The oil and gas industry is currently dealing with both a “green” or environmental problem and a “red” or cash flow problem. Both are significantly impacting investors.
With environmental, social and governance considerations playing an increasingly dominant role in finance, many institutional investors are leery to invest in fossil fuels. And, even those who aren’t as preoccupied by ESG are hesitant over the industry’s ability to deliver real returns.
For an industry that will continue to be indispensable for the foreseeable future, how will growth and forward momentum occur?
Strategists and investors speculate about the future of the oil and gas industry and its finances. Ideas range from an increased reliance on private investors, a redirect back to conventional wells and even redefining parts of the industry and how they are categorized according to ESG standards.
The Power of Perception
The willingness to invest in energy is becoming a more binary prospect, with institutional investors growing more concerned about their image as stewards of the planet, said Kevin Covey, managing partner at GrayStreet Partners and a panelist at last year’s International Meeting for Applied Geoscience and Energy.
“They don’t want to make the investments – even though I argue tremendously that the risk-adjusted returns of their pensioners are far better, and that they may be doing their customers, clients and pensioners a disservice,” he said. “The ESG movement is in full force with the institutional investment community, and there are very few exceptions.”
Exacerbating this “green” ESG problem is the “red” cash flow problem, leftover from when operators flocked to domestic shale, outspent their cashflow and failed to deliver returns to investors in the 2010s. Crude prices ultimately fell roughly 20 percent as a result of over-production.
“Even if we can convince investors to invest, they ask about returns,” Covey said. “There has been a shift from an investment sector to a cash distribution sector, so that’s got to be the new narrative: delivering free cash flow to investors at a risk-adjusted return that’s better than what they can get in the market.”
In the eyes of Bob Fryklund, AAPG member and chief upstream strategist at S&P Global Commodity Insights, operators are beginning to turn the “red” problem around by shifting their business models, with some now realizing 70- to 75-percent cash flow. This could create a new opportunity for investors who want exposure to the outsized returns that oil and gas initially provided.
“When (oil) prices come back, money is going to materialize, and particularly profits. We do have a 10-year gap, so there’s 10 years where energy, particularly oil and gas, was the only industry that was negative in the history of the industrial world. But that’s coming back.”
While the energy sector was a poor performer in the 2010s, during the last 1.5 to two years it has been the “best-performing” sector, albeit a small allocation for most asset managers and in the public markets, said Bryant Fulk, AAPG member and a principal at Aventurine Partners.
“Investors are asking about the opportunities in the next 10 years. What is there in shale left to do? Is there a pivot back to exploration?” he said. “Many industry experts have argued there should have been more exploration investing in the last couple of years.”
Today’s business environment is perhaps more conducive to the “significant” investor capital held by credit and retail investors, said Laura Pommer, CEO of EnergyFunders, which has been investing in conventional oil and gas wells predominantly on the Gulf Coast.
“I think there are a lot of people out there who are interested in oil and gas because there are still asset returns – you just have to select the right investment,” she said.
An Upstream Battle
Investments in exploration have been among the least popular choices, especially in the reserve-based lending sector, said Rob Lee, head of Corporate Advisory, Energy at MUFG Bank Ltd. In 2019, 32 banks were active in upstream investing. As of last summer, that number fell to 18 and the fall was expected to continue, he said.
“The returns have been challenged in the sector, and does management really want to fight the CEO who gets protesters showing up at his or her doorstep about ESG?” he said. “If oil and gas is a big part of the overall P&L (profit and loss), it’s easy to pull back or exit.”
Going forward, perhaps the most lucrative investments in the industry will be in conventional oil and gas.
“We are predominantly only raising money to pursue those (investments),” Covey said. “We are not doing unconventional oil and gas. We look at the costs, the EORs for unconventional plays, and we think they are get-your-money-back at best.”
Investing in the upstream sector could be lucrative if 3-D seismic shot for unconventional plays could be licensed more cheaply to identify conventional prospects.
“It’s a combination of wildcats and old geos that do bring prospects, and we invest in them,” Covey said.
When pitching to investors, Covey said the single, largest issue he must overcome is a sentiment that conventional oil and gas no longer exist.
“That is very hard to overcome,” he explained. “There is an incredulity factor in whether it exists still … and on the individual prospective well economics.”
However, infrastructure (the midstream sector) continues to attract investors, particularly bank capital and even more “creative bank capital,” Lee said.
But the environment for pure upstream risk and oilfield service has shrunk by more than 50 percent in the past five years.
“It’s a great opportunity for the non-bank lenders to step into the space with more creative solutions, faster execution and more flexibility,” he said. “So, we are seeing the non-bank lenders step into the space and doing it in a big way.”
A PR Problem
Attracting more investors most likely requires better public relations to put the value of oil and gas in proper perspective.
"Saving the planet” has become a cause that is extremely difficult to challenge in the public’s collective mind, Fryklund said. While certain arguments and examples can sway a person in his or her beliefs temporarily, “it doesn’t resonate with them for very long.”
Lee said the term “transition energy” is not helping oil and gas.
“We are not going to stop using hydrocarbons. It’s getting everyone to understand there is no silver bullet,” he said. “Just because you are directing investment dollars toward green solutions doesn’t mean that we don’t need the hydrocarbon solutions as well.”
Ideas around tackling this PR problem run the gamut: From warning against sky-high energy prices when existing supplies dwindle; informing the public of how “clean” energy and batteries can negatively affect the environment or how they rely on fossil fuels as a foundation; that coal remains the go-to energy source when renewable energy underproduces; and that natural gas is a viable option for cleaner and abundant energy.
Yet those with a cause typically fight with arms – with the end goal to eclipse any messaging from the industry. Not only can they flood the news market and social media with false narratives, they are known to file lawsuits and protest in the limelight. Typically, they out-message the industry on social media by 21 times, Fryklund said.
Current Investment Draws
Certain industry-related fields are faring better with investors.
The role of geology in energy transition fields is beginning to take shape, Fulk said, noting that Bill Gates’ Breakthrough Energy Ventures fund and others are exploring both geologic hydrogen deposits as well as direct lithium extraction.
Exxon Mobil recently acquired more than $100 million in lithium brine assets in Arkansas, marking a turning point for lithium brine extraction in the United States.
Furthermore, investors are very interested in carbon capture technology, but it has been difficult for most market participants to find acceptable risk-reward propositions, Fulk said.
“People have realized that the people who hold the carbon – that is the treasure chest,” he said. “The emitters are holding all of the carbon. Without the carbon, these projects don’t mean anything. We see this trend in several markets where the liability has become the asset.”
Fulk speculated that ExxonMobil’s recent acquisition of Denbury, Inc. and its extensive pipeline infrastructure appears to confirm that CCUS is an investment theme in which only the largest industrial firms will participate, and it presents challenges for private equity funds.
Many banks would jump at the chance to finance CCUS, hydrogen and geothermal projects if they were credit-worthy, Lee said.
“CCUS is something that is seen as an extension of the hydrocarbon industry, and there’s a sense that if you want to participate in investment opportunities, you have to bank the energy companies. So, I think it’s a bit of a lifeline for the energy companies to retain their banking relationships,” he said. “The banks would love to finance hydrogen, but there is just a dearth of credit-worthy projects that are available to be financed. So, the industry has got to change its contract structure or their financing structure in order to attract the capital that it needs.”
Some banks are beginning to take a more liberal (so to speak) view of what they see as “renewable” energy. Expanding beyond solar and wind, many currently see frozen LNG as renewable energy.
“If we can find a way to call oil and gas renewable, we would fit into that box,” Lee said.
While so much remains in flux, and an objective measure for ESG remains questionable, Covey shared that many capital investors have trouble even defining the term.
“They just know it’s not oil and gas,” he said. “I think ESG is the greatest trick the devil ever pulled.”
A World Divided
Five years from now, some see the industry splitting into separate geographic sectors stemming from investment headwinds, including the war in the Ukraine.
Noting that Russia, particularly Siberia and offshore, has many large, unexplored and underexplored basins, it is possible that the world will begin to see a bifurcation in the global oil and gas industry, Fryklund said.
There might be China, Russia, Iran and other nations on one side, and the rest of the world on the other,” Fulk added. “It would not surprise me if we started to see energy supply chains separate into those two camps.” In other words, Russia would be the main hydrocarbon supplier for China and India, instead of Europe, possibly creating a resurgence in the North Sea. Then the West would need to create a secure supply chain for energy transition minerals and metals to diversify away from China.”
Yet even if Russia expands its global energy position, the hallmark ingenuity of the United States should not be underestimated, Lee said.
“There is a growing brand recognition around responsibly sourced gas and next-generation gas. Despite regulations, the U.S. is going to come up with continued technological advances and a premium product. That product will command a premium in the international market, mostly with destinations to Europe,” he explained.
Covey said he believes the war in the Ukraine will indeed create new trade alliances that will have consequences for a “very long time.”
“It is absolutely going to increase the price of energy for the average person in the Western world, which may bode well for exploration, but ultimately it will come at society’s expense,” he said. “On a positive note, I do think sometime in the next 20 years Americans will get tired of paying $12 for a gallon of gas and we may ease up on some of our regulations. Voters do vote by ideology, but they also vote with their wallets. Who knows, maybe we will be drilling for oil in the Los Angeles Basin again.”