There’s growing sentiment that demand for oil will soon peak as the world accelerates its transition to renewable energy. As a result, some investors might believe that oil and gas exploration and production (E&P) companies can succeed only if they are pivoting sharply into renewables. However, we think the fear of peak oil is a misreading of current conditions in the energy sector. The transition will be more nuanced and prolonged, creating short-term uncertainty in determining the terminal value of these companies. In the intermediate term, investors should focus on getting as much cash as possible from their oil stocks.
Change will take time, and oil demand should remain strong
In our view, the demand for oil will grow for at least the next decade, and the decline in demand, when it comes, will be gradual. Consider areas of the economy like air travel, shipping and plastic manufacturing, where currently there are no clear substitutes for hydrocarbon fuel. And even though the transition to electric vehicles (EVs) has begun, there are only 7 million EVs on the road. That’s just a fraction of the 1 billion vehicles with internal combustion engines in the world.
Despite these factors supporting demand for oil, many E&P companies have already responded to the concept of peak oil and pressures to reduce the environmental impact of their business. European companies such as Shell, Total, BP and Eni have been leading the way in the transition away from hydrocarbons. BP, for example, is aiming to produce 40% less oil by 2030.
Still, the stock market is not yet rewarding these companies for their environmental efforts, despite the growing focus on environmental, social and governance (ESG) criteria. The stocks of the E&P companies leading the transition to renewables generally have fared worse than the companies taking a more gradual approach, with BP a prime example: Its stock has been the worst performer in the group.
Instead, the more immediate impact of the focus on renewables has been cutbacks in oil production, which is leading to the risk of supply shortages in the next few years. We think those shortages, combined with the pent-up demand for travel that will be unleashed once COVID-19 vaccines are widely distributed, will bring higher oil prices in the second half of 2021 and into 2022. That trend may benefit E&P companies whose performance is most closely tied to the price of oil, such as Occidental Petroleum and Conoco.
The challenge of maximizing value today
Faced with this longer-term transition away from oil, companies have to balance their ability to generate returns from existing assets with investments in new technologies that don’t yet provide a competitive advantage or a boost in share prices. In this environment, investors may want to seek companies that can find innovative ways to reduce the environmental impact of their operations while still leveraging their current expertise.
Occidental Petroleum, for example, is focused on reducing the harmful impact of CO2 by investing in methods to capture carbon dioxide out of the air and store it permanently—a process called sequestration. Chevron is drawing on its natural gas expertise in its efforts to generate renewable natural gas from dairy cow manure. Similarly, refining companies can use their expertise and infrastructure to focus on creating biodiesel.
Given that these new businesses may generate lower returns that traditional oil production, companies also are looking to reduce their costs. That has created a flurry of M&A activity from companies looking to generate economies of scale. In recent months, Conoco acquired Concho, Diamondback purchased QEP Resources, and Devon Energy merged with WPX Energy.
Capital discipline and cash flow are key
Renewable investments aren’t happening in an environment like the early days of shale exploration, where E&P companies could focus on long-term growth. Companies need to focus instead on creating value for shareholders.
In closing
We believe investors should look for oil companies that are generating strong free cash flow—and are returning surplus cash to shareholders through stock repurchases or dividends. Investors should also look for companies who are formalizing that commitment by tying management compensation to capital discipline and free cash flow metrics, rather than the growth metrics that typically dictated management compensation in the past.