longer situation could persuade the investment banks to change their stance and a general upgrade could emerge. I see this more as a late 2012 story.
Extracting oil costs more than it used to
The above angle was a general change of momentum. Another angle to be aware of is some structural changes over the five years. Notice that increasing oil prices do not spill over to EPS over the long period seen from 2004 - see again chart 1. There are several reasons for this phenomenon. First of all the price of extracting oil has increased, as new fields are in more difficult locations, such as deep water.
This is reflected in margins. EBITDA margins have been in the 43% level in 2006-09, but in 2010 there was a drop to the 39% level and 2011E/12E are expected at the same level. This does matter a lot for the bottom line if 4% of revenue disappears to expenses on sub suppliers etc., see table 1.
Secondly, depreciation and amortisation has risen as increased investment is required to extract oil. This has put pressure on the EBIT margin, on top of the erosion on EBITDA level. The above factors are some of the reasons not to expect earnings to be revised up substantially on back of the latest oil price rally. EPS will not match the higher levels seen in 2008.