Driving Away Investors


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Abstract

E&P companies have driven away investors in the energy sector by not delivering returns amongst a global pursuit for decarbonization. While investor disenchantment within the United States oil industry isn’t new, it appears to have worsened with the COVID-19 market environment. From 2015 to 2016 at the start of the “lower-for-longer” downturn, the market seemed optimistic about the industry. By 2020, the double impact of the global pandemic and the Russia/Saudi price war seems to have led many investors to avoid oil stocks and as they start seeking new opportunities. Moving forward into 2021 and 2022, capital will be difficult to source until investors feel comfortable that the industry can develop resources without squandering their money again. 


Key Points 

  • Since 2016 oil and gas E&P companies have driven away investors in the energy sector by not delivering returns while the world simultaneously pushes for decarbonization. Over the next several years investment capital will be difficult to source until companies show they can profitably develop resources in a low price environment while delivering shareholder returns.

  • In the first three quarters of 2020, North American and European oil and gas companies cumulatively wrote down about $145 billion from their assets. This equates to roughly 10% of those company’s collective market value. These write downs can have the effect of reducing future investment expenditures, undercut the borrowing base for future lending, and make asset sales more difficult.

  • One area inhibiting future investment in the sector is uncertainty around anticipated global oil demand, renewable energy development, and climate change initiatives. In 2016 and 2017, investment in renewable energy doubled that of investment in all fossil fuels. This trend has continued as continued climate change and ESG initiatives have influenced investments.

  • Poor return on investment during the shale revolution is another area that has been a blemish on investor confidence. Since 2010 the U.S. shale industry has produced net negative free cash flows of $300 billion, impaired more than $450 billion of invested capital, and entered into more than 190 bankruptcies.

  • Moving forward into 2021 and 2022, capital will be difficult to source until investors feel comfortable that the industry can develop resources without squandering their money again. Hydrocarbon development is still necessary as the International Energy Agency estimates the world needs approximately $1 trillion every year in new oil and gas investment to avoid price spikes. The industry must prove it can be a steward for the environment and shareholder capital, which in the near term will require a culture shift from “production growth at all costs” to “responsible and profitable development.”

Introduction

Starting in March 2020 with the onset of the COVID-19 pandemic, global oil supply and demand diverged to an extent the world had never seen before. With domestic shale companies failing to return a profit, investors have been starting to seek new opportunities. While investor disenchantment within the United States oil industry isn’t new, it appears to have worsened with the COVID-19 market environment. From 2015 to 2016 at the start of the “lower-for-longer” downturn, the market seemed optimistic about the industry. By 2020, the double impact of COVID-19 and the Russia/Saudi price war seems to have led many investors to avoid oil stocks. While the initial reaction seemed extreme, it does not appear to be the case any longer considering the record imbalance and extreme volatility in the oil market. Plain and simple: oil and gas E&P companies have driven away investors in the energy sector by not delivering returns while the world simultaneously pushes for decarbonization. Moving forward into 2021 and 2022, capital will be difficult to source until investors feel comfortable that the industry can profitably develop resources without the risk of squandering their money again. 


Write Downs 

Oil and gas companies in North America and Europe wrote down roughly $145 billion combined in the first three quarters of 2020, the most for that nine-month period since at least 2010, according to a Wall Street Journal analysis [1]. That total significantly surpassed write-downs taken over the same periods in 2015 and 2016, during the last oil bust, and is equivalent to roughly 10% of the companies’ collective market value [1]. While European major oil companies Royal Dutch Shell PLC, BP PLC, and Total SE were among the most aggressive cutters, accounting for more than one third of the industry’s write-downs this year, asset impairments occurred industry wide. Before going any further, a discussion explaining write-downs in the oil and gas industry is necessary. 

Oil producers frequently write-down assets when commodity prices crash, as cash flows from oil and gas properties diminish. Write-downs, also called impairments, as well as reduced cash flow suggest that investment spending will continue to decline absent a meaningful increase in crude oil prices [2]. Large impairment charges acknowledge that some of a company’s projects are no longer profitable and are being discontinued. Such actions decrease asset values on the balance sheet and, correspondingly, reported earnings. However, it does not affect the all-important cash flows, because a write-off is essentially no more than an accounting entry [3]. In addition, this action generally has a small negative effect on reported leverage such as the debt-to-equity ratio since a write-off reduces balance sheet equity, or book value, typically by 5%-10% [3]. While this adjustment reduces the investment expenditures that would occur, it also reduces the future estimated cash flow from the projects. Therefore, lenders may be less willing to lend if a company’s assets declined in value, or may only be willing to lend up to a certain percentage of a company’s proved reserves, which declined in value from impairments [2]. Furthermore, selling assets becomes difficult because of the impairment charge; they are typically sold at a lower valuation than when the company purchased them. This results in the company raising less cash than otherwise would be expected. 

Figure 1: Oil and Gas Write-downs from Q1-Q3 since 2011 [1]

This year’s industrywide reappraisal is among its most severe in history because oil companies also face longer-term uncertainty over future demand amid the rise of electric cars, the proliferation of renewable energy, and growing concern about the lasting impact of climate change [1]. Concerns about long-term demand are exacerbating the oversupply of fossil fuels, and companies say they have become more selective about where they invest. In addition, projects are facing much stiffer competition for capital amid ample global supply. BP, Shell and Chevron cited internal forecasts for lower commodity prices as the cause of the impairments. The problem is, these write-downs represent not only the diminished short-term value of the assets, but also a belief that oil prices may never fully recover. In coming years, heightened competition from renewable energy and policy changes toward fossil fuels could trigger further reviews of an oil and gas asset’s ability to generate future cash flows under U.S. accounting rules since they require companies to write-down an asset when projected cash flows fall below its current book value [1]. If operators claim these write-downs are an isolated incident, why are investors running for the hills? Well, it is a two pronged scare. 


Investment Scare Prong One – A Move Towards Decarbonization  

Countless companies in both the private and public sectors, in addition to a growing number of countries, have committed to net-zero emissions in the next few decades. Not only have many of these moves been welcomed, but they are claimed to be necessary as the future of this planet depends on actions taken today. While a shift towards clean energy is not a new concept, the Green New Deal (2012) and subsequent Paris Climate Agreement (2016) have made the movement mainstream. As a result, more and more focus has been placed on clean, green energy as fossil fuels have become vilified. An unfortunate consequence of such actions has led to decreased investment levels for the largest source of energy that currently runs society and a switch to increased investments in the renewable sector. 

Figure 2: Increasing Investment In Renewables Amid Decreasing Investments In Fossil Fuels [4]

There has been a growing push for the investment community at-large to divest from publicly traded oil and gas companies. Advocates for stronger climate change policies demand that investors embrace environmental-social-governance, or ESG [6]. The overarching goal is to install “sustainable” investment by forcing the oil and gas industry to report how CO2 reduction laws and more natural disasters from climate change will impact business operations. At the most extreme, these advocates insist that since oil and gas are major contributors to rising CO2 levels and climate change, investments should simply not be made in companies that produce and/or transport them [6]. As this trend continues and thanks to tougher policies to address the climate crisis, fossil fuels are gradually becoming yesterday’s source of energy as funds dwindle. Figure 2 shows since 2016, renewable power has seen twice as much investment as coal, oil, and natural gas combined [4]. Granted, ongoing investment in renewable power projects is expected to fall by around 10% for the year, but it is far less than the decline in fossil fuel power [5]. 

For the industry itself, the obvious problem is that oil and gas are the very basis for existence. Thus, the only way to fully comply with extreme climate activists is to get out business entirely. The industry has mostly ignored calls for more climate disclosure, knowing full well that oil and gas is essential to produce since it still supplies nearly 65% of the world’s energy [6]. However, activist shareholders are growing more restless as more natural disasters get tied to climate change, heating the debate over where to put their investment dollars. As economic growth ensues, demand for essential hydrocarbon commodities grow as well, which is precisely the reason why investors should think twice before turning their backs on oil. 


Investment Scare Prong Two – Failed Returns 

The year 2020 marks the 15-year anniversary of the U.S. shale boom, which heralded an era of U.S. energy independence and more than doubled tight shale oil production over the past five to six years [7]. But beneath this phenomenal growth, the reality is that the shale boom peaked without making money for the industry in aggregate. In other words, in the 15 years since the start of the U.S. shale boom, the industry as a whole has failed to return a profit. In fact, the U.S. shale industry registered net negative free cash flows of $300 billion, impaired more than $450 billion of invested capital, and saw more than 190 bankruptcies since 2010 [7]. With a history like that, it is no wonder investors are beginning to shy away from oil and gas. But, as investigated in the RP periodical Falling Short of Demand released just a few weeks ago, it is important now more than ever for investors to back the industry as the world is on track to run short of sufficient oil supplies to meet its needs through 2050. Oil is still needed despite lower future demand due to the COVID-19 pandemic and the accelerating energy transition.

Then the question becomes: looking at the history of the U.S. shale patch and their failure to return a profit, why invest in fossil fuels when returns have been a mere 97.2% in recent years and renewables in the U.S. have yielded a 200.3% return [8]? If investors abandon funding for the world’s main source of energy, there will not be enough overall energy supply to meet growth demand into the future. Those that weather the storm will reap the benefits when the world realizes its reliance on this global energy source is a key pillar for continued development of society. 


Conclusion

E&P companies have driven away investors in the energy sector by not delivering returns amongst a global pursuit for decarbonization. Moving forward into 2021 and 2022, capital will be difficult to source until investors feel comfortable that the industry can develop resources without squandering their money again. The main problem revolves around destruction of capital. When the companies write down assets it reduces the overall book value on the balance sheet, and by association the economics of previously expected revenue streams. The problem arises for public companies because the company value decreases and it is an impairment on the income statement which reduces net income. Those dollars have been lost to both the investor and the oil company. These actions can ultimately translate into a reduction in shareholder equity value and carrying a larger debt load than initially taken to develop or acquire the asset. The result is an immediate increase in the industry’s leverage ratio from 40-54%, according to global accounting firm Deloitte, which can trigger many negative sequences of events, including bankruptcy [7]. The underlying issue is a low price environment is forcing companies to write down their assets, which can be a result of choices made in different market conditions and is not always due to poor leadership. As prices inevitably rise, assets may return some of the losses, but further investments are required to sustain continued development. 

Without capital investment, oil and gas companies cannot grow. If there is no growth, energy demand will not be met. Without meeting demand, quality of life for many humans goes down. Currently the linchpin to this is E&P companies regaining investor confidence that profitability is attainable, and a repeat cycle of capital destruction will not occur. The industry knows that predictions of hydrocarbon consumption even over the mid- and long-terms are still based on speculation and estimates. This is why the International Energy Agency estimates that the world needs approximately $1 trillion every year in new oil and gas investment to avoid price spikes as demand mounts [6]. To prove to investors that recent asset write offs were indeed an isolated incident, an attitude shift from production growth at any cost to profitable development with safe margins must occur. Although some will do it more quietly than others, the ball has been set in motion, and investment in the sector will eventually return to continue developing necessary oil and gas. 


References

[1] https://www.wsj.com/articles/2020-was-one-of-the-worst-ever-years-for-oil-write-downs-11609077600 

[2] https://bpnews.com/index.php/publications/magazine/in-the-news/675-oil-companies-write-down-significant-assets-in-3rd-quarter 

[3] https://www.nasdaq.com/articles/do-asset-write-offs-matter-not-really-2020-07-03 

[4] https://informationisbeautiful.net/beautifulnews/1059-renewables-investment/ 

[5] https://www.iea.org/reports/world-energy-investment-2020/key-findings 

[6] https://www.rigzone.com/news/are_investors_really_leaving_oil_and_gas-15-nov-2019-160341-article/ 

[7] https://www2.deloitte.com/us/en/pages/energy-and-resources/articles/covid-19-implications-for-us-shale-industry.html 

[8] https://www.forbes.com/sites/davidrvetter/2020/05/28/just-how-good-an-investment-is-renewable-energy-new-study-reveals-all/?sh=308c8f934d27

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