Energy transition may help create leaner oil and gas sector, say analysts

Energy transition could be the bitter tasting pill the oil and gas sector needs, analysts said this week, as companies strive to become low-cost, low-carbon producers leading to more consolidation.

The pivot away from fossils fuels and towards clean sources of energy is causing an existential crisis for many in the oil industry. But this transition also presents many opportunities to many of the big international and national oil and gas companies.

"I think in the future we are heading into a squeezed, consolidated, concentrated industry but probably [one that is] much more profitable," the chief economist of the International Energy Forum Leila Benali said on June 16 at the S&P Global Platts GEPEC conference.

A similar message came from Goldman Sachs' head of commodity research Jeff Currie.

Currie said the oil sector could tread a comparable path to tobacco and coal, both of which he termed as "the two pariah commodities."

"What happened after the tobacco settlement? What does it keep on doing? What is it doing today? It keeps on going up if demand goes down and supply drops faster. Look at coal," he also said at the GEPEC conference on June 15.

Low-cost, low-carbon

There is also a growing consensus that the lack of investment in the upstream sector over the past few years is likely to lead to supply shortages in the future, and threaten the stability of oil supply.

Riyadh-based IEF has also previously warned that even considering uncertainties over future demand and possible peak demand, the world could lack the production capacity to meet its needs. But in this scenario, many of the already exiting oil and gas players are likely to increase their dominance in the oil market.

Those upstream projects which boast of low production costs and lower carbon intensity are likely to remain more competitive in a shrinking oil market.

"If we are able to trace carbon, measure it and value it in a more transparent way, you will have those low-cost, low-carbon integrated digitalized producers dominating in market share and the highest cost producer will be at the tail-end of what is a plateauing market," added Benali.

Many oil and gas companies are already looking to cut their carbon footprint by indulging in many strategies, such as reducing flaring, shifting to less carbon intensive production, creating more low carbons fuels, investing in carbon offsets, adding carbon capture, among other avenues, to stay viable.

Profound crisis

The impact of the lack of upstream investment is expected to last longer than after previous crises.

"The long-term nature of the crisis and profound restructuring of oil and gas will hit investment this time longer, of course sowing the seeds for a supply crunch in the future potentially and price volatility," added Benali. "The good news at least for shareholders is that consolidation, capital discipline, and the focus on graded projects is supporting a strong improvement in profitability."

Benali said the average internal rates of return for projects that were sanctioned in the last five years have been around 15-20%, which are consistent with levels that were observed in the early 1990s.

This compares to an internal rate of returns of 8-12% for projects that were sanctioned between 2006-2016.

Annual capital expenditure in the oil and gas industry has now fallen to $200-300 billion from around $800 billion - $1 trillion ten years ago, according to the IEF.

Companies are now banking on short-cycle rather than long-cycle projects.

Currie also declared the death of long-cycle production in the current environment.

"We don't expect to see any significant investment there but short cycle production like US shale, Middle East production and Russian production should go on," he added. "The bottom line is Netflix is still a much better business model than any oil and gas investment at this point right now."

Recovery in upstream investments

Upstream oil and gas investments have however rebounded slightly this year as companies recover from the financial shock of COVID-19, but spending is still expected to remain well below pre-COVID levels and is being outpaced by surging investment in renewable power.

S&P Global Platts Analytics expects global upstream investments to rise 8% in 2021 and 9% in 2022 after a dramatic drop of 24% last year.

Sustained higher oil prices are also resulting in more final investment decisions for oil projects.

So far this year, eight projects have been approved compared to only seven in 2020, according to Platts Analytics.

"As prices hold steady or continue to rise, more projects are expected to be sanctioned during the year, coming mainly from Brazil, the Gulf of Mexico, Guyana and the North Sea," Analytics said in a recent note.