INSIGHT by Carbon Tracker
Strategy of natural depletion, returning money to shareholders or diversification for some may be best way forward as big impact to project cash flow values likely if commodity prices slide
Planning for declining upstream production may be the best way for many oil and gas companies to deliver maximum value to shareholders with growing adoption of clean technologies and tightening climate policy worldwide set to erode future demand, warns a report by Carbon Tracker.
High prices have spurred companies on to continue to approve investment in new oil and gas fields, but they risk coming on stream as global demand for oil starts to weaken. If companies oversupply the market, they will drive prices down and projects may never make expected economic returns.
“With demand expected to peak this decade before falling from the late 2020s onwards, producers must adapt, and prepare for falling long-term prices. Pursuing strategies of managed investment focused on short-cycle projects or natural depletion that we outline will reduce investor risk exposure.”
-Mike Coffin, Head of Oil & Gas and Mining and author of the report
Global demand for fossil fuels is set to peak before the end of the decade, according to the International Energy Agency. Demand for oil, which passed 100 million barrels a day in 2019 is set to fall to 92.5m b/d in 2030 and to 54.8m b/d in 2050 if current government policy pledges are met.
The impact of falling commodity prices as demand drops on the net present value (NPVs) of company portfolios could be significant, even for producing fields, the report Navigating Peak Demand says, but the hit to NPV of planned developments that are yet to produce are likely even higher.
However, many large companies, including ExxonMobil and Saudi Aramco, are still planning on continued growth in demand, with some even planning based on OPEC forecasts that would see oil demand rise to 116m b/d by 2045. Last month ExxonMobil and Chevron announced huge deals to buy producers Hess and Pioneer, while Shell and BP have recently rolled back planned production declines, indicating that they now plan for a slower transition.
The energy transition is being driven by the rapid growth of clean technologies and ever-stronger government policy. Although the supply shock following Russia’s invasion of Ukraine has seen companies make record profits as commodity prices soared, it has also encouraged governments to accelerate the roll-out of renewables to meet demand and improve energy security. Moreover, demand for oil and gas in power generation, transport and heating is being eroded worldwide by the rapid deployment of wind and solar generation, electric vehicles and heat pumps.
Much of this technological innovation was initially driven by policy in support of national climate targets, yet now the transition is happening under its own steam on economic grounds. In 2022, investment in wind and solar exceeded investment in upstream oil and gas for the first time. Global electric vehicle sales are expected to grow by 35% this year and in the UK will rise to over half of all sales from a quarter now, within just two years following a classic S-Curve shape of growth.
“If demand falls short of expectations, the market is likely to become oversupplied, putting more downward pressure on long-term prices. Revenues from all projects would be hit and as the transition accelerates only the most cost-competitive are likely to remain economic. Assessments of company valuations must account for this and recognise the pace at which the transition could unfold.”
-Guy Prince, Senior Oil & Gas analyst and co-author
Companies and shareholders should be prepared for potentially rapid corrections in securities pricing. “At some point market consensus will be reached that the transition is inevitable, and significant downwards price movements could then result,” the report says.
“The greater the disconnect with the reality of the energy transition, the greater the potential impact share price fall.” Oil and gas companies owe it to shareholders to assess the likely pace of the energy transition and plan the best strategy to preserve shareholder value. Investors too must recognise the risks as peak demand approaches and be open to new business models instead of pressing companies to invest in new production based on current high prices.
The report considers the implications of two investment strategies under two scenarios of future oil demand from the Inevitable Policy Response programme, representing a moderate and a fast pace of transition. Continued “business-as-usual” investment this decade would see significant oversupply under the moderate transition; to reduce this oversupply, and to reduce exposure to the worst effects of a fast transition, a prudent “managed investment” strategy could be to meet short-term demand from shale production that can be developed faster and deplete quickly.
This managed investment case sees such short-cycle projects approved up to a breakeven price of $50 a barrel, but conventional projects, with lead times of 3-5 years or more, only approved with breakevens of $20 a barrel or lower. This would meet short-term demand over the next 3-5 years and avoid significant oversupply of the market beyond that point, helping to keep price stabilised and protect revenues.
Companies that continue business-as-usual investment to replace or even expand production will be pursuing “a dangerous strategy” that could leave them highly exposed. New conventional oil and gas projects developed today may never be profitable, except at the lowest breakeven prices.
Companies which do decide to halt or significantly reduce investment in new production, effectively a managed wind-down, or to sell off assets face the choice of whether to return value to shareholders through increased dividends and share buybacks or diversify by investing in new businesses.
CEOs may favour a strategy of diversification given a vested interest, however it’s critical that shareholders and the boards they elect appropriately incentivise CEOs to protect shareholder value as the transition unfolds.
“There is no one-size fits all approach for what to do to with cash that would historically be reinvested. With the right combination of technical and commercial advantage then some new areas may be attractive, but becoming a growth business in a new sector is not a simple transition. It may well be in the interests of shareholders for companies to pursue a cash out strategy as production declines, and incentives, both for companies and their leadership must reflect this option.”
-Mike Coffin, Head of Oil & Gas and Mining and author of the report
Many oil and gas companies claim that they are well equipped to lead society through the energy transition, but the report notes that leading oil and gas companies contributed just 1% of global renewables investment for 2022.
In a world of falling demand companies could become motivated to maximise receipts while they can, so companies should consider the risk of OPEC deciding to produce at levels which drive prices down to a level which is unsustainable for listed companies.
The report says: “All bets are off if OPEC+ decide to open the taps. Even adopting a model of natural depletion – without further investment – may not result in a sufficiently rapid exit from the sector for many if prices are driven down.”
Explore the report
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