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The Future of the Oil Company

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When it comes to the future sustainability (excuse the pun) of oil companies, there are two trains of thought, one of which is that they should ‘stick to their knitting’ and just focus on what they are good at, which is extracting oil and gas out of the ground, refining those fossil fuels and delivering petrochemical products to their customers. The other train of thought is that they should diversify their offerings in order to reduce the risks associated with a business model that is going to come under massive pressure over the coming years. US oil and gas companies, such as Exxon and Chevron, as well as Gazprom and SaudiAramco share the first view, while we see some of their European counterparts such as Shell, Total and Equinor investing heavily in new business areas such as offshore wind, EV charging, electricity trading and even battery production. This all begs the question who is right?

Financial theory tells you that there is an opportunity cost to every investment decision and that the capital should only be put to work if the potential return on that investment is greater than its cost. The nature of oil and gas is such that the business tends to be pretty risky with significant exploration risk, combined with price risk, meaning that the cost of capital tends to be high. Given the investment opportunities that US oil and gas companies have in their own domestic market, thanks to the ongoing shale boom, it is no surprise to see their capital flowing into this area. Conversely it is also no surprise that their capital is not going into renewables.

Renewables projects, to date, are largely subject to government regulation like feed-in-tariffs, reverse auctions or tax credits which is perfectly suited to low cost of capital providers, such as infrastructure funds. In fact, this is a key requirement for pushing down the costs of capital-intensive renewables as the higher the cost of capital, the more expensive the cost of that energy. In this situation it is next to impossible for oil and gas companies to generate the necessary returns on their capital. In fact, if an Exxon or a Chevron invested into low return solar as opposed to high return shale, it would probably be accused of destroying shareholder value. This then begs the question why European oil and gas companies are doing so?

One reason may be that European oil and gas companies do not have as many of the investment opportunities as their American peers have, meaning that there is an element of ‘what should we do with our capital.’ Another strong incentive is that of mounting public pressure and corporate reputation, exemplified by the fact that BP’s HQ, which is 200 metres away from my own office, has been subject to constant demonstrations for the last 6 months. Thus one could argue that there is an element of ‘greenwashing’ to appease the activists. However, there is a more practical view and that is that European oil and gas companies see long term risks to their business models, and the upside of diversification.

One major risk to their business models is carbon, with the increasing likelihood that across the world, carbon will be penalized. This in particular impacts oil which is more carbon intensive than natural gas. In addition, there is an increasing view that the electrification of the automobile will happen very quickly, alongside the increasing pressure to reduce carbon emissions. That in turn will cause the demand for oil to plateau, further pressurizing oil prices. Under a scenario of long-term low oil prices, the concern and risk is that much of their assets, in the form of exploration reserves, become unviable which would in turn threaten the financial stability of these businesses.

The hedge to that strategy is that the future will be a combination of gas and renewables with the former being the ideal way to balance intermittent renewables, alongside the benefit of gas also being used to replace the dirtiest of all fossil fuels: coal. And longer term that the existing infrastructure can be repurposed for green hydrogen. Only time will tell which approach will be the winning long-term strategy but my money is on the Shells of this world who are both embracing and creating their futures. 

Gerard Reid's picture

Thank Gerard for the Post!

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Matt Chester's picture
Matt Chester on Jan 14, 2020 1:12 pm GMT

One major risk to their business models is carbon, with the increasing likelihood that across the world, carbon will be penalized. This in particular impacts oil which is more carbon intensive than natural gas. In addition, there is an increasing view that the electrification of the automobile will happen very quickly, alongside the increasing pressure to reduce carbon emissions. That in turn will cause the demand for oil to plateau, further pressurizing oil prices. Under a scenario of long-term low oil prices, the concern and risk is that much of their assets, in the form of exploration reserves, become unviable which would in turn threaten the financial stability of these businesses.

This is well summarized why you're seeing the edge towards diversification in the oil companies. It's not just one aspect of energy trends that are pushing towards oil being less attractive-- it's coming from many different angles, and it's hard to see a scenario where it doesn't end up hurting anyone who's all in on oil and doesn't have alternative energy in their portfolio

Linda Stevens's picture
Linda Stevens on Jan 14, 2020 6:54 pm GMT

Excellent article! I clarified for me why the big US oil companies are not doing more to diversify. It seems that capital markets and investors could play a role in pushing them to diversify into renewables. 

Gerard Reid's picture
Gerard Reid on Jan 15, 2020 7:57 am GMT

They could and should indeed Linda...

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