While you have been eagerly following the sterile debate in Doha about whether to phase out or phase down fossil fuels, you probably missed an announcement on December 6, one that you probably would not have noticed anyway because it is not in your line of business. But it could presage similar events in the oil business.
Here is what happened. British American Tobacco (BAT) announced that it would write off £25 billion of the £62 billion value of the US brands it acquired in 2017 (Reynolds American). Why? Because of a combination of slowing growth, consumer reluctance to spend, and losses in the vape market that was supposed to replace revenues from old lines of cigarettes. When BAT made the Reynolds acquisition management presumably knew cigarette sales were under pressure, that government health experts didn’t show sympathy for the vapes, and that many new firms were pushing into the vape market, thereby creating more competition that cigarette companies had become accustomed to over the years. Note that BAT did not write down the assets because those properties lost money, but rather because they were forced to recognize a severe loss of value. The reason we keep an eye on the tobacco industry is that tobacco and oil (or fossil fuels in general) have shared an almost identical regulatory and legal strategy for several decades—whether the issue was denying their products links to cancer or climate change. Related: COP28: Arab Coordination Group Promises $10B To Assist Developing Nations
The Reynolds American acquisition was similar in size to the recent ExxonMobil and Chevron acquisition announcements of this fall. As an aside, we should point out something about corporate mergers and ways to distinguish them. Simply consider the underlying business. Is it growing or in decline? Interestingly, it can be sensible for both high growth and declining businesses to find merger partners although the capital allocation challenges are reversed. The two oil giants, knowing that sales are slowing and facing uncertain litigation risk from a public that holds them responsible for global warming, decided to combine and manage their decline across a much larger revenue and asset base. The strategy here is to ultimately reduce costs faster than revenues decline. This may prove somewhat easier in a cartelized industry like oil which enjoys a modicum of price fixing via OPEC.
BAT, on the other hand, purchased Reynolds American for growth not simply scale. They wanted entry into the high-growth US vape market, which it saw as its future. With the benefit of hindsight we see they paid way too much for entry into a new market and a business with considerable regulatory overhang. ExxonMobil and Chevron aren’t taking on any new business risk by partnering, they each do the same thing just in different places. It’s just about eking out economies of even greater scale as revenues flatten and decline. The companies make clear that, despite all the warnings about climate and threats of new technologies and of the entry of firms vigorously trying to reduce their markets (Tesla and the entire Chinese automobile industry as examples) they feel good about their prospects and will robustly continue old policies. Frankly, we would not be surprised to hear they actually have a growth strategy that involves Africa, S. Asia and possibly other frontier markets.
What about climate change? Well, a proposal from Sheik Al Jaber, President of the COP28 climate conference in Doha, did not include calls for closure or phase outs of oil and gas infrastructure as, for example, former Vice President Gore has been advocating. Instead, proposed reductions in CO2 emissions are all about the offsets. Offsets are like behavioral swaps. In other words we get to keep doing the formerly environmentally harmful things (like driving, cooking, or heating our home) but by switching to new, cleaner technologies our emissions will be reduced. These emission reductions come mainly from two areas, increasing electrification (like electric vehicles and heat pumps) and a tripling in planned deployment of solar photovoltaics. The other two smaller “buckets” for CO2 removal were for reduction of methane emissions and “other” which included new nuclear power generation. New nuclear is not getting much love here despite a commitment from twenty or so nations to triple nuclear capacity.
So back to our original question: will oil mergers in a declining industry like Exxon/Chevron provide financially attractive results to investors or will they disappoint like BAT/Reynolds? There are several parallels: slowing growth, possible decline in demand, uncertain timing regarding litigation and its outcomes, and a public policy designed to reduce or eliminate sale of the product. But there is one key policy difference here, the concept of “offsets”. There were no offsets for the tobacco industry or for smokers for that matter. Just punitive financial penalties and harsh warnings on cigarette packages regarding smoking and lung cancer. Offsets are a pain free way to achieve policy outcomes. No plants or facilities have to be prematurely shuttered triggering financial write offs. No unemployment or even political unrest. As long as the favored policy vehicle includes economically pain free CO2 “offsets” via new technologies, as opposed to actual plant closures, then we feel pretty good about the prospects for oil and gas mergers.
Bottom line: obviously we don’t know for sure whether recent big mergers at solid valuations will end with large write-offs for oil and gas companies as they did for “big” tobacco. And we just can’t help but notice the similarities. But there is one difference between the two industries that seems to favor the energy industry. The Republican party in the US has adopted a policy strongly advocating for increased fossil fuel usage as well as claiming that climate change is a hoax. The tobacco industry for all their chutzpah never claimed lung cancer was a hoax.
By Leonard Hyman and William Tilles for Oilprice.com
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