Former ExxonMobil CEO Lee Raymond advanced the idea in the 1980s that the quality of management trumped all else in evaluating the oil industry’s prospects. He believed oil company executives were in the best position to project supply and demand, ride worldwide growth cycles, and provide robust returns to investors, no matter how oil markets gyrated.
In Raymond’s view, oil prices mattered little: Whether oil prices were high or low, there were always ways for smart managers and a dynamic economy to generate healthy returns. Low prices offered opportunities to pick up valuable assets on the cheap; high prices generated extra cash that could be used to fund both investment and shareholder payments. Either way, good management would prevail.
Today, the rhetoric from top oil industry managers—ExxonMobil included—has been quite the opposite. As evidence of a rebound in the industry’s financial prospects, industry titans now routinely point to the rebound in oil prices. Their focus is no longer on company management, but instead, on the daily twists and tangles of global oil markets.
Global oil prices have certainly recovered from their April 2020 lows. Prices shot past $55/barrel at the beginning of 2021, and now hover in the mid-$70s. Stock prices have rebounded. The oil and gas industry led the stock market for the first half of 2021, a significant change from its last-place finishes of recent years.
The oil price increase not only benefits investors, it also offers relief to oil-dependent state and local governments in the United States. Many national governments around the world such as Russia, Saudi Arabia and Norway will benefit as well.
The industry’s recent rebound is muddied by long-term disappointment
But geopolitics has also revealed cracks in the oil industry’s bullish outlook. The memory of last year’s oil price war between Saudi Arabia and Russia remains fresh. And just last week, a disagreement between the United Arab Emirates and the rest of OPEC grabbed headlines. Harmony among oil producers remains elusive, as major exporters fruitlessly search for a “sweet spot” in supply and pricing that will satisfy everyone. When prices rise, cash-strapped producers face fiscal pressures to break production agreements, while well-positioned competitors see an opportunity for more market share. The market environment of the last few years reveals how low prices and slim profits have undermined the industry’s financial position.
Broad market measures tell us that the industry’s recent rebound is muddied by long-term disappointment. Over the last 10 years, the oil and gas sector has lagged far behind the Standard & Poor’s 500-stock index. And, while the stock gains are important, the oil and gas sector still claims less than 3% of the S&P 500, far from the vaunted days when it commanded 28% of the market.
This raises a question: Given today’s high prices and new-found cash surpluses, why are institutional investors still so shy about oil and gas?
The answer seems to be that the industry suffers from a failure of strategy and vision. Even industry leaders like Scott Sheffield, CEO of Pioneer Natural Resources, admit that the sector does not merit investor confidence. To Sheffield, there is a difference between the sound strategy of a well-managed oil and gas company, and mere cheerleading for higher oil prices.
But Sheffield’s voice is muffled by the arguments of ExxonMobil and other major oil companies. During ExxonMobil’s failed effort to convince investors this year of its financial recovery, it all but abandoned Raymond’s long-term view. Cash is now king and the engine of cash is the oil price, not sound investment strategy.
The institutional investors are making it clear that they are not buying opportunism over prices as a long-term strategy. They are saying that a company needs to show it is positioned to manage the energy transition. Investor votes and ongoing pressure have succeeded in changing the composition of ExxonMobil’s board.
A prolonged price spike will incentivize energy businesses that compete with oil and gas
But it’s not just ExxonMobil that’s feeling the heat from investors. Since January, BlackRock has given a green light to the New York City pension fund’s plan to divest its fossil fuel holdings. Its analyses for the city offer a clear-eyed view of how to manage the energy transition. New York State Comptroller Tom DiNapoli has adopted a plan to divest from fossil fuels that includes examination of the entire portfolio’s carbon footprint, even the footprints of companies that don’t produce fossil fuels. Meanwhile, the International Energy Agency (IEA) has made it clear that there is no need for new oilfield development if the world is to meet the goals of the Paris Agreement. The Norwegian government, a country where 25% of the economy is driven by oil and gas revenues, maintains the view that it faces long-term fiscal deficits through 2050 if it continues to rely upon oil and gas revenues.
Institutional investors are taking climate change more seriously. They are returning to the basics of long-term company and industry-level analysis. Governments, pension funds, universities and small investors are long-term investors because the needs of their beneficiaries are long-term.
Speculation, of course, has its place. Managed correctly, it can be quite lucrative. Anyone who invested in ExxonMobil at the beginning of the year, for example, would now be up 40%. But when an entire industry has dragged down passive indices for the last 10 years, it is time to ask some questions. ExxonMobil is down 23% over the last decade, while the broader market, represented by the S&P 500, has risen by 238%.
Another reason institutional investors remain skittish is that a prolonged price spike will incentivize energy businesses that compete with oil and gas. In prior business cycles, competitors in the power, transport and industrial sectors could not compete on price or scale. The competition now is real. In the power sector, fossil-free systems are being planned and operationalized as wind, solar and other alternatives challenge market share. A few years ago, ExxonMobil waved off electric vehicles as a fad. They now see it clearly as a competitor.
The deliberative pace of institutional investors is a protective and often frustrating check on the rough-and-tumble of the marketplace. If markets were theater, the irascible oil price would be the antagonist.
The oil and gas industry has a future. Perhaps it will find a sweet spot—a level of production that’s neither high enough to destroy demand nor low enough to eliminate profits. But in that sweet spot, oil will be smaller, both as an energy source and as a raw material for industry. It will also be less relevant as a financial resource.
The signal of rising prices is not “everyone into the pool.” Deliberative hands will proceed with caution.
Tom Sanzillo ([email protected]) is IEEFA’s director of financial analysis.
Clark Williams-Derry ([email protected]) is an IEEFA energy finance analyst.
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