Oversupply Threatens European Oil Refiners Profit Margins

A potential correction to crude oil prices poses risks to European integrated oil major’s ability to control operating costs and enhance profit margins, especially in their downstream segments, according Fitch Ratings.

Furthermore, a prolonged downturn in oil prices or continued difficulty in the refining sector could delay cash generation needed for companies to meet their strategic goals and thus have a negative impact on ratings, Fitch says in European Oil Majors – Update(Premium)

“A widening gap appears to be developing between upward crude oil price momentum in the futures market and supply and demand fundamentals on the ground,” says Jeffrey Woodruff, Senior Director in Fitch’s Corporate Energy team in London. “If oil prices start to trend lower over an extended period, European oil companies may not be able to generate sufficient operating cash flow to return credit metrics to more normal levels.”

As European oil majors increased borrowings in 2009 to fund capex and dividends during the downturn in the business cycle, their financial profiles have deteriorated alongside slower cash flow generation. Whilst Fitch rates issuers on a “through-the-cycle” basis using its conservative oil price view, for credit ratios to return to mid-cycle levels, companies will need to begin demonstrating in 2010 that business conditions are improving and cash flow generation is materialising.

Within the downstream segment, Fitch anticipates it could take up to three years to rebalance global demand and overcapacity for refined products to a level significant enough for refining profits to fully revert to the long-term average.

Examples of companies redeploying downstream assets includeRoyal Dutch Shell Group’s (RDS.A, ‘AA+’/Stable) announced plans in February to sell 15% of its global refining capacity, andTotal SA’s(FP, ‘AA’/Stable) announcement of specific refining shutdowns over late-2009/early 2010. These announcements reflect the need for the European oil industry to battle both a drop in demand for oil products and 15-year low refining margins.

Recent analyst comments via Alacra Pulse:

‘The underlying story for Royal Dutch Shell from 2012 is compelling,’ said Richard Griffith analyst at Evolution Securities. But he has a ’reduce’ recommendation on the shares since the recovery means Shell needs to complete a number of key projects in order to turn its finances around. (citywire)

Lucy Haskins at Barclays Capital believes Shell is being overly optimistic about the outlook for refining margins and that a mistake here could see the cashflow come in below Shell’s guidance. But even she is lifting her price target to £20.50 to reflect the higher cash generation forecasts.

Alistair Syme at Nomura doesn’t thinks Shell is appropriately priced based on its own profitability outlook.

Citigroup analyst Mark A Fletcher and Michele della Vigna of Goldman Sachs are much more upbeat. Both and have ‘buy’ views on the shares. They see good upside potential of 13.3% and 42% respectively.

“CEO delivered goals and plans during the firm’s 2010 strategy update that were more specific than in past years. While this meeting helped to identify how Shell plans to boost upstream production and retool downstream operations, it did not change our outlook or fair value estimate. “ Catharina Milostan, Morningstar

Total SA is one of the largest companies onAudit Integrity’s Western Europe Investor WatchList of companies that Audit Integrity views as having the greatest short-term equity risk.