In every crisis, there are winners among the losers. And while rampant inflation and rising interest rates pushing up costs and squeezing customer budgets have been a challenge for most sectors over the past year, the energy sector has rarely had it so good. High energy prices have been weighing on profit margins for those who pay for it. But they have been swelling them for those selling energy commodities.
Source: TradingEconomics
After a plunge in global demand over the Covid-19 pandemic saw oil and gas prices hit rock bottom in 2020, benchmark Brent crude prices have held at over $85 a barrel for most of the past year. That’s seen the intrinsically cyclical nature of energy companies’ business swing to the other extreme. The biggest oil and gas companies made so much money in 2022 that they started this year by announcing record profits.
How these companies choose to invest the massive windfall will define the trajectory of their businesses and valuations over the next two decades at least. The choice is how to balance the short term interest to maximise income from oil and gas assets and investments while the going is good with the longer term strategic requirement to transform into sustainable energy companies.
It’s not an easy call. On the one hand, oil and gas prices remaining consistently higher than they have been for some time and expected to do so for the foreseeable future represents a golden opportunity to fund the low carbon energy transition. On the other, a shift in focus back to oil and gas threatens the pace and effectiveness of Big Oil’s transformation into Big (sustainable) Energy.
Investments in oil and gas now may be extremely lucrative over the next few years. But they also represent investments in renewable assets that are not being made. And while the low carbon energy mix transformation is one Western policymakers appear intent on enforcing, which all the current evidence points to, oil and gas assets are likely to have a business expiry date enforced long ahead of what would be expected otherwise.
As has happened in recent years with big tobacco, markets will start to stop pricing future growth potential into how they value oil and gas companies. Future growth will have to come from renewables and other low-carbon energy assets.
As such, the oil and gas supermajors all now face the challenge of best balancing upcoming capital investment between the near and medium to long term. Investors will punish them if they fall too far behind rivals when it comes to maximising profits today. But they will also punish short-termism that is perceived as overly focused on squeezing out as much oil and gas revenue as possible today to the detriment of competitiveness in the future low carbon economy.
Those who get closest to the optimal balance can be expected to offer investors the best long term returns.
Record profits for Big Oil
This week Reuters reported Big Oil more than doubled its profits in 2022 to $219 billion, smashing previous records in a year of volatile energy prices where Russia’s invasion of Ukraine reshaped global energy markets. On Wednesday, Norway’s Equinor reported a doubling of adjusted operating profit in 2022 to $74.9 billion. The windfall comes on the back of a surge in European natural gas prices and as it became Europe’s largest gas supplier after Russia’s Gazprom cut deliveries amid the West’s support for Ukraine.
Source: Reuters
France’s TotalEnergies reported record profits of $36.2 billion on the same day with chief executive Patrick Pouyanne stating that he wouldn’t be surprised if oil prices again reach $100 this year. Prices have been moving up and down in a relatively tight range around $85 a barrel over the past couple of months. However, demand is rising again with the relaxation of China’s zero-Covid policy.
BP also posted underlying replacement cost profit, used as a proxy for net profit, of $27.7 billion for 2022 compared with $12.8 billion for the previous year. And Shell announced a record profit of almost $40 billion, more than doubling 2021 income. The two U.S. super majors Exxon Mobil and Chevron also enjoyed record profits last year bringing in $56 billion and $36.5 billion respectively.
Energy stock investors have enjoyed a significant short term boost
A big chunk of the windfall enjoyed by big publicly-traded energy companies is being returned to shareholders.
Source: Reuters
BP this week announced a further $2.75 billion share buyback and boosted its dividend by 10% to 6.61 cents per ordinary share. Big Energy peers like Shell, Total and the U.S. giants have followed suit, helping to drive their valuations to record highs after years of investor complaints about both a lack of long term returns and capital investment.
Last year oil and gas majors returned a record $110 billion to investors through a combination of dividends and share buybacks.
Debt has also been driven down. Companies have diverted some of the huge inflow of cash over the past year to paying off much of the borrowing required over previous years, during the pandemic had driven prices down.
Loud voices are calling for governments to increase taxes for oil and gas companies raking in record profits while consumers are struggling to afford to heat their homes this winter. However, while one-off windfall taxes have already been levied in Europe and more can’t be ruled out, there is an equally valid argument that if profits are particularly fat at the moment, cyclicality is the nature of the business.
The UK and the European Union have already imposed temporary levies on oil and gas sector profits. Politicians and unions have called for those to be increased. In their results updates, Shell, Total and BP revealed that the new taxes would cost them each about $2 billion — about 5% to 8% of profits.
ExxonMobil, meanwhile, is suing the EU to get the bloc to scrap its new windfall tax. The US’s largest oil firm argues that Brussels does not have jurisdiction to impose the levy, which it says is normally a role for national governments.
Exxon spokesperson Casey Norton said in December that the tax would “undermine investor confidence, discourage investment and increase reliance on imported energy.”
Oil and gas giants have borrowed, not asked for taxpayer-funded bailouts, during lean periods. They argue that demands being put on them to invest huge sums of money into transitioning towards clean energy over the next few decades need to be funded from somewhere. And that the current bonanza has contributed towards solving a funding problem for which there wasn’t previously a clear solution.
A change of investment strategy for Big Energy
But all of the current outsized profits will not go towards returning cash to shareholders, paying down debt and investing in new clean energy assets. Plenty of it will be reinvested in improving oil and gas output too with investment in existing and new assets.
While all the oil and gas supermajors of Shell, BP, Total, Chevron and ExxonMobil have committed to achieving net zero emissions status by 2050, the shift in the market for fossil fuels over the last year is resulting in an overhaul of strategies. More money is again planned for investment in oil and gas assets.
If prices remain elevated over the next few years, which many expect, that income will theoretically make the transition to low carbon energy financially smoother. Profits generated from the sale of fossil fuels will fund investment in their replacement as part of the long-term carbon neutral energy mix.
There has also been a shift in the position of Western governments, especially in Europe. Russia’s invasion of Ukraine means priority is now being given to shorter term energy security and controlling price volatility. Previously, pressure was being ratcheted up on Big Energy to accelerate its transition to net zero emissions.
Sector analysts such as Bernstein’s Oswald Clint now expect Big Energy to “lean more into oil and gas for the rest of this decade”.
That was reflected in statements made by BP’s Looney last week, who outlined:
“We’re announcing up to $8 billion more investment into the energy transition this decade and up to $8 billion more into oil and gas in support of energy security and energy affordability this decade.”
How well Big Energy manages to balance maximising oil and gas income and profits over the rest of this decade and into next with investment into low-carbon energy assets will determine share price performance in the short, middle and long term.
ExxonMobil’s $55.7 billion 2022 profit was not only its record but the highest profit figure recorded by any company in the sector in history. It was achieved because of all the supermajors, ExxonMobil has resisted pressure to decarbonise its business most forcefully. The result was more oil and gas output to benefit from higher prices and an over 50% increase in valuation over the past year.
Of its rivals, BP came closest with gains of circa. 40%. 17% of that has come since the beginning of the year precisely because the major that had so far done most to speed up its low carbon transition process has said it is changing strategy to invest more in oil and gas again in the near term.
In the short term, markets are rewarding Big Energy for remaining closer to its Big Oil roots. That’s being reflected in the extent of investment into low carbon assets. BP was punished for its forward-looking strategy by its share price lagging rivals and ExxonMobil rewarded for focusing on the here and now of fossil fuels.
Last year Chevron made $35.5bn in profits and announced plans to return a huge $75bn to investors through share buybacks. It will spend just $2 billion on low-carbon projects in 2023 out of a total capex budget of $14 billion, and $10 billion between now and 2028.
How should Big Oil invest for the short and long term?
The biggest question for investors is if Big Oil’s management has learned from the excesses of previous periods of high oil prices. The Economist quotes one executive describing oil bosses “spending like drunken sailors”, when coffers overflowed. The results of trigger-happy dealmaking made by cash-drunk boards has been huge waste and overproduction.
Multiple oil projects around the world were losing billions of dollars over the several years ahead of the Covid-19 pandemic, destroying shareholder value. Investors are now demanding better returns from capital investment.
One benefit of that is a new focus on shorter-cycle investments able to deliver returns within 5-10 years. In theory, those are also the kind of oil and gas investments that could help fund the pivot towards low carbon energy without derailing it.
Investors in the oil and gas supermajors are likely to be faced with a choice between diverging approaches to investing the current record profits. The American supermajors of Chevron and ExxonMobil are likely to plough more of their capital investments into oil and gas projects than their European peers and competitors.
As evidenced by ExxonMobil’s valuation surge over the past year, that could well see them outperforming Europe’s representatives in the Big Energy club in the short term. When markets will decide they’ve become too shortsighted, or if they will, is hard to judge.
Europe’s big energy companies continue to pay greater lip service to their 2050 carbon neutrality commitment and are under more regulatory pressure to do so and to demonstrate timelines are realistic. Greater investment in lower return renewable assets in the near term than U.S. rivals may well make them more competitive in the longer term. But that’s a bet on an unknown future investors will have to make.
