Oil and gas producers must get creative in risky future – Carbon Tracker

The strategic choices for oil and gas producers will get narrower and riskier in the transition to a low-carbon economy, climate-focused financial analysts said in a research paper that offered bold ideas.

The options available to producers ranged from doubling down and increasing production — a strategy that carries the risk of overinvesting in stranded assets — to allowing production operations to decline naturally, according to analysts at the Carbon Tracker Initiative. Carbon Tracker is a London-based think tank that analyzes how the energy transition will affect investors and investments.

"With demand expected to peak this decade before falling from the late 2020s onwards, producers must adapt, and prepare for falling long-term prices," Mike Coffin, Carbon Tracker's head of oil, gas and mining research, said in a statement.

The International Energy Agency has projected that fossil fuel demand will have to fall by roughly half by 2050 to meet global net-zero emissions goals. Based on that projection, Carbon Tracker said price declines will come abruptly as demand falls off, forcing drillers to write off assets whose production they can no longer profitably sell and leaving shareholders with an equity that is losing value. In September, the IEA eased up on its position that no new oil and gas projects should be developed if the world is to achieve net-zero emissions by 2050.

The US Energy Information Administration's "International Energy Outlook 2023," released in October, forecast that global demand for oil and natural gas will continue to grow through 2050 under a range of scenarios.

E&P stocks as annuities

While the concept of an exploration and production company drilling out and going out of business might seem like a contradiction, Carbon Tracker said it is the path with the least risk. Companies could sell oil and gas at reasonably high prices, then sell the assets for full value. A slightly less contradictory path would be to allow assets to decline naturally with no new development. Carbon Tracker said the stock of companies following either path will return cash to investors through increased dividends. The stock would behave, in effect, like an annuity.

In a managed scenario, companies would devote capital for short-cycle development such as shale oil and shale gas production — projects that can be turned off and on relatively easily, Carbon Tracker said.

"The key difference between an unconventional or a shale project is it doesn't take as long to start up typically, and your investment profile is much shorter," Guy Prince, Carbon Tracker senior oil and gas analyst and report coauthor, said in an interview. "If you're a company with a future of declining oil demand, you would be at less risk by pursuing short-term, smaller investment projects."

The type of project at the greatest risk of being stranded is offshore oil and gas production, Prince said. "You would be searching deep or developing very expensive, long-lead-time, deep-water offshore Guyana-style projects, because by the time those projects actually get producing, we could already be seeing a far more sustained fall in oil demand," Prince said.

"There's no one-size-fits-all for companies," Prince said. "Now, we're seeing a real different range of strategies. We've seen some of the biggest deals recently with Chevron Corp. and Exxon Mobil Corp., clearly pursuing a strategy of growth. ... The European majors are maybe one notch to the left."

'The math'

Ed Hirs, an energy fellow at the University of Houston, said predicting when oil will peak is difficult because technology advances in areas such as hydraulic fracturing change the variables in the supply-demand equation. Further, with high commodity prices, the rate of return is greater for oil and gas companies to stay with business as usual than it is to pursue exit strategies, Hirs said.

"If there's no rate of return involved, don't expect it to be done," Hirs said in an interview.

North American oil and gas drillers have become so efficient at extracting oil and gas that they count on double-digit returns. Wind and other renewables projects have single-digit percentage returns, said Hirs, who has decades of experience advising policymakers and oil and gas leaders.

"[Carbon Tracker] talked about, should the oil companies take their cash and diversify?" Hirs said. "Exxon tried that years ago: Exxon Office Solutions. At one point, Mobil Oil Corp. owned part of [Montgomery Ward Inc.]"

"Shell PLC and BP PLC have turned their strategies around from being more green to 'Hey! We're oil companies!,' because if you put a billion dollars into a renewable power plant, the most you're going to get is a 6%-7% rate of return," Hirs said. "This has been the math for more than 25 years. If I put a billion dollars into an oil and gas venture, I can get a multiple out."

"That's the math," Hirs said.

A spokesperson for the leading US oil and gas trade group, the American Petroleum Institute, said in an email that the company expected to see an "all of the above" path for meeting the energy needs of the future that includes oil and gas.

"Our members continue to make significant progress in reducing emissions across their operations while also leading in the development of low-carbon solutions like [carbon capture and storage] and hydrogen that are critical to meeting the world's emissions reduction targets," the spokesperson said.

Pipelines gain value with opposition

One way for investors to navigate the twists and turns of the energy transition would be to put their cash into midstream companies, according to Roberta Caselli, commodities research analyst at Global X ETFs, which creates and manages exchange-traded funds. Midstream operators have more value because they have long-term contracts and because public opposition to new pipeline development increases the value of existing infrastructure assets, Caselli said. That trend is expected to continue.

"North American fuel infrastructure acquisitions like Energy Transfer LP's acquisition of Crestwood Equity Partners LP and [Oneok Inc.'s] acquisition of [Magellan Midstream Partners LP] reflect the growing challenges of building new projects in this sector," Caselli said in an email.

"US midstream pipelines continue to have high distribution yields and low valuations," Caselli said. "Diversification potential and inflation pass-through capabilities are core features of the sector. Its defensive contracts and fee structures have historically positioned it better in volatile price environments than other energy sectors."

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