Could short-term capital discipline pressure lead to longer-term underinvestment in oil and gas as the energy transition to a low-carbon world unfolds?
“Our models suggest that investment will need to rise about 20% per year over the next three years to stave off a supply shortfall and then roughly $500 billion in annual capex will be needed by the end of the decade to ensure sufficient production,” said Rebecca Fitz, senior director and founding member of Boston Consulting Group’s Center for Energy Impact.
The insight, shared during a recent webinar hosted by the Center for Strategic & International Studies, shifts the conversation from a focus on peak demand to whether the industry is nearing peak investment in oil and gas. The conversation on capital also comes amid heightened focus on ESG and a global push toward cleaner sources of energy as oil and gas companies try to attract and keep investors.
BCG, working with the International Energy Forum, released a report in late 2020 stating upstream spending dropped by about 35% in 2020 compared to 2019. However, Fitz said spending so far in 2021 has recovered somewhat, as energy demand picks up following COVID-19 vaccine rollouts and precautions. “We’re still looking at about a $100 billion gap between 2021 and 2019,” she said.
With all the easy to trim project management costs already cut, improving the cost curve will require more innovation technology solutions, she added.
Gaining access to capital remains tough for energy companies.
The chances of seeing rounds of financing into traditional oil and gas companies is low, according to Ashley Fernandes, natural resources sector leader and portfolio manager for Fidelity Investments.
“I don’t think it’s necessarily an indictment of the industry by any measure,” he said. “I think it’s more a question of the returns that have been put up over the course of the past decade.”
Those haven’t been so great over the last decade for many companies, though several showed strong profits during the latest earnings season as oil prices rebounded from demand loss due to the COVID-19 pandemic.
The influx of investment the U.S. sector benefited from in the last decade is not likely repeatable, according to Fernandes.
When considering oil and gas investments from a public equity’s perspective, the formula is simple, according to Fernandes: it’s all about returns, regardless of whether it’s green or traditional oil and gas.
Still, “there’s nothing that would excite me more if I saw a company investing in a market that serves the energy transition, which has a couple of different ingredients,” he added. “The first is competitive advantage. Second is scalability and the third is returns. Those are the three magic things I’m looking for. It’s tough to see right now, to be honest.”
He used the offshore wind market, for example, saying rising steel and copper prices along with the potential for harsh weather conditions leave much room for error.
However, “Every time I go back to the spreadsheets and analysis I do, it tells me the supply curve will fall over quicker than the demand curve,” he said.
Core versus Low Carbon
Thinking about reinvestment in the core versus investment in low-carbon energy, Fitz said that some see the latter as future value creation. “Admittedly, we're not there yet. We’re upstream oil and gas in large part funding a transition.”
It’s a balancing act that energy producers are facing, and it’s one that has already led to portfolio adjustments or business model changes for some.
The cyclical nature of the oil and gas business brings with it volatility that’s unappealing to investors, which have demonstrated an appetite for investments that keep environmental impacts in check.
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The mandate of some companies—particularly the European ones—have changed and some can’t return to traditional investments, Fernandes added.
Speaking on a separate panel, Shell Oil Co. President Gretchen Watkins spoke about Shell’s renewables, low-carbon and core oil and gas business plus the importance of natural gas and carbon capture and sequestration in the energy transition.
Regardless of which energy source makes up the largest chunk of the mix in future years, understanding demand is key when allocating capital.
“About a third of the power that we buy and sell is renewable power,” Watkins said. “So we have customers, frankly, like Amazon and Microsoft, that have their own net carbon footprint reduction targets that come to us and say, can you help us by providing us with a portfolio that that is mostly or all renewable energy.”
Hydrocarbons are and will be still in demand, according to Watkins and Pioneer Natural Resource Inc. CEO Scott Sheffield, who joined her on the panel.
“We have a net-zero target by 2050, but that doesn’t mean that in 2050 we won’t be producing any hydrocarbons,” Watkins said. “In fact, we believe the world will still need hydrocarbons in 2050 and probably far beyond that.”
This outlook includes petrochemicals as well, she noted. “One of our biggest investments in the country right now is as at the Pennsylvania chemical plant,” she said.
And as for the Permian Basin—Pioneer’s primary asset, the prolific region will still be in play when it comes to oil production in Sheffield’s opinion.
If forecasts by the International Energy Agency pan out and “we’re down to 65 million barrels a day by 2050, then we think the Permian is still going to be producing at that point in time,” he said. “It’s still got huge potential.”
But he warned the world should not look to U.S. shale to fill the gap if demand picks up faster than expected in 2022 or 2023.
“There is no shale to save everybody like it did in 2014 or 2019 when we grew over a million-million and a half barrels a day,” said Sheffield. “I don’t think the U.S. shale industry will ever recover to its peak of roughly 10 million barrels a day or U.S. producing 13 [MMbbl/d].”
Lowering annual growth rates today bodes well for shale underlying decline rates.
“We used to decline at 45% per year. It’s moving down toward 30%,” Sheffield said, “and over the next three or four or five years, it should move even lower because you're building up this great base of lower decline wells as wells get older.”
Changing Models, Consolidation
For Permian-focused Pioneer, switching to what Sheffield calls the free cash flow model was needed for the company to survive through downturns and attract investors.
“Everybody knows we’re the worst performing industry in the S&P 500 over the last 10 years, so something had to change,” Sheffield said. He described the lows and highs of the company’s stock price as it went through the last three industry downturns.
Pioneer, which reported last week first-quarter production up to 473,937 boe/d compared to a year ago with adjusted net income of $396 million, has committed to return about 80% of its free cash flow to shareholders and grow production at only 5% per year.
That’s a change from the days when shale producers were growing at double digits, reinvesting more than 100% back into plays and growing rig counts. Back then, Sheffield pointed out, compensation was based on factors that included growth and reserve replacement.
Times have changed.
Like Sheffield, Watkins agreed the focus in the unconventional space has shifted to growing free cash flow. “It’s a much more prudent way to run a business,” she said. “We’re very much a value over volume investor in shales and frankly, in the upstream in general, that's really what we’re looking at, not out chasing barrels, but really chasing value and chasing cash.”
She believes the industry is seeing the same with the recent consolidation wave, especially in the Permian Basin.
“I think that the industry will be less susceptible to creating some of this volatility,” Watkins said, “but the markets, of course, no one knows what that’s going to do.”
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