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Could oil Majors and Independents generate record free cash flow this year?

International oil companies (IOCs) have just been through one of their toughest ever years. But the sector is primed for a V-shaped free cash flow recovery, potentially to record levels. What’s fuelling the shift in fortunes, and how will it shape corporate priorities?

This article is an extract from Majors and Independents primed for record free cash flow generation.

After the storm – IOCs are more resilient

In the depths of the 2020 downturn IOCs were haemorrhaging cash. But the crisis has forced them to take action to be more resilient to lower prices. Savage cost-cutting in response to the Covid-19 pandemic saw average corporate cash flow breakevens reduce from US$54/bbl pre-crisis to US$38/bbl. Our modelling shows that seven of the companies in our peer group of 40 IOCs would break even below US$30/bbl in 2021.

The scale of the financial reset has primed the sector for a recovery in free cash flow. At an average price of US$55/bbl, we estimate free cash flow generation could top US$140 billion in 2021 – exceeding any previous year since 2006. If oil prices reach US$70/bbl, free cash flow would be double the previous peak.

Deleveraging will be a priority for IOCs in 2021

Capital allocation priorities will be very different to any previous up-cycle.

Mending broken balance sheets is top of the list. Average leverage (excluding operating leases) ballooned over the last decade and hit 44% in the third quarter of 2020 – the highest this century.

To help weather future price volatility, companies will want to lower gearing, either by cutting debt, growing equity – or both. We expect most would prefer to deleverage towards the low end of historical gearing ranges, which is about 20%.

Companies will continue to plan for the worst, prioritising net debt reduction in redeploying surplus cash flow. Some will also look to speed up debt reduction by selling non-core assets.

Bringing investors back on board

The next priority is restoring investor confidence. Even as confidence in higher prices grows, investment will still be slow to recover. Strategic M&A will continue to favour paper over cash; share buybacks will be preferred over dividends for any surplus cash post-deleveraging.

The sector is in ultra-capital-disciplined mode to win over investors. And we expect it will stick to its tight management of investment for some time.

Concerns that under-investment could lead to a supply squeeze in the medium term are rising. Indeed, the free cash flow generation we forecast is in part a result of scaled-back spend.

Don’t forget the energy transition

At the same time as IOCs look to recover from the shock of 2020, they must also continue repositioning their portfolios for the energy transition.

An elite group of financially strong operators can afford to be more strategic at current prices, allocating more capital to grow and decarbonise their legacy businesses or diversify into low-carbon energy. Others will follow once their balance sheets allow.

How much surplus cash flow can IOCs generate after distributions? How quickly can they deleverage? Will higher oil prices trigger a new wave of investment? 

Interested in the top corporate themes for the year ahead?

We recently set out our predictions of five corporate themes to look out for in 2021.
Source: Wood Mackenzie

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