Crude awakening

One direct impact of COVID-19 has been to accelerate the demand for companies to generate free cashflow, particularly in the US shale sector. Those that cannot do so will struggle to secure financing, encouraging more consolidation and possibly a decline of the whole industry.

“There is no growth story for oil majors and these companies have been burning cash for decades. Whenever they have had free cashflow, it has come from selling assets. In fact, many are busy acquiring renewable assets and will let their oil and gas production decline,” says Lei Wang, credit analyst at Aviva Investors.⁴

An indirect consequence of the pandemic is that, in Europe and the US, stimulus packages to support the recovery are looking to shift investment into green areas, accelerating the implementation of decarbonisation targets in the industry.^5,6

Utzinger says these and other key trends have impacted oil majors over the last few years. The first is the growing regulatory and reputational risks that have pushed most oil majors to begin addressing their own emissions – for instance by curbing methane flaring, sequestering carbon dioxide (CO₂) and sourcing renewable power for oil and gas facilities.

In addition, investors have questioned companies over long-term value creation and new market opportunities, as the return on capital in the oil sector has been declining for several years.⁷

“The analyst consensus is that the age of high rents in oil production is over, so it is sensible to ask these companies whether they have identified any opportunities outside their conventional remit, which are in low-carbon technologies that would also future-proof their business,” explains Utzinger.

At the same time, the outlook for renewable energy has changed dramatically. Combined with the pressure around climate change and the increasing electrification of the energy system, it is a perfect storm for oil and gas companies.

Figure 1: Cost of solar versus coal, 2009-2019

Figure 2: Share of primary energy from renewable resources, 2019

“Energy storage and wind and solar power are on the S-curve of cost-reduction. What is also interesting is that renewables can be decentralised. If providers continue to implement cost reductions, energy can become much more easily available around the world. A decentralised energy grid could help billions of people who don’t have access to electricity today,” says Stathers.⁸

Over the last 18 months, this has culminated in some surprising commitments from the oil majors, albeit with a clear Atlantic divide, stemming in part from the fact North America has oil reserves while Europe is dependent on other regions.

“Europe’s dependency on foreign oil and gas pushes them to favour the switch. That is why authorities and other stakeholders have been supporting the growth of renewable capacity and putting pressure on the likes of BP to shrink their fossil fuel production. The US and Canada have oil reserves, so there is much less pressure there for the majors to transition,” says Wang.

European players, which account for about eight per cent of global oil production, have acknowledged public and investor concerns on climate change and are starting to take responsibility. Some are going beyond just the mitigation of direct operational emissions, towards including emissions that occur when customers use their products – for instance individuals driving cars.⁹ Others are less ambitious, targeting reductions in carbon intensity and ramping up clean energy production but adhering to some share of oil and gas production.

“You can almost see different visions of the future being articulated, ranging from completely reinventing themselves, which is the path BP is on, to articulating targets on carbon-intensity reductions, which is what Royal Dutch Shell, Equinor and Total have been trying to do,” says Utzinger.

North American oil majors’ approach is more reluctant. While their corporate disclosures articulate awareness and concern over climate change, the way it translates into corporate-level targets leaves room for improvement.

“For example, ExxonMobil has only applied intensity targets to its Canadian oil-sands business, so it is not encompassing the whole of its operations. Similarly, even though Chevron has made some progress over the last few years, it is nowhere near catching up with the European oil and gas majors,” adds Utzinger.

Despite some signs of progress, Wang and Stathers remain sceptical of oil and gas producers’ intentions to transform their business models completely.

“These are essentially mining companies that extract fossil-fuel reserves, not electricity-providing companies, which is what the future economy will be based on. They have two ways to go: they can buy all this technology if they don’t have the skillsets in-house, or they can run down their reserves and return cash to shareholders,” says Stathers.

Wang adds the conversion to renewables will be expensive, with no guarantee of future profitability; Utzinger agrees execution risk is a key question. Capital allocation presents another risk, if companies cannot find enough profitable projects to invest in to meet their ambitions.

“That being said, these are unprecedented times and maybe they can pull a rabbit out of the hat, and transition even faster than we assume. My view on those big commitments is that they should be welcomed, but with a caveat; oil companies still need to prove their competitive advantage in this new environment,” she says.

From a climate perspective, these potential acquisitions raise the question of added value. Will they just result in a transfer of renewable energy production, allowing the majors to achieve their climate targets, or will they lead to increased renewable capacity and lower overall emissions?

“The point here would be whether or not they have a projected peak and then fall in oil and gas production. For instance, BP and ENI have projected a production plateau to 2025, so you could argue their contribution might be net positive. By contrast, for companies that have articulated their goals around intensity, just adding a venture capital arm dealing in low-carbon energy won’t change anything if oil and gas production remains steady or increases,” explains Utzinger.

This could be offset if carbon capture and storage (CCS) technologies reach maturity. However, these have been discussed for a long time and the practical challenges to widespread implementation remain significant (as we wrote about here). Hydrogen is another area that seems to offer great potential, but the technology remains too immature to offer a clear vision (see Hydrogen: Back to the future). It would also require dedicated infrastructure, as well as energy and natural gas inputs, creating its own challenges.

In contrast with oil, natural gas produces half the amount of CO₂ per unit of energy to coal. It is widely seen as a transition fuel until the shortcomings of battery storage can be overcome, to make up for the intermittent nature of wind or solar-produced electricity.

Many oil and gas firms have included an increase in gas production as a substantial component of their emissions reductions.¹⁰ However, this is controversial, with the issue of fugitive methane emissions across its production, transportation and distribution.

“Methane has 24 times the global warming potential of CO₂ and, according to some studies, it means natural gas emissions could be equal to coal’s over the total lifecycle. At the moment, it is not being captured by the regulators or the industry, so it might come up as an issue,” says Stathers.

Utzinger agrees. “The US Environmental Protection Agency’s goals have been weakened, to remove all the requirements for operators to install technology to detect and fix methane leaks. The Oil and Gas Climate Initiative is a bloc of US majors that abide by a methane-reduction target of 0.25 per cent by 2025, but they only account for around 20 per cent of US output,” she says.¹¹

The cost of making the infrastructure compatible with carbon sequestration adds to the difficulty for firms on a net zero pathway; on the other hand, there is little appetite for further investment in gas infrastructure, and capital expenditure plans have reduced significantly.¹²

“Return on capital has improved thanks to production levels stabilising and because the winter months always drive prices up slightly. However, many producers are on the brink of bankruptcy and a lot of assets are not even sellable,” says Wang. “If prices go up, pumping operations will mushroom because production is easy to ramp up, but that will drive prices down again swiftly. There is barely enough demand to go around.”

Looking further ahead, the technology shifts mean renewables should get an increasing share of the energy pie. Oil and gas companies are likely to still be around, but the industry is consolidating at pace.

“We saw a first wave of consolidations in 2016, and conditions this year are forcing a second slew of forced marriages. European firms are already concentrated, but many US high-yield names are barely surviving, which is also putting pressure on a lot of oilfield services firms. There is pain everywhere,” says Wang.

As for the majors, Utzinger thinks some players might move aggressively with internal restructuring but most will keep the onus on oil and gas production, with some tweaking at the margins to expand clean energy.

What may also change the landscape, in addition to better battery technology, is regulation. Europe is moving forward decisively, and that seems a more likely prospect in the US too, judging by Joe Biden’s campaign promises and commitment to re-join the Paris Agreement.¹³ In the meantime, individual US states have implemented their own regulations to curb emissions over the last four years.

Ultimately, the biggest lever would be to apply an effective universal carbon tax, to finally put a price on the impact of oil and gas on the climate.

“At the moment, only 20 per cent of greenhouse-gas emissions have any form of carbon tax around the world, at an average of $2 per tonne. The International Monetary Fund says we need $70 to $75 per tonne to get on a 1.5-degree pathway. The money generated from that tax could then be invested to improve resilience and adaptation and stimulate a low-carbon economy,” says Stathers.¹⁴

In US high yield, the energy sector dramatically underperformed the overall index in the first half of 2020 but outperformed it later on. This was down to a recovery in oil and natural gas prices, a number of bankruptcies that led companies to drop out of the index and the fact many high-yield credits tend to be natural gas exploration and production companies (E&Ps), which were supported by a faster recovery of natural gas prices relative to oil. The natural gas price recovery was due to the rapid decline of associated production from oil producers. However, energy remains one of the most vulnerable high-yield sectors, with many companies still distressed.

Figure 3: Credit spreads of US high yield energy versus US corporate high yield

In the US investment-grade market, credit spreads of energy companies widened dramatically then tightened sharply in 2020. After the initial shock, the index rallied thanks to a combination of OPEC’s move to cut production, E&P's decision to both cut production and reduce supply, which led to a recovery in the oil price, and the fact weaker credits were downgraded to high yield and dropped out of the investment-grade index. However, even after the first news on vaccines, US investment-grade credit spreads for energy firms remain much wider than the corporate index.

Figure 4: Credit spreads of US investment-grade corporate energy versus US credit

In contrast, in the European investment-grade market, the energy sector performed in line with the market during the first COVID-19 lockdown. It has since underperformed, but valuations continue to closely track the movements of the European corporate index. “Spreads are not much wider than the overall corporate index, as the issuers are mostly oil majors with inflated ratings,” says Wang.

Figure 5: Credit spreads of pan-European investment-grade corporate energy versus the pan-European corporate aggregate index

While the balance sheets of oil majors remain relatively strong, investors should not assume that will be the case indefinitely given the structural uncertainty hanging over the sector.

“Over the medium term, these companies will have to significantly adjust their business mix, focusing on M&A, most likely in renewable energy,” says Tom Chinery, investment grade credit portfolio manager at Aviva Investors. “Questions are being asked about the valuation of certain assets as the risk of these becoming stranded increases. Companies that do not adjust for the future will be left facing tougher questions from investors.”

So far, however, companies that seem to have a clearer plan to transition to renewables like BP are not benefitting from tighter spreads than less ambitious ones. “A dramatic transition to renewables is not necessarily well perceived, as investors don’t like uncertainty,” says Wang. “BP and Repsol announced dramatic changes and that drove their share price down. This kind of transition is costly, and investors don’t know how to analyse and quantify renewable energy, which tends to have low returns on capital.”

Wang believes current differences between companies are more geographic in nature, pitting a US sector with many small players against a consolidated European industry. “Shale producers, for example, are not integrated in the way European players are, so they tend to be more vulnerable, due to lower regional prices and sharp declines when new shale sources are found,” she says.

Adding to the sector’s woes, refining companies are also suffering from weak global demand. Many refiners worldwide have been forced to shut, unable to even find a buyer. Midstream companies face higher risks too, as their customers are battered, and some regional pipes and infrastructure could be decommissioned if Biden bans fracking on federal land. 

“Europe doesn’t face such risks as the market is very consolidated, mostly made up of oil majors. European credits are holding up better than US ones due to the lack of competition in the region,” she concludes.

Oil and gas is not performing on the equity market either, a trend that predates COVID-19. Although US prices have risen significantly since mid-September, outperforming the rest of the S&P 500 (albeit from a low base), this may prove more of a ‘last hurrah’ than the start of a long-lasting recovery.¹⁵