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Better than a dismal second quarter

The positive ought to be that this reporting season should at least seesequential cash flow improvement. This highlight aside, however, we look to aclutch of quarterlies that will at best support rather than enhance expectationson forward cash flow. With restructuring costs still prevalent,

volumesseasonally weaker and capex elevated our suspicion is that the emerging cashstatements will do little to advance the industry's investment case. Combinethis with an expectation that the recovery in oil is set for pause and we wouldrather buy potential cash inflection, not least at ENI and Shell, once the neartermtrading picture becomes clearer.

“Derr – it’s the commodity stupid”

With 3Q’16/2Q’16 commodity moves showing Brent broadly unchanged, USnat gas stronger and refining weaker the indicators don’t exactly suggest anoutstanding quarter. But push into the detail and higher utilisations in refining,seasonally better marketing and robust chemicals suggest downstreamearnings holding their own against prior quarter. Despite upstream volumesdown 2% QoQ, better margin capture from new project and in US gas point toa small uplift in E&P. Away from underlying earnings, this quarter feels asmuch a call on how to quantify the known unknowns of tax and restructuringcharges. Visibility is exceptionally low but our expectation is for sequentialimprovement as the drag from one-off charges roll over and cost savings beginto drive margin expansion.

What will the market focus on Cash flow

Of greater focus than earnings this quarter will (again) be progress on cashflow, where we provide an updated quarterly tracker by company within thisnote (page 3). Three quarters through 2016 and with investors focused mostsignificantly on the companies’ ability to rebalance their cash cycles – albeit in2017 and at a c$60/bbl oil price – we expect to see some improvement inunderlying operating cash flow versus a dismal first half. Of course cashstatements remain riddled with restructuring spend on the one hand and thenegative drag from tax lag on the other. At a time of project

delivery highermargin growth barrels are also frequently missing. Yet, annualizing first halfoperating cash delivery only gets us so far and to the extent that three quartersare a better predictor than two, the markers set have the potential to underpinor erode confidence in balance.

Valuation& Risk

So how do we position going into the quarter Despite the strong absolute andrelative performance evident across the sector since the start of the year wecontinue to believe that there is medium term value. All told the sectorcontinues to feel more a ‘buy on weakness’ than a ‘sell into strength’.
But withlittle conviction in the robustness of our quarterly forecasts our preferencewould to be to use weakness or improved confidence as a buying opportunity,rather than chase selected names ahead of uncertain results. In short, we gointo this season with our powder dry but with a view to later expending it onthose names where we see greatest potential for cash yield re-rating, namelyENI (Buy ?15.25) and Shell (Buy 2220p).