Photo: Wood Mackenzie

Oil & gas plays trump low-carbon investments in H1 2022, says WoodMac

In the wake of the current geopolitical crisis and ever-increasing energy security concerns, market volatility and high oil and gas prices have marked the first part of 2022, which has impacted the motivation driving energy investors. Instead of the anticipated ramp-up of the shift into green investments, Wood Mackenzie, an energy intelligence group, points out that pure oil plays still trump low-carbon diversification.

As investing in the low-carbon economy was a huge stock market theme through 2020 and 2021, the policy support in the wake of net zero pledges at COP26 in November 2021 only seemed to set the seal on a structural shift into green investment plays and out of fossil fuel sectors, explains Wood Mackenzie.

However, this trend has not maintained its momentum and a very different story has played out in the first half of 2022, as the war in Ukraine and the changing economic climate have turned things on their head. Due to Russia’s attack on Ukraine, the outlook for the supply, demand, and price of hydrocarbons is constantly changing, which is leading to a rewriting of energy trade flows.

Furthermore, the energy market, particularly the oil and gas sector, was a stellar stock market performer for the first five months of the year, with the rising tide of oil and gas prices lifting all boats, based on Wood Mackenzie’s research, which looks into whether this has changed investor perceptions of the different decarbonisation strategies across the sector.

The energy intelligence firm outlines that investors piled into the pure play oil and gas producers that are most leveraged to oil prices during the first five months of 2022, much as they would in any upcycle. In this regard, the U.S. independents led the sector rise through early June before the oil price and shares fell back over the last month.

Wood Mackenzie highlights that persisting with capital discipline paid off big time in 2022, with high prices turning upstream players into cash machines. This is best demonstrated by financially stretched companies that were expected to take up to five years to pay down debt to “normal” levels at $60-70/bbl, which were suddenly able to do it in two years at $100/bbl. In line with this, earnings and cash flow ballooned, and share prices rose.

However, Wood Mackenzie underlines that the free cash flow isn’t being ploughed into growth this cycle as most companies are targeting low-to-mid single-digit production growth, well below the targets of yesteryear. Investors do not seem to want companies to spend more as a tight upstream supply chain has diluted the bang for the buck for incremental spend. Additionally, there is also self-interest, according to the energy intelligence provider, as management has found that the “less they spend, the better the company’s shares perform.”

The firm expects that dividends and buybacks will stay high at $100/bbl while variable and special dividend bonuses have been a “bonanza for shareholding employees who have never had it so good.”

U.S. majors vs. European ones

Moreover, integrated companies are less leveraged to price but have also performed well in 2022 as strong upstream and trading profits are being boosted by record refining margins – a rare treble. Wood Mackenzie informs that share prices for the U.S. majors ExxonMobil and Chevron have kept pace with the rampant independents’ peer group during the first five months of the year and have held up better in the sell-off since early June.

While European majors are also reaping the earnings and cash flow boom with share price performance being strong relative to the wider stock market, most have lagged their U.S. peers. The energy intelligence provider underscores that the U.S. majors have long commanded a premium rating over their European counterparts, partly a function of the relatively high rating of the U.S. stock market. Although, this gap has now widened.

Based on Wood Mackenzie’s research, a big differentiator is the pace of decarbonisation since the U.S. majors are only at an early, “tentative” stage of committing to investing in decarbonisation, whereas the European ones are already well ahead in diversifying and are accelerating investment. In lieu of this, budgets for new energy have doubled in the last two years and, by 2030, the most aggressive, such as BP, could be spending 50 per cent of the total investment on low-carbon projects.

The rationale behind the European majors’ strategies is reinforced by the REPowerEU Plan, the EU policy to accelerate the energy transition and make Europe independent of Russian fossil fuels before 2030, as a result of the EU’s determination to end its reliance on Russian fossil fuels, intending to ban almost 90 per cent of Russian oil imports by the end of the year.

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Despite this investors continue to harbour the same doubts around Big Energy: Big Oil’s ability to execute low-carbon strategies, the modest returns from investment in low-carbon opportunities and the sustained cash burn as the new business is built out, as explained by Wood Mackenzie.

Failure to adopt to low-carbon world to result in de-rating

Wood Mackenzie also ponders when and how investors’ perceptions might change, stating that it may take longer than expected in the immediate aftermath of COP26 as Russia’s invasion of Ukraine has highlighted the world’s current dependence on oil and gas, and cast doubt over the pace the world is prepared to embrace decarbonisation.

With the structural dislocation in oil and gas markets, the energy intelligence firm now expects elevated oil and gas prices for the next few years. The company claims that this has transformed the financial outlook for the sector and the attractiveness of pure plays and oil and gas-focused players to investors as they are making big money now.

Although, the firm confirms that its longstanding view still holds as “the transition is going to happen” and oil and gas companies have significant value at risk whether from the increased implementation of carbon pricing or future declines in oil and gas demand – or both. To this end, Wood Mackenzie has emphasised that companies which fail to adapt to the emerging low-carbon world will suffer a “progressive de-rating” in the market.

Source: Wood Mackenzie
Source: Wood Mackenzie

Change takes time and the signposts of the business transformation journey the European majors have embarked on lie some distance in the future, says WoodMac. The firm forecasts suggest that it will take until 2028 for free cash flow from the existing renewables project pipelines to turn positive, but even then, these assets will only contribute around 10 per cent on average of the European majors’ group operating cash flow, based on this research.

Wood Mackenzie further stated that abundant cash flow enables diversifying majors to placate investors with higher pay-outs and buy-backs while they push forward with investment in low carbon and building a sustainable future.

In the meantime, the trick will be to demonstrate value, says the energy intelligence firm, elaborating that an IPO would be the “big reveal,” delivering the high new energy multiples some European majors hanker after. While it seems that particular ship has sailed for the time being with the stock market downturn, Wood Mackenzie concludes there still appears to be plenty of private capital looking for opportunities to access renewables portfolios.

The energy intelligence group anticipates more farm downs, an option that Repsol, TotalEnergies and Equinor have used “successfully” to unlock gains and perhaps even go a step further, as Repsol did last month by selling 25 per cent of its renewables unit for EUR0.9 billion (around $964 million).