By Toby Belsom, Head of Research
It is coming up to six months since we published a report outlining how structural trends and heightened uncertainty would disrupt future oil demand with significant implications for publicly-listed oil companies and their investors. It also outlined the choices both investors and management have over the excess cash following improved cost control and stabilising oil prices. Would management teams ramp up capital expenditure and growth or return cash to shareholders through dividends and buy backs? We felt it was worth revisiting how the environment has moved on.
Well, the oil price has changed – as have share prices. At the end of February, brent was hovering around the $65 per barrel and this has now crept up towards $80. Share prices have also moved. BP has gone from 460p to above 550p, Shell has increased from 2200p to over 2400p. Both are outperforming a fairly moribund UK stock market. Fear and greed are powerful drivers in the fund management community and these changes will not have gone unnoticed. Risk teams and trustee boards will look to challenge fund managers’ under-weight positions. It has been easy to avoid the sector for the last five years – is this set to change?
For management teams these changes are also important signals. The recent period of cost cutting across the industry will increasingly be challenged by managers who see this as a sign to increase spending – just like previous cycles. Bob Dudley said as much in the BP’s July earnings call: “I cannot remember when it has looked this good” referring to growth opportunities for the oil major.
As oil is in a better place financially and threatened by renewables, investors must demand capital be returned to them and more renewable experience on company boards.
BP has been true to its CEO’s word and made one of the most significant corporate acquisitions recently when it agreed to take on BHP’s US shale assets earlier in the summer. The $10.5bn price tag represents BP’s largest acquisition since the Deepwater Horizon disaster and is an unashamedly oily acquisition. This was not acquired to refocus the portfolio on natural gas – the so-called fuel of the future. This is also an acquisition that might have been done by many of the majors, with Shell and Chevron apparently bidding on the assets too. M&A is clearly back on the table.
Organic growth is also back on the agenda. As highlighted in our earlier report, increasing number of projects are receiving financial approval by executive boards. Wood Mackenzie reported that the first quarter of 2018 ended with six multi-billion dollar projects sanctioned by oil companies. Though these tend to be smaller and cheaper than projects in the previous capex boom, the acceleration of capex spend to grow production is starting to increase.
So is this the start of another normal cycle where investment starts to flood back into the sector, M&A becomes increasingly common, and the oil sector starts to behave like a growth industry again?
Though most industry observers don’t question that oil and gas will still meet a substantial global energy demand for decades and maintenance investment in the sector is still required, many predict peak oil to be closer than ever before: DNV predicts 2023 and these predictions seem to be coming closer rather than further into the future.
Improving fuel efficiency, pressure on end markets such as plastics, better energy storage technologies and alternative energy sources will increasingly focus the minds of investors on an industry in structural decline. This is new territory so predictions and timings will be difficult to forecast however slowing demand due to structural changes can often result in rapid changes in valuations. The key argument within our earlier research was that slowing structural demand in a commodity sector does not end well for owners of fixed assets with long economic life.
So how should investors respond?
In an insightful update to our earlier research we reviewed the non-executive board structure of the European oil companies. One clear finding was that these boards, despite a wealth of non-oil industry experience, lack hands on experience from the renewable sector. This is a sector that is effectively undermining their future prospects and, supposedly, a key area for growth as the oil industry starts to explore new technologies. Investors should be pushing from more renewable experience on boards – and quickly.
Another recommendation of the previous report was to adapt executive remuneration to prioritise returns and profitability over hydrocarbon production growth. BP investors might want to ask what metrics drove the decision make the largest acquisition since Deepwater Horizon and grow oil production rather than renewables.
In a recent article, Simon Flowers at Wood Mackenzie called it the “siren call to invest’. With improving cash flows and lower costs, the sector now has some key decisions to make that will set the direction of travel for years to come. For investors, these questions are now more pressing than six months ago. From our reviews of remuneration structures and board composition, we would question whether those decisions should be made by management’s teams. Investors should continue to press for the return of shareholder capital in lieu of investing in new hydrocarbon growth.
Thanks Toby! To find out more about our work engaging the world’s largest fossil fuel companies to transition to low-carbon business models, click here.