The definition of what constitutes a “viable” energy company has changed, with more unknowns added into an increasingly complex equation
Market conditions are changing as more energy sources are becoming commercially viable. At the same time, energy companies are held to high standards by shareholders, governments and the general public when it comes to resilience, flexibility and decarbonization. This requires petroleum producers to balance their strategy between repaying debts and improving profitability, reshaping their investment portfolios to remain viable in the long run, and reducing their carbon footprint. These strategic concerns are intertwined and in some cases contingent upon each other. A future-proof strategy needs to secure value creation through responsible and efficient growth, while also investing in decarbonization. Which begs the question: what companies should be doing to remain investable in the new market reality?
Read our special insight from Olga Savenkova, Vice President and Head of Sustainability Analytics at Rystad Energy.
Oil companies have enjoyed strong cash flow in recent years thanks to high energy prices. With investments in upstream oil and gas production fairly balanced, the additional cash could have provided an opportunity to invest more heavily in decarbonization and low-carbon areas to speed up the energy transition. Yet, large oil and gas companies have prioritized returning more cash to shareholders. A decade of poor capital discipline and low returns in the oil and gas industry, coupled with the long-term market uncertainty, has left overall portfolio investments low. This becomes clear when comparing the return on capital employed (ROCE) for majors’ upstream businesses over the past 20 years with the ROCE of their overall portfolios – an analysis that can also shed some light on why companies are hesitant to invest more in low-carbon sectors.
Both upstream and overall portfolio ROCE have been on a downward trend since 2008. The inflection point for oil and gas companies was in 2009, when the sensitivity of returns to oil prices lost its elasticity. As a result, returns continued to fall even during the period of high oil prices from 2010 to 2014.
Changes in portfolio composition, is one reason for the disparity. In 2003, about 80% of the majors’ producing portfolios consisted of low-cost, conventional assets, such as onshore and shallow-water assets with productive reservoirs and flexible contract terms. These assets provided proven, attractive returns across commodity price cycles. However, starting in 2008, high-cost, capital-intensive assets such as US shale and deepwater projects began to take up more space in the majors’ portfolios.
Portfolio ROCE shrank to zero in 2020 due to low oil prices and drastic budget cuts during the Covid-19 pandemic. Record high cash flows and disciplined capital allocation sent the return on capital back up to more than 15% last year – however, the 10-year profitability is still quite low even when including 2022 results.
The recent period of relatively lean years for oil and gas companies means that their first order of business now is to recover from the downturn, secure their balance sheets, pay off debts, prioritize shareholder returns to gain back investors’ trust, and making sure their investments will be viable through the cycles. Once investors start to see improved returns for an extended period, companies are likely to reinvest more capital to support faster growth of their low-carbon businesses. The lessons learned from the previous oil price boom, when high investments into pioneering segments eroded returns, is likely to make companies more cautious about redeploying capital into decarbonization and low-carbon areas until they have carefully assessed the potential profitability and long-term impact on portfolio returns.
In this context, what seemed to be the right recipe for oil and gas companies over the past few years is not going to be the right one for the future. A future playbook for oil and gas companies is now centered around three main concerns: repay, reshape and reduce.