Staring down the barrel
Transformation Insight: the oil and gas sector
- Traditional business models in the oil and gas sector have come under scrutiny
- In most cases, limited diversification of the product offering coincides with a hefty carbon footprint
- Climate litigation risk is growing steadily
- Only those companies that adopt a comprehensive transformation strategy will succeed in the long term
Time is running out for the oil and gas sector
Some may recall that, just a few decades ago, there was concern that humankind might run out of oil. In 1974, geologist Marion King Hubbert predicted that global oil extraction would reach its peak in 1995 and that oil production would decline significantly from this point onwards. In the end, technological advances and the discovery and development of many new oil fields meant that Hubbert’s prediction did not come true. And from today’s perspective, the idea of all remaining oil reserves being extracted is a concerning thought for entirely different reasons. In order to curb climate change, as much of it as possible should be left in the ground untouched.
Despite all efforts that have been undertaken so far, fossil fuels such as coal, gas and oil still accounted for around 80 per cent of global demand for primary energy in 2019. And based on the New Energy Outlook 2020 published by Bloomberg, the global appetite for energy is not declining but, in fact, increasing, driven by countries such as China and India. The International Energy Agency (IEA) conducted a study that came to similar conclusions1. However, our window of opportunity for action is closing. In addition to the necessary substitution of fossil fuels by renewable energy sources, the oil and gas sector also needs to improve the CO2 efficiency of the oil- and gas-based energy and derivative products it provides.
Two significant events have further highlighted the importance of transformation in recent weeks:
A potentially groundbreaking ruling by a Dutch court requires oil company Royal Dutch Shell to improve its climate strategy, which was deemed too vague and not ambitious enough2. The court reasoned that the strategy currently in place was incompatible with the objective of the Paris climate agreement to limit global warming to 1.5°C. It demanded that the reduction of carbon emissions be stepped up to 45 per cent by 2030, when Royal Dutch Shell had previously aimed for a reduction of just 20 per cent. This ruling could have far-reaching implications, especially if it is upheld by the court of appeal. Other big oil and gas companies – sometimes referred to as the Oil Majors – may also need to overhaul their climate strategies in this scenario.
As far as the facts are concerned, the reasoning of the judges from the Netherlands is also backed by a report from the International Energy Agency that has attracted much attention3. The demands and suggestions contained in the report, set out in the form of a roadmap, are remarkable – not least because the IEA had historically always emphasised the significance of fossil fuels and underestimated the growth of the renewable energies sector. According to the IEA, reaching net zero emissions in the energy sector by 2050 while ensuring a stable global energy supply will require a number of conditions to be met and measures to be implemented, including:
In order to reach the reduction targets, the IEA study envisages no new oil and gas production projects from 2021 except for projects that have already been approved.
Annual expenditure to meet energy needs has to be increased from US$ 2 trillion per year to around US$ 5 trillion by 2030. Investment has to be clearly focused on renewable energies (especially wind and solar farms) that will progressively replace fossil fuels.
Substantial research spending will be required in order to find ways to use renewables even more efficiently and develop further technological solutions to support the transition to green energy. After all, the aim is to achieve 45 per cent of the planned emission reductions by 2050 through the use of innovative technologies. In some areas, government support will be required to mitigate some of the initial costs, which can be extremely high – for example in the field of green hydrogen technology.
The IEA’s study sets out that there is a way of achieving net zero emissions if the necessary measures are implemented successfully, as outlined in figure 1.
Figure 1: Trajectory of global greenhouse gas emission reductions*
In this scenario, greenhouse gas emissions from fossil fuels are reduced drastically by 2050. The small residual amount of emissions will be offset, for example, through the integration of carbon capture, utilisation and storage (CCUS) techniques in production processes or methods to capture carbon dioxide directly from the atmosphere (DAC)4. The measures recommended by the IEA and the reduction trajectory they project show that the endeavour of transforming the sector is ambitious, but achievable.
Emissions have to be reduced at all levels
So much for the theory. The practical implementation is, of course, complex and subject to a fair amount of uncertainty. For starters, oil and gas companies will need to find ways to cut their own emissions (scope 1 and 2), for example by reducing the flaring of gas during extraction, preventing unwanted methane emissions and using more green electricity at their plants. But, even more importantly, oil- and gas-based end products (such as fuel for combustion engines; scope 3) have to be decarbonised to the greatest possible extent5. Affected downstream sectors need to find alternative energy sources and new input factors.
The sector basically has to try and square the circle here. In effect, the goals of the Paris climate agreement and, by extension, the Dutch court ruling, the IEA report and similar guidance, call for nothing less than the abandonment of the traditional business model of these companies. How are the companies handling this? Three different ‘coping mechanisms’ are emerging, which seem to be influenced at least in part by whether the business in question is a state-owned company or a private enterprise.
Climate pioneers: A number of companies took the decision several years ago to withdraw from their traditional environmentally harmful business lines as quickly as possible and to shift their focus to segments that fall within the renewables sector. One prominent example is Orsted – formerly Dong Energy. The Danish company’s operations used to be focused on coal, oil and gas, but it now plans to withdraw completely from the fossil fuel segment by 2025 at the latest. Instead, Orsted intends to become a leading wind farm operator and green power supplier. Another example is Neste from Finland, which now primarily produces biodiesel. The company specialised in this segment early on and has managed to become the market leader. Today, Neste already generates the bulk of its profits from this sustainable line of business. In terms of climate action and transformation, these two companies are therefore pioneers within the sector.
The unyielding: The future strategies of many national oil companies (NOCs) present a stark contrast. Because these companies are state-owned and – in most cases – not exchange-listed, they are less exposed to public and regulatory pressure and are, to some extent, even actively protected by their governments. Many of these companies do not necessarily treat the transition to a business model with a smaller carbon footprint as a priority. In fact, players such as Saudi Aramco, Qatar Petroleum, Abu Dhabi National Oil and various Chinese oil companies have been stepping up their purchases of additional oil and gas assets – at the risk that these investments could turn into ‘stranded assets’ in the long term. At present, NOCs already account for around 85 per cent of the global oil supply while exchange-listed global Oil Majors contribute just 15 per cent. In the short and medium term, NOCs cannot be counted on to reduce their carbon emissions swiftly and significantly.
Some private oil companies form the US are also lagging behind their (European) competitors when it comes to climate-related transformation efforts. Like many NOCs, Exxon and Chevron seem to be focusing primarily on strengthening and expanding their position in established business segments and are showing little interest in a more diverse and less carbon-intensive product portfolio. The only nod to calls for transformation is the increased use of CCUS technology – albeit purely to offset their own emissions. And yet, there is a crucial difference compared with NOCs: Shareholder pressure on Exxon and Chevron has been mounting, especially more recently. Calls from investors for these companies to adopt transparent and credible climate strategies are growing louder.
Transformation candidates: While the Oil Majors are playing a diminishing part in the extraction of fossil fuels compared with NOCs, their role in the hunt for strategic and technological alternatives should not be underestimated. Some of them are willing to transform. Their approaches differ in some respects, but what they have in common is the ambition to develop a more carbon-efficient product offering that can satisfy the continuing unbridled demand for energy in the market. Figure 2 provides an overview of climate-friendly, future-oriented areas in which selected Oil Majors are investing and the amounts being invested.
Figure 2: Investment in alternative low-carbon technologies is rising
In 2020, the coronavirus pandemic inevitably upset companies’ investment plans. But nonetheless, oil and gas companies have been investing not only in wind and solar power but also in other technology and efficiency-focused projects. Energy storage systems, CCUS, biofuels and hydrogen applications, for example, play a key part in the expansion of the product offering. BP, Royal Dutch Shell, Equinor and Repsol are among the founding members of the international Hydrogen Council initiative. Their hope is that they will be able to tap into business opportunities in the hydrogen sector in the long term while improving their carbon footprint at the same time. Many Oil Majors already have assets and expertise relating to their current operations that can also prove valuable for new lines of business. For instance, parts of the existing pipeline infrastructure could be used to transport hydrogen in the future, and the underground spaces from which oil and gas reserves have been extracted could be used for carbon storage as part of CCUS processes.
Transparency, consistency and credibility will be rewarded
Companies that are prepared to transform themselves and that also meet the necessary social and corporate governance criteria are analysed and rated by Union Investment based on three proprietary key performance indicators (KPIs):
Vision & strategy (KPI 1): The company must be willing to transform and demonstrate this by means of clear strategic targets for decarbonisation and continuous transparent reporting on its transformation progress in the short, medium and long term. Aspects that are factored in by the analysis include, for example, whether the company reports both absolute and relative CO2 metrics in relation to its production and whether it pursues and complies with sufficiently ambitious emission reduction targets. In addition, social risks and social criteria relating to the company’s operations have to be taken into account in a transparent manner, not least in order to preclude potentially costly reputational risks.
Sustainable investment strategy (KPI 2): Investment decisions have to be consistent with the goals relating to KPI 1. Available capital should not be allocated to the fossil fuel segment in any material quantities. Instead, it should be used to expand the low-carbon product portfolio. Potential areas for investment include renewable energies, biofuels, CCUS, a broader product offering in connection with electric-powered transport and increased efforts in the field of CO2-efficient energy services. Capital expenditure in relation to digitalisation and personal safety is also taken into account.
Credible corporate management (KPI 3): It must be evident that the supervisory board is aware of the risks arising from the lack of a sustainability strategy and it must take such risks into consideration. Management board remuneration should be linked directly to several relevant, measurable ESG criteria. Lobbying activities and memberships of industry associations should be disclosed in order to improve transparency in the realm of corporate governance.
Companies that meet these standards and are willing to be benchmarked against them will be able to successfully undergo the necessary comprehensive transformation process. A positive side effect is that trailblazers will attract greater interest in the capital market, especially from sustainability-oriented investors.
Transformation can succeed – but not overnight
Who the winners and losers of this incipient transformation process will be remains to be seen. But almost all (private) companies are getting involved in the search for new complementary business models. However, this capital-intensive innovation process will probably only start to bear fruit in the medium to long term. In the short term, companies with relatively low production costs who may even be expanding their market share through purchases of additional oil and gas assets will have a financial advantage. This applies primarily to some NOCs. But in the long term, this may well prove to be a Pyrrhic victory. Ultimately, the same external conditions and risks apply to all affected parties in this sector:
Regulatory and statutory requirements are forcing exchange-listed companies, in particular, to tackle their transformation. Stubbornly clinging to the existing product portfolio is therefore a risky approach that could prove fatal in the future, especially for NOCs that are unwilling to change.
In addition, carbon pricing – for example through emission allowances – is on the increase in many countries, exposing affected companies to mounting cost pressure. This has an adverse impact on the profitability of fossil fuels and end products derived from them and, by extension, on the sector as a whole.
The repercussions of these developments in the capital market are already far-reaching. In recent years, companies from the oil and gas sector have been forced to recognise billions in impairment losses in respect of existing projects and plants because the value of these assets no longer matched their (higher) historical valuations. This is bad news for investors with a long-term focus who are exposed to these companies. There is a persistent risk going forward that plants (especially expensive ones) of certain oil and gas companies will become ‘stranded assets’ if sites have to be closed for profitability reasons or if further impairment losses have to be recognised.
The number of capital market participants who are turning their backs on companies that do not have a credible climate strategy and fall into the aforementioned unyielding camp goes beyond sustainability-oriented investors and is growing steadily. In the long term, this could become a financial burden for entire countries. The most susceptible economies are those that do not have diversified sources of income but are instead heavily dependent on revenue from fossil fuel exports, for example several countries on the Arabian Peninsula.
Transforming the oil and gas sector will be a long, complex and costly process, but it is necessary from a climate change perspective and it also creates opportunities for transformation candidates. Strategic investors can use this to their advantage in the capital market:
The success of climate pioneers such as Orsted and Neste could serve as an example for other companies that a fundamental transformation can provide a path to a prosperous future. After all, Neste and Orsted have not only become market leaders in very promising segments, but have also been rewarded for their transformation efforts in the capital markets. Investors who established positions in these companies early on benefited from significant price gains.
Transformation candidates that manage to gain a market share in new, promising, low-carbon segments ahead of their competitors are well positioned to benefit from an ‘early mover’ bonus in the capital market. This bonus serves as a reward for a credible strategic reorientation and is also a way in which these select companies can benefit from growth in these markets of the future from an early stage. Noteworthy examples in this category are mostly European companies such as Total, Equinor and Repsol, who have been making significant efforts for several years to expand their operations in the wind and solar power segments.
Companies that manage to develop and implement a credible and transparent and climate strategy are generally also less likely to be affected by climate litigation and are better protected against reputational damage. This sets them apart from competitors in the sector in a positive way. Among the Oil Majors, Eni from Italy has set the standard with its ambitious CO2 reduction targets. For instance, in June 2021, Eni became the first company in the sector to issue a sustainability-linked bond with a coupon that is tied to specific sustainability targets.
Conclusion and outlook
From Big Oil to Big Energy – this is the vision that companies in the oil and gas sector need to pursue against the backdrop of climate change. But the journey will not be straightforward and likely a marathon rather than a sprint. Not all market participants will get on board. But the transformation of the oil and gas sector is crucial to the fight against rising greenhouse gas emissions and continued global warming.
There is no ‘one size fits all’ roadmap for a successful transition. The starting conditions differ too much from one company to the next, as do their individual target visions for future core business activities. What matters most from an investor’s perspective is that companies’ transformation plans are sufficiently ambitious, consistent and transparent, so that the success of their transformation can be measured on an ongoing basis. The most promising strategies in terms of sustainability are those of companies that plan to progressively transition from their existing product portfolio to carbon-efficient business lines. By contrast, the strategies of companies who continue to focus their operations and investment activities on fossil fuels because the industry environment is still favourable (for now) are most problematic from a long-term perspective.
Union Investment uses its proprietary analysis of key KPIs and its engagement initiatives to assess and support the transformation process that has begun in the oil and gas sector. The aim is to identify credible transformation candidates that are suitable investment targets even for sustainability-oriented investors.
- 1 See also the IEA report ‘Oil 2021 – Analysis and forecast to 2026‘, published in March 2021.
- 2 See also context and outcome of the lawsuit against Royal Dutch Shell.
- 3 See also IEA: Net Zero by 2050 – A Roadmap for the Global Energy Sector.
- 4 DAC is short for ‘direct air capture’, a process that uses a special filter to extract CO2 from the air. The captured CO2 can then be used as an input factor, for example in the chemical sector.
- 5 Scope 1 emissions are directly linked to the extraction, processing and transportation of oil and gas. Scope 2 comprises any emissions attributable to the sector in connection with the purchase and use of energy and heat. Scope 3 emissions arise outside the sector from the use of fossil fuels (e.g. in internal combustion engines) or as an intermediate product (for example in connection with chemical products).
Angela Quiroga Manrique and Mathias Christmann
As at: 12. July 2021