IEEFA Update: Oil and gas industry caught in a capex conundrum
The oil and gas industry confronts a host of challenges that would have been inconceivable a decade ago: weak cash flows, meager profits, slumping stock values, volatile revenues, unreliable demand growth, and rising competition from renewables, to name just a few.
The industry now faces a quandary. Should companies continue to invest in new drilling projects, doubling down on their increasingly risky bets on fossil fuels? Or should they ignore long-term production growth and simply return cash to investors?
Both choices are fraught with peril.
When companies spend money in hopes of increasing production somewhere down the road, they alienate investors desperate for short-term returns. But when they increase payouts to shareholders without investing in the future, they signal that they’re a shrinking industry.
In 2008, the energy sector commanded roughly 16% of total Standard and Poor’s 500 market capitalization. Today, that figure has fallen to roughly 6%. In 1980, seven of the top 10 companies in the index were oil companies. Today, only ExxonMobil is in the top 10 (ranking tenth).
For much of the past century, Wall Street gauged an energy company’s value by the size of its oil and gas reserves. Oil and gas companies responded in lockstep, spending cash on exploration and drilling in order to boost their reserves.
After years of subpar results, however, as companies spent more on drilling than they realized from oil and gas sales, investors are now urging oil and gas companies to prioritize profits over production growth. Today, Wall Street punishes and gas companies that fail to exercise “capital discipline,” while rewarding companies that hand cash back to investors.
Nonetheless, some companies are once again finding reasons to boost capital expenditures. After three years of cutbacks and freezes, oil and gas capex will rise to $500 billion in 2018, by some estimates.
This trend intensifies financial pressures in a cash-strapped industry. Oil projects, particularly high-capital projects such as Canada’s oil sands and deep-water drilling, expose companies to severe long-term risks.
Prices will have to top $100 barrel, with a reliable upward trajectory, for company CEO’s to take their thumbs off cost controls. Natural gas investments may look more financially sustainable than oil because of projected growth in global demand. But natural gas is now a low-margin business. Pursuing growth in gas output exemplifies the production-over-profits strategy that has sapped the sector’s financial vitality.
Low and volatile prices make it more difficult for the industry to justify capital expenditures for drilling, pipelines, mining, and other infrastructure. And it becomes especially hard to defend new capital projects when the industry is still writing off prior failures.
MAKING CAPEX DECISIONS IS A DAUNTING TASK, in no small part because exploring for oil and gas is often a multi-decade process, fraught with risks that range from geological to geo-political. Multi-billion-dollar costs must be weighed against benefits that may never accrue. Making matters worse, price and demand forecasts are subject to unpredictable shifts in technology, policy, and economic growth.
Mistakes by oil and gas companies can have outsize consequences, due to the massive scale of investments.
Consider ExxonMobil, which as of 2016, was the only oil major that had not yet taken any significant write-downs of its assets, despite the sharp drop in oil prices in 2014. Exxon finally took significant impairments after the SEC began making inquiries:
- In 2016, the company wrote off more than 4 billion barrels of reserves in the Canadian tar sands. This amounted to 19% of the company’s worldwide reserves. It is a write down of a full decade of acquisitions wrongly predicated on the assumption of ever-increasing oil demand at ever-rising prices.
- The company also acknowledged a mistake in overpaying for the reserves secured in a $6 billion acquisition of XTO’s natural gas assets.
- The company wrote down other natural gas assets in 2016, and again in 2017.
- It recently acknowledged it would not be going forward with a North Sea deal with Russia.
Whether ExxonMobil’s investment missteps were also accompanied by false and misleading statements to its investors is an open question.
The oil majors—ExxonMobil, BP, Shell, Total, Chevron, Eni, and ConocoPhillips—vary in how they are address capital spending decisions.
At one end of the spectrum, ExxonMobil is doubling down on new oil and gas projects. Pick a continent, and Exxon plans to drill for oil or gas there. Over the next three years, it plans to spend $25 billion a year on average, much of it on upstream development. ExxonMobil appears to have no belief in—and no plans for—a low-carbon future.
In contrast, Total and BP have signaled a pivot toward a low-carbon future. Their activity on this front is modest but meaningful, and bears watching. Earlier this month, Total announced plans to take a $1.7 billion stake in a French electricity retailer, Direct Energie, increasing the parent company’s low-carbon assets. BP executives have committed to restraining capital expenditures in 2018 while describing aggressive plans for renewable energy investments.
THE UPSHOT TO OIL AND GAS INDUSTRY TURMOIL is that sophisticated investors now treat oil and gas companies as speculative investments. These investors are looking for cash, in the form of dividends and share buybacks, and are skeptical of high levels of capital expenditures for exploration and drilling.
The combined pressures of weakening prices, rising competition, and a negative investment outlook have diminished the status of fossil fuel investments in the stock market.
Further, the sector’s erratic financial performance strengthens the hand of its opponents. It increases the odds that activists will succeed in stopping individual fossil fuel projects. It fuels demands for market and environmental reforms. And it adds weight to the financial case for divestment from the sector as a whole.
Tom Sanzillo is IEEFA’s director of finance ([email protected]), and Kathy Hipple ([email protected]) is an IEEFA financial analyst. Clark Williams-Derry ([email protected]) is an IEEFA contributor and director of energy finance at Sightline Institute.
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