Oil and gas executives agree the biggest internal challenge to implementing their company’s strategy is the tension between the need to transform vs. the predictability of current operations, according to the annual EY Capital Confidence Barometer (CCB). Investors are putting pressure on companies to show how they are responding to the energy transition and their balance of capital investments in core businesses and renewables.

Creating and executing a path forward around two lenses—today and tomorrow—is a significant challenge. A constantly evolving portfolio strategy is integral to the approach. But what will that look like in oil and gas? And how will leaders and laggards be defined by it in the coming months and years?

Enhance today’s portfolio to increase efficiency, reduce costs

Even before the COVID-19 pandemic and the resulting drop in oil and gas demand, companies were reshaping their portfolios to improve financial performance, primarily in response to lower commodity prices. But those efforts gained new urgency in 2020. And while industry M&A transactions dipped sharply in 2020, a few key themes emerged: the deals that were completed were primarily focused on consolidating assets in a particular basin or basins, reducing debt or divesting of non-core assets.

This type of strategic portfolio enhancement is likely to continue and accelerate as companies strive to improve margins. In the EY CCB, more than half of respondents (51%) expect bolt-on acquisitions to be the primary planned M&A activity, while 24% point to acquisitions focused on increasing operational capabilities. A significantly smaller portion anticipate transformative deals or acquisitions in adjacent sectors. Increasing the number of low-cost and short-cycle projects, reducing late-life assets and consolidating lease holdings to increase scale in a particular region are all strategies that can help oil and gas companies reduce costs and improve return on capital.

Portfolio optimization should include non-M&A activities, such as high-grading processes and utilizing talent and digital approaches to advance operational excellence and enhance workforce efficiency. Digital tools and skilled employees to utilize them, can help companies lower general and administrative costs while maintaining rigorous health, safety, security and environmental protocols.

Additionally, portfolio changes play a role in longer-term decarbonization efforts. Divestment of fields that require significant energy usage to spur production, for example, can improve a company’s overall emissions levels and deliver ESG benefits, as can shifts to a portfolio that is more heavily weighted toward natural gas.

Strategic investments to enhance the transition

It’s clear that a driver of energy M&A in the years ahead will be the need to enter new businesses or acquire assets to maintain competitiveness in a transitioning marketplace, which will likely include those outside the traditional energy industry. In fact, 70% of oil and gas respondents in the CCB expect to see an increase in cross-sector M&A in the next 12 months.

To determine their roles in this future marketplace, oil and gas companies need to form their own views, or look to industry experts, to determine what the future holds with regard to economic growth, carbon pricing, consumer choice, changes to transportation and power generation demand and the expansion of alternative energy sources. Based on these forecasts, companies can project their capital expenditures and asset returns and ultimately determine the outlook for their current portfolios—or a potential portfolio—based on a broad range of futures. This approach will inform their transaction, asset and divestiture strategies on a recurring basis.

Additionally, companies need to be intentional about what parts of the alternative energy value chain in which they choose to invest. For example, oil and gas companies can respond to changing expectations by acquiring firms involved in emerging sectors such as carbon capture and storage, hydrogen production and geothermal technology. There are also opportunities in the fast-growing electric vehicle market. Services such as public charging stations and battery swapping management, customer apps and point-of-interface technologies, electric vehicle financing and leasing and fleet management can give oil and gas companies an entry into new markets and help balance the new with the old.

However, every energy (including alternative energy) project has well-defined roles, and each one carries different risks and rewards. As oil and gas companies consider their roles in the energy transition, they’ll need to ask: where do our assets and skills align with future opportunities in the alternative energy value chain? Only a few will be a good fit for the skills that they already have (or can readily acquire or extend) and carry risks that they are comfortable managing.

Leading companies are looking to their investor relations teams to confirm that the investing community recognizes these shifts in strategy and understands how key performance metrics are changing.

Proper capital allocation: the bridge to the future

While refocusing on profitable oil and gas production is a necessity today, it’s not enough to protect future growth and earnings in a world that is quickly evolving toward renewables. Oil and gas companies must smartly project future portfolio returns over a broad range of decarbonization scenarios to determine that they are making the proper long-term moves.

About the authors:

David Johnston is a partner at Ernst & Young LLP and serves as the EY US-West Energy Strategy and Transactions Leader. Mitch Fane is a principal at Ernst & Young LLP and serves as the EY Americas Energy & Resources Leader and US Oil & Gas Leader.

The views expressed are those of the authors and do not necessarily reflect the views of Ernst & Young LLP or any other member firm of the global EY organization.