Energy Council Research
The Re-Imagining of the E&P Sector
Published 2 February 2021
by Ben West, Portfolio Manager – Americas & APAC
The Downfall of the Upstream E&P Sector
The Upstream E&P sector has long been facing a number of ever-increasing headwinds and capital flows into the sector have been following a downward trend for some time. The sector has gone about destroying value by loading up on debt and prioritising growth at all costs, with little thought for the consequences. Ultimately, 2020 proved this approach unsustainable.
This trend began long before any mention of the coronavirus pandemic. Numerically, the outflow of capital is pretty stark. Rewind to 2016 and E&P offerings in the public markets were as high as $33 billion; fast forward to 2019 and public E&P offerings did not even cap the $1 billion mark. Similarly, new energy funds raised fell from $54 billion in 2017 down to $16 billion in 2019. All of this before 2020 triggered the biggest downturn in the sector’s history and drove the energy industry down to record lows of as little as 2% of the S&P 500. The fact of the matter is that this downward trend was set in motion long ago; the double-whammy impacts of the coronavirus pandemic and the Saudi-Russian oil price war merely brought the clocks forward and pulled the wool from over our eyes. The E&P sector was a ticking time bomb.
NB: There are very large, stark drop-offs when you include some of the bigger outliers
Source: Investors Are Leaving US Shale & They Are Not Coming Back webinar debate which took place on 8th October.
So what were the factors behind the demise of the E&P sector? Put simply, poor performance. It is a lack of returns and unfulfilled promises over a prolonged period of time that have driven investors from the E&P sector. The cause of this poor performance is more ambiguous. From commodity price volatilities, ill-disciplined management teams and changes in the way we demand and consume energy, to a heightened focus on environmental performance and increasing ESG headwinds, household E&P investors are abandoning the sector. Why? To be less reliant on oil prices, and to distance themselves from an industry that is widely perceived to be not doing enough to improve its environmental performance.
Is This the End of the Upstream E&P Sector?
Put simply, no. Roughly 79% of the world’s energy is supplied by Oil & Gas today. The world still needs Oil & Gas and will continue to for decades to come until developments in renewable energy technologies enable them to be cost-competitive enough and efficient enough to be developed at the scale required to meet the world’s ever-growing energy needs. Until then, the world faces the very real threat of being undersupplied if there continues to be a lack of investment in the Upstream E&P sector. Saying that, this is the end of the Upstream E&P sector as we know it. Oil & Gas companies must recognise the threat that changing market conditions – most notably the energy transition – pose to them and be prepared to change if they are to have a long term future in a world that demands a low carbon economy.
During the 2014-2016 downturn, the industry had an opportunity to remodel itself and bounce back fitter, leaner, stronger. However, it failed to recognise this opportunity. Instead, it resorted to what it knows best: growth at all costs and banking on cashing in on the exit. The E&P sector mistook a structural change for a cyclical change; the refinancings did not go far enough; the restructurings did not go deep enough. They simply papered over the cracks. But today, there can be no mistaking it: Oil & Gas companies must recognise and embrace this secular change or accept their place in the history books.
What must Oil & Gas companies do to attract investors back to the E&P sector?
The good news is there is still a healthy pool of investors who continue to see value and significant future upside potential in the Upstream E&P sector. The general consensus is that less capital should continue to create good opportunities for those that can raise it, and those who will be able to raise it will be those who are successfully able to manage risk, run efficient asset bases and re-evaluate how they are able to create value for investors. There are a number of investors and companies who are already making strides in this arena, and many industry leaders can draw hope and inspiration from their example.
Take Kimmeridge Energy for example. In 2020, Kimmeridge Energy launched a dedicated activist fund focused on reforming the public E&P sector, releasing a series of white papers throughout the year which set out their key pillars for reform and explained how they intend to go about doing this. Those pillars are as follows:
- Operating Model
Materially reducing re-investment rates to a maximum of 70% of cash flow while providing visibility into returning 100% of the enterprise value in cash over the next 10 years.
Promoting alignment and making sure management teams are properly incentivised to deliver value to shareholders and evolve their business model to remain competitive with other industries.
- Environmental Performance
Companies need to address their own environmental deficiencies, including the need to: stop flaring; stop venting methane into the atmosphere; materially reduce the emissions intensity while providing long-term targets that are aligned with the Paris Agreement.
On the other side of the spectrum, Diversified Gas & Oil have been paving the way for other E&P companies seeking inspiration. At a time when the industry’s capital availability was at historical lows, Diversified Gas & Oil have been able to successfully raise capital as they were promoted onto the Main Market of the London Stock Exchange. This success has been predicated on good stewardship, stable cash flow, value-driven investments and rewarding investor confidence with a healthy dividend.
Therefore, Oil & Gas companies and their investors need to come together to agree on their long term targets and create a roadmap to success. Investors need to be clear about their expectations and incentivise companies to do the right thing, while Oil & Gas companies must be prepared to evolve if they are to thrive long into the future. Only then will they be able to accrue a better valuation. Only then will that spur others to follow…
Who will be prepared to lead the way?