An oily mess

Take the West’s increasing focus on economic self-sufficiency while simultaneously doing our level best to undermine it. The pursuit of greater self-sufficiency arises from the unintended consequences of globalisation; namely, the increasing reliance on dodgy or downright hostile regimes for some of life’s economic necessities. Meanwhile, undermining that aim is the messianic fixation with climate crisis and the consequent pursuit of environmental policies that undermine self-sufficiency in energy.

A striking example came along earlier this month when ExxonMobil (US:XOM), by far the biggest quoted energy company in the free world, was pretty well hijacked by a tiny firm of activist investors who, despite holding just 0.02 per cent of Exxon’s shares, got three of its nominees onto Exxon’s 12-person board of directors.

True, the activist, Engine No. 1 – whose name is suitably hip for a firm located in San Francisco’s Bay area – both picked, and picked apart, its victim expertly. Compared with other oil majors, there is little question Exxon’s board lacked industry experience; nor did its bosses’ business-as-usual rhetoric do it any favours. Even so, the impression is that Engine No. 1 was pushing against an open door; that Exxon’s leading shareholders, quite possibly its top executives too, were so desperate to get onto the politically-correct side of the debate that swapping three non-executive directors for three with acceptable – even impressive – CVs was a small price to pay.

Yet, in doing so they acknowledged a new axiom of the western world’s oil industry – that the pursuit of fossil fuels is for fossils. Or, to put it as a stark question, in a world obsessed with the pursuit of net-zero carbon emissions, can the oil sector continue to be what it says on the can, explorers for and processors of hydrocarbons? That prompts a supplementary question, where does this leave investors in oil majors – holding a sticky mess or with an opportunity?

Exxon’s directors and shareholders are not the only ones to have had a Damascene moment recently. Only last month the International Energy Agency (IEA) had one too. For years the IEA, an energy-industry adviser funded by rich-world governments, has been sceptical about the potential for renewable energy sources to replace the reliable but CO2-emitting kind. It changed tack dramatically with its Net Zero by 2050 Road Map, which reckons – admittedly on an optimistic scenario – the world can meet the net-zero obsession without investing in any new fossil-fuel resources. In other words, the hydrocarbon projects already up and pumping will be sufficient to meet the world’s needs as the march of the renewables – especially solar and wind power – progresses.

Yet it does not take a cynic to say it probably won’t work out that way. There is an awful lot of CO2 to be eliminated, either honestly or by sleight of hand. Globally, CO2 emissions are still on an upwards path. Sure, emissions fell almost 6 per cent in 2020 – an unprecedented amount in both percentages and volume. But they will rebound in 2021. The IEA expects more than three quarters of 2020’s drop to be recouped. Thereafter they will most likely resume an upwards crawl. In which case perhaps 38bn tonnes of the stuff will be emitted by 2030 though, on a pessimistic scenario, the figure could reach 40bn tonnes. To put that into context, global emissions were about 22bn tonnes in 1990 and perhaps only 6bn tonnes in 1950.

Much will depend on what happens in China and India, the world’s two most populous countries and its biggest consumers of coal, a rich source of CO2. China was the only major economy where coal consumption rose in 2020. It is set to rise further this year since so much of China’s electricity comes from coal-fired power and demand for electricity rises in lock-step with changes in economic output. To what extent that link weakens depends on the development of renewable power sources. Such is China’s demand for power that it manages to be both the world’s ‘dirtiest’ electricity producer and perhaps its ‘cleanest’, especially via solar and hydro-electric power. Meanwhile, in India meaningful alternatives to coal-fired power are more limited.

So this is a world where demand for oil and gas will fade slowly at best. Even the IEA only sees growth in global demand coming to an end “within 10 years”, by which time consumption is likely to be clear of 100m barrels a day, a figure that will compare with 96m barrels in 2019, only 88m barrels in 2020 but rebounding to perhaps 93m barrels this year.

In that context, it may be worrying – and perhaps should be – to see investors’ aversion towards exploration projects on the part of the oil majors and the huge concentration of oil and gas reserves in the hands of companies – mostly state controlled – from nations that are, at best, unreliable partners of the west or, in some cases, downright hostile. Not one of the 20 companies with the biggest oil reserves is based in a developed democracy, while the national oil companies of Iran, Iraq and Libya all figure. Saudi Aramco predictably has the biggest reserves and companies from China and Russia make the cut. Only towards the bottom of the 20 do companies from pro-West nations appear – Mexico’s Pemex and Brazil’s Petrobras (US:PBR).

One response is that it was ever thus. Much of the foreign policy of the USA these past 75 years has been directed to securing a flow of oil from places where no law-abiding company really wants to operate. Yet that was balanced by western companies doing much of the exploration, development and production themselves. Nowadays this is less likely to be the case, pushing western companies towards projects that are marginal at best. In a world of increasing scepticism about burning hydrocarbons that has been a poor corporate strategy, especially when – as in ExxonMobil’s case – the productivity of capital spending has been falling fast. According to Engine No. 1’s dismantling of Exxon, cap-ex that generated 39 barrels of oil for every $1,000 spent in 2001 only generated eight barrels in 2020.

No surprises that this marginalisation of oil majors is reflected in their stock-market value. The chart shows how this has fallen away this century. Taking the stock-market value of eight leading US and UK oil majors, it shows they have suffered a combined 44 per cent loss of value – or $750bn – since 2007. Put another way, companies whose combined worth was equivalent to almost 15 per cent of the S&P 500 index of leading US stocks in 2008 has dwindled to less than 3 per cent.

But if demand for oil isn’t vanishing any time soon and the West is increasingly fretting about its economic vulnerability perhaps this value shock is overdone. Even the IEA acknowledges that “declines in production from existing fields create a need for new upstream projects, even in rapid energy transitions”.

That may be another way of saying big oil is hardly finished. In which case, are its shares worth buying? The table shows some key metrics for the five majors. By comparing performance for the latest year with the average for 2010-20 the notion of decline becomes real. Almost everywhere, profit margins and return ratios are declining as is the ability to generate free cash; meanwhile, debt ratios are rising. But not necessarily disastrously so, and the much maligned ExxonMobil isn’t always the worst performer.

All of which prompts the thought, will shares in big oil behave much like those for big tobacco in the early years of the century? That was a time when public opinion assigned cigarette makers much the same moral status as drug dealers. No matter. Their shares performed wonderfully well as each succeeding healthcare settlement still left big tobacco with enough revenue in effect to fund generous annuities to shareholders. As a result, for example, shares in British American Tobacco (BATS) outperformed the FTSE All-Share index by 700 per cent as their price rose from about £5.75 to over £55 in the 15 years to 2016.

There is no immutable law that says the same must happen to shares in ExxonMobil et al. Even so, smoothing out the contradictory dynamics of pursuing both ‘net zero’ and economic self-sufficiency while producing enough affordable energy to go around indicates their shares will return to favour. The only question is when.