By Alex Kimani
For more than a decade, esoteric fracking companies have been hot cakes for investors – particularly private equities – chasing high yields and growth, in large part due to the industry’s huge appetite for capital.
But lately, the tables have turned.
Investors are now shying away from energy plays amid growing concerns of dwindling cash flows, credibility and carbon.
The E&P (Exploration and Production) sector is experiencing a ‘crisis of perception’ as investors shun it based on perennial underperformance as well as Environmental, Social and Governance (ESG) aspects.
Money continues to flow from the sector to better performing index funds and/or other “greener energy” sectors, as evidenced by shrinking stocks and the sector’s weighting in the S&P 500 dropping from 13% at the height of the shale boom to just 5% currently.
So, how are E&P strategies changing?
Here are three main ways energy companies are tweaking their ethos.
Strategy #1: Cost Discipline
The growing reluctance to invest in E&P raises major concerns regarding capital availability for the sector. This is especially worrying in light of recent announcements by financial institutions, including banks and pension funds, to limit their allocations to certain or even all fossil fuel investments.
Consequently, energy companies have moved from living on a wing and a prayer, hoping for another oil boom to get them out of the rut to a more proactive philosophy where capital and cost discipline have become the new mantra.
Debt levels in the energy sector peaked in 2017 but have gradually been coming down. Debt and leverage ratios have steadily improved since then, driven by improved cash flows and increased capital discipline. Many companies turned to debt financing mainly as a stop-gap to keep production flowing in the hope that prices would rebound quickly.
Obviously, this has not happened, with the WSJ reporting that North American energy companies now have $200 billion of debt maturities over the next four years with $40 billion due in 2020.
The bad part: It’s unclear how they will repay that mountain of debt, and many might have to stick to the usual playbook of selling shares in the secondary markets. Investors hate share dilution, and this could trigger another wave of selling.
Meanwhile, although organic capex in 2019 increased compared with 2018, it’s still a fraction of the levels recorded in 2013/2014.
Strategy #2: Projects that Deliver Faster
As part of capital and cost discipline, oil and gas companies are rapidly shifting to shorter-cycle projects with faster payback periods. In many cases, they are prioritizing investments with a lower carbon footprint, especially gas.
According to IHS Markit Research, investments in low-carbon sectors by seven leading integrated oil & gas companies have exceeded $8 billion over the past decade.
The strategy seems to be paying off: According to the IEA, energy companies are bringing capacity to the market 20% faster compared to a decade ago. The changing energy system is helping the industry better manage capital at risk.
Nowadays, many people dismiss even genuine attempts by the energy sector to adopt the language of climate action and sustainable production as a disgraceful and desperate attempt at greenwash. But truth be told, scores of fossil fuel companies really are at the forefront of the clean energy drive.
Evolving new technologies, shareholder pressure, and rapidly changing consumer preferences are forcing oil and gas companies to explore new business streams, renewables being chief among them.
The last four years have seen a surge in renewables investments by oil and gas companies. In the first three quarters of 2019, oil companies closed about 70 deals in various renewable energy sectors including solar, wind and biofuels with Royal Dutch Shell Plc cutting the most valuable deals.
Interestingly, European companies lead their American counterparts by a wide margin, investing 7x as much in the renewable sector last year.
The question now is whether oil companies have missed the boat on changing their ethos to combat the crisis of perception among investors.
With $40-billion in debt coming due already this year, our answer to that question may come sooner than we think. The adaptation strategies are working, but they’re going to have to work faster. That’s also what’s likely to make 2020 a year of consolidation more than any other. Those who’ve managed to successfully tweak their ethos can likely scoop up those who haven’t for a nice discount.