The low price of oil has influenced the strategy of companies in the oil and gas sector and ourengagement with them.
Setting the scene
Just a few years ago, the long-term forecast by energy experts and organisations was that the only way for the oil price to go was up. Increasing demand for the commodity, fuelled by more industrialisation in developing countries, as well as shrinking reserves and geopolitical conflict in oil-producing countries bolstered the price a decade ago. However, with the advent of the shale oil and gas revolution in the US the price of oil began to slide, creating the low oil price environment of today.
A glut of shale oil and gas in the US, subdued global demand for oil, coupled with strong supplies, including increasing production from Iran and stable output from the Organization of Petroleum Exporting Countries (OPEC) despite ongoing geopolitical tensions in the Middle East, have created a weaker environment for the oil price. OPEC’s ability to affect prices has been limited as Saudi Arabia has chosen not to reduce production.
As a result the price of WTI crude oil plummeted from over $100/barrel in 2014 to below $30/barrel in February 2016. Although the oil price has recovered since, a long-term recovery to $100/barrel is not in sight anytime soon.
This has been a wake-up call to the industry, which had been resting on its laurels for too long in the belief that oil prices would never be low over long periods of time. Oil companies are now more accepting that longer periods of low oil prices are increasingly likely future scenarios although they continue to bank on the recovery of the oil price to $60-70/barrel. And this has had major impacts on the activities and strategies of extractive companies.
Companies in the sector have had to cut back on their overall costs. While some have reduced the dividends they pay to their shareholders, others have been trying to conserve cash and borrow to maintain their dividend policy. Others have stopped the buy-back of their shares.
Some oil and gas companies are increasing their debt to increase the dividends to investors. BP, for example, reported that its net debt increased by 20% in 2015.
The low oil price has also led to sharp reductions in the capital expenditure of oil companies. High-cost, long-lived projects have been slowed, postponed or even cancelled, with oil companies believing that the restriction of supply will help prices to increase.
After spending billions of dollars on its two drilling seasons off Alaska, oil major Shell, for example, announced the withdrawal from its Arctic drilling programme in 2015. The company has written off its investment, blaming its failure to find meaningful oil and gas reserves and the uncertain regulatory climate in the US for the aborted mission.
We came across varying estimates of the operational costs of each barrel of Arctic oil extracted, but if there was little imminent prospect of recouping the capital expenditure already spent and likely to be spent in a low oil price environment, Shell’s decision was maybe a matter of business economics, made more simple by the reputational and regulatory difficulties it experienced there. Its balance sheet is under particular pressure following the company’s strong commitments concerning its dividend policy and the acquisition of UK peer BG Group, which again was predicated for higher oil and gas prices.
Most US shale exploration and production companies are in varying degrees of financial distress and only able to pay the interest on their debt by using the revenue from existing production and cutting costly drilling. This will allow others to begin to buy distressed assets cheaply, particularly as their debts mature and hedges expire.
Canadian company Suncor Energy has already bought other Albertan oil sands assets, as players in the region have also been struggling. In addition to the low oil price, the introduction of an emissions cap and a higher tax on greenhouse gas emissions by the provincial government of Alberta in Canada have put further pressure on oil sands activities.
Solar and wind are beginning to reach cost parity with prices from the electric grid in the developing world. However, superficially, it is still a higher oil price that strengthens the case for renewables. Prolonged low prices for oil and gas reduce the attractiveness of investments in energy efficiency and renewables as investments will take longer to pay back. However, the oil and gas industry has a history of betting on high oil and gas prices as they invest in massively capital-intensive projects that often overrun their budgets. This suggests that investors may increasingly find investments in the low-carbon economy much more attractive. This will be particularly the case if the momentum of the post-COP21 climate agreement is maintained.
Any exposure to renewables by oil majors is generally limited. Instead they prefer to conduct early stage research into cleaner energy options, such as carbon capture sequestration, whereby CO2 emissions from fossil fuels are captured and stored and converted into other materials, as well as biofuels.
And so, the pause in oil and gas investment provides a great opportunity to speed up the move beyond fossil fuels to other energy sources and a low-carbon economy.
In an attempt to position themselves as helping in the fight against climate change, oil companies are increasingly turning to the lowest carbon-producing fossil fuel in their portfolio – gas. When oil prices were high, large gas fields were less attractive but now they are seen as the big saviour in the battle against carbon emissions and supply is plentiful.
Through anti-pollution and climate regulation, gas is rapidly replacing coal in the developed world and there are encouraging signs that China is moving to reduce its coal consumption similarly.
Coal has already begun to strand in the US as a result of shale gas exploitation and clean air regulations. Coal-fired power stations have been closing in favour of gas-fired power plants, therefore resulting in a drop in the price of coal and an increase in the number of US coal producers seeking to export the fuel. In Europe, however, due to cheap coal prices and the phasing out of nuclear power in Germany, the trend has begun to reverse, and coal use by utilities has been on the rise, at least in the short term. The slide into bankruptcy protection of Peabody Coal in the US is a harbinger of similar events, despite the likelihood of it re-emerging free of debt, with lower wages and benefits under new owners.
Although health and safety has improved across the industry, which is backed up by statistics, companies can easily become complacent, as the memories of the 2010 Macondo oil spill disaster in the Gulf of Mexico begin to fade.
With corporate balance sheets often stretched and contractors under even more pressure, we seek to ensure that companies are not cutting corners on health and safety, environmental protection and investment in their social licence to operate.
We urge companies to maintain their advances on energy efficiency and not make false economies in preventative maintenance. The Aliso Canyon disaster, which vented almost 100,000 tonnes of methane in California between October 2015 and February 2016, serves as a reminder that, fugitive methane, leak detection and repairs must remain a priority for the oil and gas value chain, particularly amid tightening industry legislation. While the focus is often on new projects, methane and other leaks are generally associated with existing projects and ageing infrastructure.
As part of our engagement in this area, we, for example, gained an insight into the response to low oil prices at an investor meeting with the outgoing CEO and the appointed co-CEOs of an extractives company. Management presented its new operating model, which is on track to deliver sustainable cost savings. Through its cash conservation plan, aimed at positioning the company for a low oil price environment, the company’s management has reduced headcount and paced capital expenditure. We challenged the CEO on the impact of significant cost savings on the company’s environmental and social performance and were reassured that its sustainability performance has not been compromised but seek further meetings on this and other issues.
Against the backdrop of more mergers and acquisitions, we also encourage companies to apply their best practices to the newly acquired parts of the business.
In a meeting with a US oil and gas company, we made the point that it was rightly proud of the conservatism with which it runs its business, its balance sheet, capital discipline and commitment to minimising operational and project risk. But we highlighted that this conservatism could also be its blind spot in relation to the energy transition that the global economy is facing in the next two to three decades if the world is to avoid the worst effects of climate change. We reminded the company that the industry had done a great job after the Macondo oil spill in reviewing, improving and rehearsing for possible catastrophic accidents. By doing this work, we believe that the industry as a whole has worked well to improve its risk management and operational standards. The industry accepts that this type of stress-testing and rehearsal of different scenarios is a vital part of the risk management it needs to conduct. We argued that it needs to think about low oil prices and climate change with the same attention as it has done on the lesson from Macando.
It is crucial that the industry continues this work, even in a low oil price environment.