Free cash flow is like the canary in the coal mine. Earnings can be massaged with accounting magic, but it is more difficult to massage free cash flow. Total (NYSE:TOT), along with its fellow big oil brethren, has seen its free cash flow fall significantly in 2013. Now is the time to examine the fundamentals and see just what sort of unique risks and challenges big oil faces.

Oil prices are stable, but free cash flow is falling



Sometimes, falling free cash flow is a short-term issue. Such was the case after the 2008 oil crash. Oil prices fell, and as a result free cash flow fell as well.

The current downturn is different. Oil prices have remained relatively stable and yet free cash flow is falling. The reason for this change is simple. Capital expenditures (capex) are rising at a rate far above revenue, thus cutting free cash flow.

It's not hard to see why capex is rising. Big oil deposits are hard to find, and many are even more difficult to develop. Just look at the Kashagan field. The field has estimated future peak production of 1.66 million barrels per day (mmbpd), and yet after spending $50 billion and 13 years of work the field is still mired in problems. There are reports that two 55-mile pipelines will have to be replaced with an expensive nickel-based alloy to counteract naturally occurring hydrogen sulfide.

The partners Total, ExxonMobil (NYSE:XOM), Royal Dutch Shell (NYSE:RDS.A), and others have already been slapped with a $737 million fine by the Kazakhstan government for the large number of delays. This fine is small compared to the bigger picture, however. The project may not come online until 2016 while posting $45 million per day in lost revenue, making for total lost revenue around $27.6 billion.

Is this peak oil?

The most extreme peak oil pundits conjure up the idea that in one instant the world will run out of oil and earth will grind to a halt, returning humanity to the collective technological capability of a caveman. While this could theoretically occur, it is more likely that a post-cheap oil world will come about in a gradual fashion.

The more tempered peak oil view is that once the easy-to-find deposits are extracted, costs will rise significantly as the industry goes after marginal supplies. This looks eerily similar to today's world. In 2004, Mexico's Cantarell field produced more than 2 mmbpd, a significant amount considering that North Dakota at its current peak is producing around 1 mmbpd. As of March 2014, Cantarell's production fell to 0.353 mmbpd and Pemex continues to struggle to replace lost output.

Big upstream firms are the companies that really suffer in this situation. Medium-sized drillers can find small deposits, grow, and turn a profit even if world oil production doesn't grow. Big oil has such a large production base that it needs to bring major fields online or face falling output.

How is an investor to attack this situation?

Total is a great example of how big oil can deal with the new world. Total has a number of big drilling programs active in Africa where it is hunting for big deposits. Further down the upstream cycle, it has six major projects expected to start up between the second quarter of 2014 and the end of 2015.

Total is de-risking its operation in innovative ways. While vertically integrating upstream and downstream operations is the traditional way to help stabilize earnings, Total is the majority owner of the major solar manufacturer SunPower. Total's 2011 $1.37 billion purchase of SunPower stock means that if hydrocarbons really fall out of favor, the company will be profiting from one of fossil fuel's best alternatives.

Get ready for the new world

Big oil can cut its capex to try to maintain its free cash flow and dividends, but its production will suffer. The alternative is to maintain capex, cut free cash flow, and constrict dividends to maintain production.

Total's dividend payout ratio is already 50, so don't expect any big dividend increases for some time. ExxonMobil and Chevron are in a better situation with respective payout ratios of 33 and 35. Their ratios of capex to revenue are rising, but they have more cash flow to play with as well. Royal Dutch Shell is worse off with very thin margins, a payout ratio of 68, and a big production base.

Focus on the best

Smaller firms like Total and Chevron are in better position to deal with the future. Total's strength is found in its African exploration programs and willingness to put big capital into alternative fuel sources like solar. Chevron is in a good position with its relativity low production base of 2.6 mmboepd in the fourth quarter of 2013 and low dividend payout ratio.

