With lower returns to shareholders, energy companies may have to turn towards investors that take a long-term view, including sovereign funds
Leila R. Benali, Ph.D
Chief Economist, Head of Strategy, Energy Economics and Sustainability
Dammam, Saudi Arabia, 25 December, 2019: This year has been one of game-changers, from non-traditional surgical warfare on oil and gas installations in the Gulf, escalating trade wars between major economies, public backlash against economic policy issues — at times in unexpected countries — to the long-awaited listing of Saudi Aramco on Tadawul on December 11.
Beyond these headline-grabbing events, however, certain profound and interrelated market transformations are transpiring beneath the surface and shaping the energy company of the future.
After knee-jerk price spikes following the largest supply disruption in history with the unprecedented attacks on Aramco’s facilities in Abqaiq and Khurais, energy markets were swiftly brought back to reality by demand fundamentals and crude quality differentials.
With petrochemicals being possibly the sole bright spot for future oil demand growth, it is not surprising to see sustained efforts towards vertical integration within energy companies in order to extract maximum value from finite hydrocarbon resources, as evidenced by the massive capital-intensive refining or even crude-oil-to-chemicals schemes under way. Several oil and gas companies are deploying relentless efforts to build up integrated LNG portfolios, from production and liquefaction to trading, shipping, regasification and marketing.
To pull off projects of such size and complexity, private sector energy companies and National Oil Companies (NOCs) alike require flexibility, scale and mobilisation of significant financial resources to provide working capital and manage price risk.
However, the energy sector is looking at a significant uphill battle in this regard due to relatively low shareholder returns and squeezed margins across the entire value chain. For example, the energy sector provided — by a substantial margin — one of the lowest returns to shareholders during the last decade among the companies in the S&P 500 index.
This confluence of factors could lead to the emergence of a new model of integration; between oil and gas companies on one side and investment funds — including potentially Sovereign Wealth Funds (SWFs) — on the other. This consolidation could establish an unprecedented industry structure that might boast the type of flexibility, scale and significant financial resources required.
If — and it is an admittedly big if — the journey to integration is done the right way, we may witness the dawn of the fourth chapter in the history of the energy industry structure, with the first three being the unbundling of Standard Oil in 1911, the nationalisation of companies in the 1970s and the rise of International Oil Companies and the mergers and acquisitions activities of the 1990s. And, as history has taught us, there are marriage terms that take longer to hammer out.
For successful NOCs, budget autonomy and the ability to keep part of their sales to invest in maintaining or expanding capacity have been key differentiators. The current financial model enables the most active NOCs to deliver on their strategies and capacity plans. NOCs with no control on their finances struggle — if not fail altogether — to meet their targets.
In the wider relationship between the state and an NOC, success generally comes when integration is embodied at all governance levels. Even when the NOC enjoys high operational autonomy, the state is either represented on the board to ensure continued alignment with the national interest, or it maintains direct interests in the assets.
The story is less theatrical but equally as interesting for utilities and renewables, where smaller scale, distributed generation and more investments in storage are likely paths of the future, especially when considering that this end of the intricate energy landscape represents the second-most preferred infrastructure industry for institutional investors.
The ever-increasing momentum to reinforce national contributions under the United Nations Framework Convention on Climate Change (UNFCCC), coupled with the complexity of the task at hand due to the variety of stakeholders’ needs and interests, will determine the energy mix in many countries across the globe.
There is also a growing realisation that the existing energy system, which took a large part of the 20th Century to build, has “synch costs” that cannot just simply be written off, as well as wariness by investors to do so due to uncertainties about decreasing costs, particularly for technologies requiring specific commodities, such as cobalt.
Conventional funding continues to be more readily available for large-scale, well-rated companies. This leaves the smaller players, which are typically focused on testing new technologies, tapping into tailored funding mechanisms as the rest of the value chain — including storage — lags behind.
With the accelerated pace of energy transitions, how some of these market forces will evolve over the next two to three years will play a significant role in shaping the energy industry for many years to come.