The oil majors are at a crossroads and there are growing signs that their business model can no longer last. The combined effects of cheap oil, the increasing difficulty in expanding bookable reserves, and ever-tightening environmental regulation on “unburnable carbon” leave the largest oil companies not only with few growth opportunities, but also with the prospect of being forced into decline.
For decades, the largest oil companies pursued a business model that relied upon perpetual growth of finding and booking new oil reserves. According to a recent report from Chatham House, there is strong evidence that this model has reached its limits, amidst signs of “growing shareholder disillusion with a business model rooted in assumptions of ever-growing oil demand, oil scarcity and the need to increase bookable reserves, all of which increasingly lack validity.”
Since most of the world’s oil reserves are under the control of national oil companies (NOCs), the oil majors had to look at increasingly far flung and expensive locations for new sources of oil. But complex and expensive oil depended on steadily rising oil prices and unending growth in demand. For a while, the strategy made sense. But massive cost overruns in megaprojects like the Kashagan field in the Caspian Sea, or the billions of dollar blown on the Arctic, plus the Deepwater Horizon disaster in the Gulf of Mexico, have raised serious questions about the majors’ ability to bring new sources of production online in a safe and profitable way. The collapse of oil prices blew up the financials for many of these projects.
Crucially, however, the oil majors are also no longer even succeeding in growing their reserve base. In 2014, the oil majors added the smallest volume of new reserves since 2010. Last year was even worse – in 2015, the oil industry only discovered 12.1 billion in new oil reserves, the lowest level since 1952. Many of the oil majors failed to replace the oil that they burned through in 2015, posting reserve-replacement ratios below 100 percent for the first time in decades. Moreover, the largest oil companies have had to dispose of assets, cut spending, and take on large volumes of debt in order to maintain their dividend policies and buyback shares.
Still, as Chatham House notes, the returns to investors have eroded over time, even before the collapse of oil prices. The return on investment for oil and gas has been lower than that of other industrials for about a decade. Related: How Low Oil Prices Are Erasing The Glut
Part of this has to do with companies that have become too big and unwieldy, with annual expenditures that inexorably climbed for most of the past decade. The markets have become wary of this reckless growth. Chatham House notes that in October 2013 when the five largest oil majors announced their spending plans for the upcoming year, only Total unveiled spending cuts. Following the announcements, Total saw its share price rise while the others saw theirs fall. This occurred at a time when oil traded for $100 per barrel.
So these problems have plagued the industry for some time. However, more recently, new threats have emerged, not the least of which is the prospect of the oil majors sitting on “unburnable carbon,” or oil and gas reserves that might never be produced because of stricter environmental and climate regulation. Last week, several of the majors fought off shareholder resolutions over the disclosure of this financial risk to climate change. While oil executives fight climate legislation and downplay the extent of climate change, shareholders are not as sanguine. Related: Nigeria’s Oil Production In Free Fall After More Attacks
If the world get serious about addressing climate change, and sticks to the target of limiting warming to 2 degrees Celsius, it would theoretically require about one third of the world’s oil and gas reserves to remain in the ground. This is a monumental threat to the financial trajectory of the industry, a threat that has not yet been priced into the value of the oil majors’ future prospects. This message does not just come from environmentalists – the FT offered a pretty bleak assessment of the industry’s future, telling Big Oil that it has no other choice but to become smaller.
“Rather than investing in potentially stranded oil and gas projects, or gambling on new technologies that they do not fully understand, the oil companies would do better to continue returning money to shareholders through dividends and share buybacks,” the FT wrote on May 27. “Instead of railing against climate policies, or paying them lip-service while quietly defying them with investment decisions, the oil companies will serve their investors and society better if they accept the limits they face, and embrace a future of long-term decline.”
By Nick Cunningham of Oilprice.com
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