S&P Global Ratings thinks the Middle East's national oil companies (NOCs) and state-owned players in the energy sector are better placed than most global peers to weather the increasing and accelerating impact of the energy transition. Notably, we believe regional shareholder structures, benefiting from government ownership and the expectation of support from generally wealthy--and highly rated--sovereigns, provide a framework to accompany the necessary, and sometimes costly, transformations induced by the energy transition, helping mitigate abrupt and sudden disruptions. This is reinforced by companies', particularly NOCs', large and abundant reserves, cash flow visibility, and competitive cost profiles.

Pricing data support our view that the market does not currently account for transition risk for NOCs and state-owned energy operations from a regional perspective, with funding costs in the energy sector not substantially different than other sectors in the Gulf Cooperation Council (GCC). For investors, it seems energy transition challenges do not outweigh, from a pure credit perspective, the benefits of supportive sovereign owners. That said, we note that this particularly applies to NOCs and government-related entities (GREs) that are low cost energy producers with abundant reserves and also could benefit from strong ties to their respective sovereigns. In contrast, issuers like oilfield service providers and smaller oil players face funding maturities with higher costs.

Companies in the region are also taking several environmental, social, and governance (ESG) and sustainability initiatives. This supports our view that, while the region enjoys a more favorable competitive profile and good cashflow visibility, it is not entirely decoupled from the sector. Therefore, we think the equilibrium may change over time and we will continue to observe the funding cost evolution for GCC corporates in the energy sector.

Frequently Asked Questions

How do you compare the energy sector in the GCC with global peers?

We think GCC NOCs are better positioned than most global players to weather the increasing and accelerating impact of the energy transition. Notably, we believe these players' large and abundant reserves, good cash flow visibility, and attractive cost-competitive profiles could mean they are the last ones standing among oil producers.

That said, we revised down our industry risk assessment for the oil and gas exploration and production (E&P) sector earlier this year, which constrains our business risk assessment, to factor in declining profitability, increasing volatility, and the overall impact from the energy transition. Even if NOCs remain better positioned for now and are less exposed to immediate credit pressures, we don't see them as immune from sector trends.

Is there a divergence between cost of funding in the energy sector (oil and gas and chemicals) versus other sectors in the region?

The data we have on pricing support our view that capital markets are yet to see risks from ESG and the energy transition in the GCC energy sector.

Over the past few months, the global investor community has increased scrutiny of the oil majors and ESG strategies. This includes a court ruling against Royal Dutch Shell PLC (A+/Stable/A-1; must reduce greenhouse gas [GHG] emissions 45% by 2030), shareholder activism to cut carbon emissions during Chevron Corp.'s (AA-/Stable/A-1+) annual meeting, and an activist hedge fund winning board seats and pension funds and management lending support to ESG-related investment changes at Exxon Mobil Corp.'s (AA-/Negative/A-1+) annual shareholder meeting. However, we think it is unlikely that stakeholders--investors, shareholders, activities, nongovernmental organizations, or simply wider society--exert as much pressure on GCC energy companies as listed players in Europe or North America, at least in the short to medium term. This gives NOCs in the GCC more time to manage the transition and implement strategic changes.

Although the region is still only starting to attract international investors for its debt issuances, our findings suggest that capital markets are not differentiating GCC companies based on perceived ESG risk, at least for now.

If we look at aggregate amounts, companies in the GCC energy sector do not face higher funding costs than other regional corporates, or even banks. In fact, funding costs for the energy sector are currently lower than for other corporates and relatively in line with those of Russian peers and the oil majors.

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How do you define cost of funding?

To analyze funding cost differentials, we reviewed primary market bond issuance yields (including matured and outstanding) in the GCC since 2012 (until Aug. 11, 2021), across the corporate sector. This included energy sector (among them oil and gas and chemical players) and other corporates, banks and financial institutions, and sovereign issuances. We also looked at issuances for peers in the energy sector, including low-cost countries such as Russia (among them oil and chemical companies) and the oil majors. In addition, given limited historical trends, we took a closer look at the United Arab Emirates (UAE) and Saudi Arabia, where the energy sector remains a key growth driver, to identify potential differences in funding costs. For consistency, we looked at U.S.-dollar denominated issuances, and calculated the floating rate, based on interest rates at the time of issuance.

Do ESG considerations and potentially higher funding costs (in the longer term) affect your ratings on companies in the GCC energy sector?

We have yet to change any rating, or outlook, on a GCC corporate in the energy sector specifically due to ESG considerations, even if these factors are an important part of our credit considerations. From a pure rating perspective, we believe the increasing challenges the energy transition poses to these companies, especially NOCs and GREs, are for now somewhat mitigated by the strength of relevant sovereign shareholders. These shareholders have a strong incentive to support a sector of high importance to the local economy and/or to create a favorable ecosystem to allow NOCs and GREs to grow and develop despite shifting global dynamics. However, like for corporates globally, we believe overall sustainability strategy is fundamental to these companies' credit quality and will become even more important.

We distinguish between NOCs and large chemical players, and smaller oilfield services companies, which are not linked to the regional sovereigns. We think NOCs and large chemical players will continue to benefit from three main factors:

• Importance to their governments: Primarily since most NOCs and big players in the region's energy sector are GREs (owned by either a sovereign wealth fund, or state-sponsored investment vehicle), with strong ties to their respective governments (predominantly investment grade). In most cases, this primarily drives the rating and subsequent cost of funding rates more than pure ESG considerations, at least for now.
• Cost profiles: Despite increasing concerns on profitability, volatility, and the overall energy transition, we view the long reserve life and low production costs of GCC NOCs as supporting credit ratios and balance sheets in the short-to medium term.
• The search for opportunistic yields, for now, still outweighing ESG integration for investors in the context of abundant liquidity globally: ESG integration is picking up pace with developed market investors, largely spurred by demand from pension funds, but it is yet to materialize in the GCC asset owner community. We expect this could take time given most companies in the sector are predominantly GREs, with limited material nonregional ownership.

Market trends are also supportive of our view. Looking more specifically at the UAE and Saudi Arabia, our findings suggest opposing trends for energy sector funding costs. On aggregate, costs appear higher for energy companies in the UAE than for other corporates. This could indicate increased perception by investors of ESG considerations, but is also representative of the higher number of lower-rated companies in the sector (including high-yield issuers like oilfield services company, Shelf Drilling Holdings Ltd. [CCC+/Stable/--]). The story is quite the opposite in Saudi Arabia, where the energy sector has lower funding costs than other industries, including sovereign. This could partly be explained by companies' classification as GREs, including Saudi Aramco (not rated), by far the dominant energy player in the kingdom.

The appetite for regional NOC issuances has been strong. Notably, Qatar Petroleum's (QP's; AA-/Stable/--) $12.5 billion bonds in June 2021 secured about $41 billion in orders, and landed 10 basis points (bps)-15 bps wider than the sovereign curve, similar to Saudi Aramco's $10 billion inaugural debut issuance in 2019, which attracted more than $100 billion in bids.

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Do low production costs offset the need for lower emission requirements?

In our view, it depends on the approach adopted to meet emission reduction goals. The GCC benefits from low-intensity gas-based feedstock like methane and ethane for downstream production with very low lifting costs. This means regional energy players are already better positioned from a GHG emission perspective than most global peers, even low-cost players such as those in Russia.

We understand countries in the region have committed to reduce GHG emissions, in line with the Paris Agreement. We expect oil and gas will remain a part of the global energy landscape for some time, albeit likely with a smaller market share than today. In our view, demand will be increasingly met by the lowest-cost producers, including regional NOCs. That said, even if GCC energy companies may have more time to adjust, the energy transition and other ESG considerations are of utmost importance to them, and for the medium-term evolution of their credit quality. Changes in end-consumer behavior and evolving investor sentiment will force regional energy players to gradually reconsider and adjust their business models and production capacities.

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Are NOCs and big players in the regional energy sector taking actions to reflect their ESG focus?

We see some effort to embed ESG into corporate strategy from the regional sector. However, there is for now only a modest sense of urgency to accelerate this, especially in comparison to global players that are facing shareholder activism and requirements to increase transparency on climate disclosures.

In addition to aligning sustainability targets with the Paris agreement, which includes initiatives like achieving zero flaring by 2030 and carbon-intensity reduction, energy players in the region are looking at carbon capture methods.

Among them:

• Abu Dhabi National Oil Co. (not rated) in the UAE is studying the feasibility of producing blue hydrogen (derived from natural gas) and hydrogen carrier fuels by 2025 and Saudi Aramco has announced plans to invest in blue hydrogen, with ramp up expected in 2030. In Qatar, QP has committed to reduce routine gas natural flaring to zero by 2030, and in 2019 it launched the largest carbon dioxide recovery and sequestration facility in the Middle East, with a capacity of 2.2 million tons per year. In our view, a key factor for these projects will be balancing the off-takers and market demand for the product while ensuring healthy returns.
• Large chemical players, such as Saudi Basic Industries Corp. (SABIC; A-/Stable/A-2), are contributing to efforts in the circular economy and reduction of single use plastics, albeit in regions such as Europe where regulatory requirements and supervision are increasing.

What is our view of governance in the region?

We think governance remains a key element for the assessment of any corporate entity's credit quality. GCC-based companies' corporate governance has improved over the past decade, but it remains below international best practices. As the GCC continues to import capital, conditions imposed by institutional investors are likely to strengthen governance practices, financial transparency, and sustainability reporting. In our view, governance practices are stronger for GCC financial institutions and larger nonfinancial companies active in capital markets (for example, SABIC) because they are subject to greater regulatory scrutiny, disclosure, and market discipline. Similarly, government ownership appears to bring closer supervision of certain basic governance practices. In our rated peer group most NOCs are GREs, meaning board members are primarily representative of sovereign shareholders. Therefore, the importance of these companies to their respective sovereigns, and the ability to execute mega projects on track, are somewhat balanced by limited disclosure and communication to capital market participants.

To successfully adapt to a carbon-constrained economy, companies will need to rethink their strategic positioning, which requires effective boards with members sufficiently skilled in sustainability. However, GCC boards mostly lack expertise in environmental or climate-related areas. There is an increasing global trend of companies building climate or ESG skills at board level and setting up dedicated committees. We believe companies that do so are likely better positioned to continue operating sustainably going forward.

In addition, we see that GCC boards are somewhat lacking in diversity compared to international standards, particularly in terms of gender. Female representation in the workforce and on boards is still at a nascent stage compared to global peers and remains well below European averages, despite continued improvement.

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Related Research

• Corporate Governance Practices In The GCC, March 15, 2021