Oil and gas companies that have pursued production or reserve growth have underperformed companies that have instead focused on shareholder returns, even if that meant slower growth.
More to the point, companies that have executive compensation tied to these growth metrics have also fared worse. “Most oil and gas companies incentivise their management to pursue growth, rather than focus solely on shareholder returns,” Andrew Grant, a senior analyst at Carbon Tracker, wrote in a new report.
Carbon Tracker argues that these incentive packages result in companies engaging in “value-destroying behaviour.”
Oil executives are rewarded for growth due to an array of incentives, including production or reserve replacement targets. There are also more subtle incentives, such as rewards based on cash flow or earnings.
That may not sound problematic, but earnings can be gamed in such a way as to create the semblance of financial improvement, while in reality reckless growth puts the company at risk. Earnings or cash-flow-based metrics “do include an element of value,” Carbon Tracker notes, but “they still incentivise production growth – for example, the easiest way to boost earnings might be to increase leverage and acquire more assets.”
Related: 2 Reasons Why Big Oil Isn’t Rushing Into Renewables
Instead, oil and gas companies should de-link executive compensation with growth, Carbon Tracker argues. Very few companies have actually done this. As of 2017, 92 percent of oil and gas companies had policies in place that directly incentivized growth in fossil fuel development. Carbon Tracker singled out Anadarko, Cabot Oil & Gas, Canadian Natural Resources, and Oil Search.
Meanwhile, only three companies – Galp Energia, Diamondback Energy and Origin Energy – did not include production or reserve growth in their incentive structures. In 2018, BP and Equinor scrapped these incentives, joining the other three in the small group of companies that are not blindly pursuing growth. For instance, BP got rid of its incentive metric for reserve replacement growth while adding an incentive for returns on capital employed.
Of those five, only Diamondback Energy had no incentives linked to growth at all. The other four had some subtler indirect growth incentives.
Still, the trend is starting to change. After years of red ink, even though production soared, shareholders began to wise up. In the last few years, investors have put more pressure on companies to focus on profits rather than production growth. Between 2017 and 2018, 10 companies “introduced or increased emphasis on returns measures,” according to Carbon Tracker.
Why does all of this matter? The prospect of peak oil demand means that companies that are currently pursuing aggressive reserve or production growth could be destroying value. These assets may eventually become stranded due to weak demand and lower prices. Ultimately, if the world is to get serious about climate change, oil and gas production will have to decline and a lot of reserves will have to remain undeveloped.
Related: OPEC’s Next Big Crisis
Demand doesn’t even need to peak for this to be destructive behavior. It merely needs to slow, putting some higher cost reserves out of reach. Carbon Tracker pointed out that the oil market bust of 2014-2016 stemmed from a rather minor 2 percent excess of supply, which resulted in a 51-percent decline in prices.
“The transition risk to the oil and gas industry is therefore likely to be that of overinvesting, and wasting capital on projects that turn out to deliver poor returns and destroy value,” Carbon Tracker warned. “While some exceptionally low-cost producers may be able to keep production steady or even grow it against a backdrop of weak or falling demand, this would need to be made up by greater reductions in production from other producers elsewhere.”
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However, this isn’t merely a theoretical problem with consequences that lie far off into the future. Even today the growth strategy falls short. In the two years following the oil market downturn in 2014, the U.S. companies “with a lower proportion of reserves or production incentive in their annual bonuses outperformed more growth-oriented companies by 7% CAGR,” Carbon Tracker concluded. “Shareholder returns exhibited a negative correlation with production and reserves-related annual bonus metrics, but a positive correlation with financial returns metrics.”
By Nick Cunningham of Oilprice.com
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However, such a strategy is not only short-sighted but is also based on a faulty assumption, namely the prospect of peak oil demand and the risk of reserve assets becoming stranded due to weak demand and lower prices.
The core business of oil companies is and will continue to be oil, gas and petrochemicals for the foreseeable future. The survival of oil companies in the long term depends on replenishing their reserves and growing their production. They have to maximize returns on their assets and without reserves and growth they can’t achieve that.
Oil companies should base their future strategies on two pivotal principles. The first is that a post-oil era is a myth. Oil will continue to reign supreme throughout the 21st century and probably far beyond.
The second principle is that there will be no peak oil demand either. Global oil demand will continue to grow well into the 22nd century. While a wider penetration of increasing numbers of electric vehicles (EVs) into the global transport coupled with government legislations could decelerate the demand for oil, EVs could never replace oil in global transport throughout the 21st century and far beyond. Even if 400 million EVs were to be on the roads by 2040 which is an impossibility, they will only be able to reduce global oil demand by 8% or 10 million barrels a day (mbd) out of a daily consumption of 120 mbd by then.
Dr Mamdouh G Salameh
International Oil Economist
Visiting Professor of Energy Economics at ESCP Europe Business School, London
Some years ago the petroleum industry talked about facing a new era of tough oil. Oil is harder to bring in today, and the cost for doing it has ballooned. Today, conventional oil is in slow, steady decline in the U.S. Tapping reservoirs, not very deep down, is easy oil and is harder to come by. Tough, unconventional oil is a growing percentage of the total. Investor optimism and low interest rates (cheap money) have helped to keep the game going.
In the short term, those who are coasting on production that is already in progress will show the best immediate performance. What if all U.S. petroleum companies eased-up on production to reduce cost and grow profit? It's unlikely, but is that where we're headed, if the game has changed, and we're in the era of tough oil?
--Time for Petroleum companies to become energy companies, in the broad sense. Cost of production is rising for petroleum; cost of production is falling for clean energy. The future seems pretty clear, as a transition away from burning fossil fuel. We may want to accelerate the transition.